It is widely expected that the Office of Budget Responsibility (OBR) will state that the UK is not on track to hit Chancellor Rachel Reeves' fiscal rules. It seems more likely than not that the margin of error will be substantial. But why is fiscal credibility so essential and what choices does she have?

The UK national debt is just over 100% of GDP. This is an unprecedented level of debt for the UK in peacetime. From the 1970s to the financial crisis under Gordon Brown in the mid-2000s, the UK national debt varied between around 25% and 40%. Oil crises came and went, we had power cuts and the three-day working week, inflation went above 25%, we had the winter of discontent, Britain went to the IMF to seek a bail out, unemployment tripled to over 3 million – a level at which democracy was felt to be in danger – and yet, through all that, the national debt stayed within a relatively narrow range. 

This matters because when the national debt is below 40% of GDP it is easy for a country to borrow money. There are always some people – notably pension funds – who will want to hold low risk, low return domestic assets. This will be true for all countries. Supply and demand matters – if the supply of gilts is low, the price will be low as well. 

Once the national debt is large, however, the government has to compete for money that is genuinely footloose. Money that could be invested in other asset classes, or in other countries. As one financier said to me – there is a wall of money. If you offer the right return, it will come to you. And if you don’t, it will leave you. A national debt of 100% – accrued overwhelmingly under the last Labour and the Conservative-Liberal Democrat coalition government – really does put the UK at the mercy of the money markets. 

This is compounded by the “term structure” of the national debt. If it was the case that no existing UK bonds matured this year, the UK government would only have to borrow to the extent of new borrowing. This is not the case. In 2025-26, £176 billion of UK gilts will mature, and the UK government will have to borrow that amount, as well borrowing to cover this year’s deficit. In total, the UK government will have to raise £5 billion a week from the markets. 

This means that the credibility of the UK fiscal position matters greatly.

If the markets view the UK government as a risky proposition, they will require an interest rate premium in order to hold UK government debt. When the debt is 100% of GDP, the cost of even a small rise in interest rates is meaningful. Less credibility means more debt interest which means higher taxes and/or worse public services. That is why the Chancellor is right to care deeply about credibility. 

Credibility can be defined but not measured. It means that the markets believe you will take tough decisions as and when they are necessary. 

In this view, the most fiscally credible Prime Minister and Chancellor combination in recent times was Margaret Thatcher and Geoffrey Howe. In 1979 the incoming Conservative government raised the rate of VAT from 8% and 12.5% (there were two rates previously) to 15%. They raised interest rates repeatedly, causing a massive recession. There were protests and riots. Through all of this, the government was not, in the Prime Minister’s phrase, “for turning”. 

At the opposite extreme, the Truss government proved that markets take a dim view of politicians who have no sense of fiscal probity. The yield on ten-year government bonds rose from around 2% in the summer before Liz Truss was Prime Minister, to over 4% by the time her government collapsed. The period in which the markets realised that she might become Prime Minister, and might have no fiscal discipline, and then saw that that was indeed the case, saw a massive, unprecedented rise in UK borrowing costs. 

Although 2% to 4% is unprecedented, we should not think that we are the only country assessed by the bond markets. Germany has recently seen interest rates on ten-year government bonds rise from 2.4% to 2.8%, after Merz announced a higher level of borrowing. The cost to Germany of a 0.4% rise in interest rates is lower than it would be in the UK, however, because the German national debt is only 63% of GDP. 

The Chancellor has chosen to gain credibility by tying herself to a particular set of rules. Whatever the merits of those exact rules, she is right to believe that the underlying issue of credibility matters. 

The Chancellor’s fiscal rules are that the government will borrow only for investment and that public sector net financial liabilities will fall as a share of national income in 2029-30. The autumn 2024 Budget decisions and forecast gave her £9.9 billion headroom against the former and £15.7 billion against the latter.

At one level, it is very odd that the OBR are reporting at this time. The Chancellor has decided, sensibly in the view of most commentators, that there should only be one fiscal event a year. It is at least arguable that it would be sensible to have the OBR report only once a year, at the same time. The law, however, requires at least two OBR reports a year, and so we will get one now. 

As many have noted, the Budget margins were exceptionally small, and changes in the economic and fiscal position mean that the OBR is expected to announce that the Chancellor is no longer on course to meet at least one of those targets.

The OBR’s judgement is just that: a judgement. It is not a fact. It is not a case that the markets will judge the Chancellor dramatically differently if she meets or fails to meet them by £1. Still, assuming that the OBR says that the Chancellor is off course by billions, a reaction will be necessary in order to preserve credibility.

The Chancellor has many options. We outline six here. We start with the smallest possible action, moving to more substantive measures later in the list.

1. Do nothing, at least for now

The Chancellor could note the OBR report, repeat her (sensible) position that there will only be one fiscal event and that she will deal with the position in the autumn, in her next Budget. This would be a “nothing to see here, move along” approach. This might be credible if the OBR judges that the government is still almost on track. The problem with this approach is that not being on track – especially by a meaningful amount – is something to see, both politically, economically and financially. Politically, her opponents will be able to say that she is off-track, and will demand to know what taxes she plans to raise in the autumn. If the narrative takes hold that taxes will rise in the autumn, the public are likely to engage in more precautionary saving. That will lower economic activity and, with it, lower tax receipts – making the problem worse. The political problem will create an economic one. It is also possible that the markets will worry that the Chancellor has said that she will close the fiscal gap in the autumn, but she is not willing to say how – opening up the chance that she won’t.

2. Talk about the supply side, now

Relatedly, the Chancellor could say that she accepts the OBR’s position, but states that the supply side measures that the government have taken – notably on planning – will bear fruit by the autumn. She would then say that if they don’t, she would of course take necessary measures in the autumn, but that she does not expect that this will be necessary. The OBR might well confirm that they have not given credit to the government for these reforms as yet, and so the cracks would be plastered over. As well as planning, the OBR will always count immigration as growth enhancing – the government could, for example, announce a plan to allow in the brightest and the best from US universities, faculty and students. (Although this might annoy Trump, however.)

3. Announce spending cuts, later

It would not be credible to announce spending cuts at the end of the current spending review period. That will be just before an election and would clearly show an unwillingness to make tough decisions. OBR Chair Richard Hughes was scathing when Jeremy Hunt did exactly that – “some people have referred to that [Hunt’s fiscal numbers] as a work of fiction. I think that's probably generous given that someone's bothered to write a work of fiction, whereas the government hasn't even bothered to write down what its departmental spending plans are underpinning the plans for public services.”

4. Announce spending cuts, now

The Budget deficit is the difference between tax revenues and government spending and the three-year comprehensive spending review is upon us. The Chancellor could either announce specific spending cuts immediately, or announce that the overall total will be lower than people are expecting. Given the closeness of the spending review, both would be credible. That said, stating the actual specific cuts now and getting backing from the Labour party for them would be most credible of all.

5. Announce a tax rise now, for much later

The obvious tax rise to announce would be a further freeze in the income tax thresholds. This is usually popular with HM Treasury insiders, who have a theological belief that it is better for more people to pay income tax, so we can be certain that the Chancellor will be getting this advice. The polling side will also note that this is far less damaging politically than raising rates. The aim of announcing a delayed tax rise is to reassure markets, without reducing short term economic activity. That said, the Chancellor has said repeatedly that she is not a tax and spend Chancellor, so although fiscally credible, this might have issues of personal credibility for the Chancellor.

6. Change the fiscal rules

It is hard to imagine the Chancellor doing this, for good reason. Credibility matters, and whatever the merit of the exact rules, changing the fiscal rules as soon as they prove awkward is not sensible. We would expect an immediate reaction from the financial markets – which is why this is surely not going to happen. 

The Chancellor has no good options this week. Upsetting the markets would cost the country money in terms of higher debt interest payments. But not upsetting the markets will upset her colleagues in parliament, Labour party members and supporters. To govern, as they say, is to choose, and sometimes none of the choices are appealing.