September 6, 2019

News in Charts: The economic impact of a Labour government

by Fathom Consulting.

With the turmoil in British politics reaching new heights this week, what happens next is anyone’s guess. One of the many possibilities — however unlikely — is an outright majority for a Corbyn-led Labour government. While the impact on the real economy may take months or even years to be seen, Fathom Consulting believes that financial markets will react immediately.

Having made every effort to distance itself from Tony Blair’s New Labour, today’s manifestation of the Labour Party looks increasingly like the old one. One that oversaw two domestically driven financial crises in the second half of the 20th century.

The Wilson administrations of 1964–70 experienced large and persistent ‘twin deficits’ (a government deficit combined with a deficit on the current account of the Balance of Payments) which precipitated the 14% devaluation of sterling within the Bretton-Woods system of fixed exchange rates in 1967. The Wilson–Callaghan government of 1974–79 saw the public sector deficit, inflation, gilt yields and corporate spreads all reach peace-time highs, while growth stagnated and the value of sterling (post Bretton-Woods) reached a record low.

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Labour had a poor track record until the Blair government of 1997, the only Labour government in recent history with a reputation for economic competence. In opposition, Tony Blair spent years putting serious efforts into maintaining investor confidence. The Blair government gave the Bank of England operational independence on its first day in office and committed to adhering to the Conservatives’ spending plans for its first term. Markets were sanguine.

It is difficult to determine whether the market reactions were to actual or perceived incompetence. What we do know, however, is that a mixture of market-friendly narrative ahead of the 1997 election and self-denying ordinances thereafter meant that the government was not irrevocably blown off course by an adverse market reaction, as its predecessors had been.

Mr Corbyn’s Labour Party has not engaged in creating a market-friendly narrative about what a Labour government would look like, and has instead dabbled in market-hostile narratives. Investors are worried, perhaps rightly, that Labour will follow through with some of the various policy ideas that have been floated, such as:

  • Modern Monetary Theory
  • Revoking the operational independence of the Bank of England
  • Taking direct control of the private banks that are partially or wholly owned by the public sector
  • Imposing capital controls to prevent a run on the pound
  • Redistributing a proportion of shares in large private companies to ‘the workers’ and insisting on worker representation on the boards of those companies

It is therefore likely that investors will respond to a new Labour government in the way they used to. Fathom Consulting uses the experience of 1974–78 as a gauge to answer the question of what that might that look like.

  • Sterling fell by 15% in real effective terms ahead of and during the Wilson–Callaghan government. (see chart above)
  • Gilt yields rocketed by 400 basis points on the election of the Wilson–Callaghan government, controlling for all the other impacts on the gilt yield, arising from inflation, growth and short rates. The chart below measures this ‘risk premium shock’

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  • Sterling-denominated risk spreads rose sharply, with the investment-grade corporate spread in particular reaching an all-time high (since surpassed) of more than double its post-war average.

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In Fathom’s central Corbyn scenario, these market impacts are replicated. Sterling depreciates by 15%, inflation increases by 2 percentage points, the level of GDP falls by 4% by 2023 and gilt yields spike by 250 basis points, all relative to the baseline forecast. These outcomes trigger an outright recession in 2021 and bring about the return of stagflation.

Such a government is unlikely to survive very long. So, the likeliest outcome in this world is a short-lived government with a weak mandate, destroyed by a market response that it has actively encouraged while in opposition.

However, Mr Corbyn and his advisers are aware of this. They have plans to prevent that set of outcomes — capital controls, control of monetary policy, and the rest. Part of their problem, though, is that the damage might be done before they take office, as markets judge the likelihood of that eventuality to be increasing. By the time Mr Corbyn walks into Number 10, if he ever does, it might already be too late.

The charts in this post have been created using Chartbook on Datastream. The Chartbook, created and maintained by Fathom Consulting, is a library of over 9000 charts, containing up-to-date macro and financial market data for over 170 countries. Whether it is a particular topic, country or variable you are interested in charting, the Chartbook has everything you need. Simply type search ‘cbook’ into your Eikon search bar or click the ‘Chartbook’ tab on Datastream to find out more.

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