The significance of productivity for the Budget
You know, you just KNOW, that when the Guardian starts promoting the idea (supported by Rachel Reeves’ former chief economic adviser and the left-leaning Resolution Foundation) that Britain’s productivity is picking up, that the battle is on over the productivity assumptions that will underpin the Budget’s fiscal and economic projections.

Higher productivity equals more growth, more tax revenue and less pressure on the Chancellor. Each 0.1 percentage point change in the productivity growth assumption means a £ 10bn-a-year effect on the fiscal deficit by the end of the forecast period.

The OBR has invariably been too optimistic on productivity and in March reduced its medium-term estimate from 1.3% a year to 1%. 1% would nonetheless be an acceleration from the 0.7% a year it assumes for this year. Until there is more convincing evidence, 0.7% a year - the increase recorded y/ y in 2026Q2 - is my central estimate over the medium term.

What the figures show.
In theory, measuring productivity is easy – it’s output divided by labour input. The problem is that the UK employment data have been a mess. The historically most important source of data, the Labor Force Survey, has been beset by falling reporting rates and other issues. The ONS now relies more on real-time information (RTI) from tax returns to record the number of heads, though hours per head still come from the LFS, which makes the now-preferred measure a bit of a dog’s breakfast. Self-employment numbers also derive from the LFS.

Source: ONS

Since 2024, the ONS has improved the LFS, finding more workers that were previously underreported. So, the LFS-based measure has given too dark a picture of productivity growth in the last couple of years because the LFS has overstated employment growth.

The LFS-based measure shows productivity growth of -0.2% per year over the last two years. The RTI measure shows 1.1% per year, which will be used to justify sticking with, or even revising up, the OBR’s productivity estimate.

The problem is that the two-year comparison partly reflects a recovery from a period when productivity fell, so it probably overstates the trend. Moreover, the figures over the last year do not support sustained faster productivity growth. Productivity fell 0.8% q/q in the second quarter of 2025 and was only 0.7% higher than in 2025Q2.

Proponents of the UK trend-productivity-is-picking-up story don’t offer a convincing explanation, with Resolution promoting the idea of a pick-up in Total Factor Productivity (TFP. However, because TFP is a residual, it’s not a convincing rationale. To the extent that the government’s job-destruction measures, such as the increase in employers’ national insurance rates, tighter labour market regulation and increases in the minimum wage, are responsible for putting low-productivity firms out of p business and reducing low-skilled workers’ ability to find jobs, it is no reason to celebrate,

What would constitute a convincing faster productivity growth story?

If the UK were indeed seeing a sustained productivity revival, we would expect to see

• Faster GDP growth

• Faster productivity growth

• Lower cost and price inflation

• Stable or rising employment

Instead, we have seen

• Continued weak GDP growth, up only 1.2% y/y in 2026Q2

• Productivity growth was only 0.7% y/y in 2026Q2, with output per hour down on the quarter

• Employment is falling, down 86,000 y/y in 2026Q2 on the preferred ONS measure

• Unit labour costs were up 5.1% y/y in 2026Q1

These developments don't reasonably support a story of accelerating productivity, faster GDP growth, and robust employment growth that would underpin a healthy set of fiscal projections. But guess what, that’s exactly what is being promoted, and I would expect this tosh to be a key bulwark of the Budget.

Conclusion
The case for a pick-up in trend UK productivity is extremely flimsy. It rests on wishful thinking and spin linked to promoting a rosier-than-justified fiscal picture. No policy steps have been taken that would promote faster productivity growth. In fact, many policy initiatives, including expanding the share of the public sector, seem likely to dampen productivity growth. The UK’s problem is deep-seated. While high-tech sectors have seen good productivity growth, the frontier sectors are far from the whole economy. Since 2019, sectors accounting for a little more than half the economy have contributed negatively to the pathetic 4.6% increase in UK output per hour. Solving the problem will require radical measures that the current government is unlikely to take.

Figure 2: Decomposition of growth of output per hour worked, hours worked and gross value added (GVA), Quarter 1 (Jan to Mar) 2026 compared with 2019 average, percentage change, UK

Source:ONS

The Budget
As ever, the Budget will be based on over-optimistic productivity assumptions, guaranteeing a succession of budgetary overruns, stop-gap measures, and an increasing tax burden.

Better spring, lousy summer for the labour market
The Indeed data tell us that the period of better labour market data in the spring is over. With squeezed incomes, the higher minimum wage, higher energy and other costs for employers, and NICs, the demand for labour is falling.

The services PMI reports hiring freezes, and a significant reduction in hiring.

AI isn’t helping
AI is adding to the fall in vacancies. The services PMI reports AI is being used to cut costs to combat a big squeeze on profits. The Institute of Student Employers reports reduced demand for graduates and a rebalancing towards apprenticeships.

Given sticky wages, the timing of wage settlements (the peak period is past), and the influence of the minimum wage, the adjustment is going to be in labor volumes, not slower wage growth.

The Bank is in a dilemma
This is a recipe trapping the Bank of England between a rock and a hard place. Inflation is too high, and there is a strong likelihood of second-round effects - at least relative to their forecast. But demand is falling, and the labor market prospects are grim.

Tightening policy will exacerbate the downturn, but given a flat UK Phillips curve, the inflation benefit of a slacker economy is small, while it would trash the public finances.

Bank prioritising growth
The signs of an imminent sharply deteriorating labor market are not a recipe for the MPC to grow a backbone and seriously tackle inflation. They will resist higher rates until it is impossible to resist further, and then change by the minimum possible amount.

That’s exactly what Andrew Bailey’s recent comments suggest: “Given the context of softness in the real economy and uncertainty around the scale and duration of the shock, tolerating temporarily above-target inflation to provide some support for the real economy is an appropriate way to approach the trade-off [between inflation and activity].” “But that tolerance would weaken if signs of second-round effects begin to emerge.”

By which time, obviously, it would be too late. We know how this movie ends, as it’s a remake of 2021/22.

The challenge is to create wealth
The language from many in the government, including Chancellor Reeves, is familiar: "those with the broadest shoulders should pay their fair share", "the wealthiest should pay the most", or "the wealthy must shoulder the burden". The assumption underlying each statement is that prosperity already exists, and the challenge is how to redistribute it. Underlying that is the presumption that the wealthy haven’t earned their wealth and are undeserving.

We’ve seen this movie before
There are echoes here of Labor Chancellor Denis Healey, who is widely quoted as saying he would “squeeze the rich until the pips squeak.” And he did. By the late 1970s, Britain taxed investment income at up to 98%, while corporation tax stood at 52%. For a top-rate investor receiving distributed profits, the combined tax burden could approach 99% of the company's original profit. The scars still linger; the culture of saving, investing, and accumulating wealth was permanently damaged.

It is hard to think of a clearer illustration than the 1970s of an era in which policymakers viewed capital less as something to attract and nurture than as a parasitic income source to harvest. We are heading back in that direction.

The AI revolution poses a different question
In an economy where growth increasingly depends on a relatively small number of entrepreneurs, engineers, investors, and innovators, the more important question is how to create more wealth creators in the first place. A tax system designed primarily around dividing an existing pie is extraordinarily ill-suited to an era in which economic success depends on expanding it. Increasingly, Britain’s tax system is incapable of supporting the type of economy we claim to want.

Politicians regularly tell us that the future lies in technology, innovation, entrepreneurship, and artificial intelligence. Yet the tax system’s structure leads to an inexorable conclusion that policy is increasingly focused on extracting revenue from those activities rather than encouraging them.

This time IS different
This matters because AI is not simply another industrial technology. The wealth it creates is likely to look very different from the wealth created during the post-war decades.

A steel plant employs thousands of workers and generates taxable wages. An AI company may employ only a few hundred highly skilled engineers while generating enormous profits and capital gains. The rewards accrue disproportionately to founders, investors, and employees with equity stakes. That fundamentally changes the tax calculus.

For much of the twentieth century, governments could focus primarily on creating labour income. In the AI era, income arising from capital gains, stock options, business ownership, and wealth may become just as important - it must be encouraged, not rebuffed and incentivized to relocate offshore.

Capital is undervalued in the UK
Unfortunately, Britain appears to be moving in the opposite direction. Higher effective marginal income tax rates, fiscal drag, repeated reductions in capital gains tax advantages, and growing uncertainty surrounding wealth and inheritance taxation all reduce the rewards to successful risk-taking. Concentrating on keeping the tax burden down for “working people” shows an underappreciation of the role of capital in production and income creation. When labor is a complement to capital, when capital does well, and investment rises, workers do well through higher employment and wages.

This is not “trickle-down” economics
The objection that this amounts to "trickle-down economics" misunderstands the argument. Trickle-down suggests that enriching the wealthy is an end in itself and that everyone else will somehow benefit indirectly. That is not the claim. The claim is that economies grow when they encourage investment, risk-taking, innovation, and business formation. The rewards earned by successful entrepreneurs are not a policy objective; they are often the mechanism by which societies induce people to take risks, allocate capital, and develop new products. The relevant question is not whether founders become rich. It is whether fewer firms are created, scaled, and financed when the rewards for success are reduced.

Compare and contrast the UK and the US
The comparison with the United States is instructive. America possesses deeper venture capital markets, more developed IPO markets, and a culture that celebrates entrepreneurial success. It also generally allows innovators to keep a larger share of the upside when their businesses succeed. This is not simply a question of fairness. It is a question of economic incentives.

Where would you establish your AI business?
If you were an entrepreneur planning to build the next Nvidia, OpenAI, or Meta, where would you rather locate? Where would you rather raise capital? Where would investors prefer to deploy their money? t the UK.

High risk demands high rewards
These questions become even more important because AI investment is unusually risky. Much of it involves intangible assets, rapidly depreciating hardware, and uncertain future revenues. Traditional bank lending is often poorly suited to such projects. They depend instead on venture capital, private equity, and public equity markets. The countries that combine deep pools of risk capital with attractive tax treatment are likely to attract a disproportionate share of investment. The riskiness of the investments means that many projects will fail, but there will be significant rewards for the winners. High UK taxes mean the probability-weighted return on AI investment is substantially lower than in the US.

Neither are AI, entrepreneurs, and skilled workers tied to a particular location. AI is incredibly mobile. Why incentivise it to locate elsewhere?

Britain’s challenge is therefore broader than simply encouraging AI research or adoption. Partly due to the tax system, much of the value-added by AI will accrue as profits in the US, not the UK. Will that benefit or harm UK workers? The UK already produces world-class scientists, engineers, and entrepreneurs. The problem is retaining the businesses they create, encouraging them to scale here, and ensuring that the economic benefits accrue domestically.

The government is presenting a false choice
The debate in Westminster is often framed as a choice between taxing wealth and protecting public services. That is the wrong question. The real question is whether Britain is creating the conditions for future wealth creation at all.

The tax system is not fit for the AI purpose
A tax system designed around the redistribution of existing wealth will prove poorly suited to an economy in which growth increasingly depends on encouraging the creation of new wealth. AI is forcing many assumptions about work, investment, and productivity to be reconsidered. It may also force us to reconsider the tax system itself.

The danger is that Britain enters the AI age with policies totally unsuited to the world that is coming.

Good at inventing, poor at reaping the rewards
Britain's economic strategy sometimes appears to be: invent it here, tax it heavily, and watch it scale elsewhere. We celebrate our scientists, researchers, and entrepreneurs, then express surprise when the companies they create raise capital in America, list on Nasdaq, and generate jobs and wealth abroad. The conventional explanation is that the UK lacks deep capital markets. That is true. But incentives matter too. Countries that allow founders, investors, and skilled employees to retain more of the rewards from success are likely to attract more of the scaling, implementation, and wealth creation that follow innovation. Increasingly, that’s not the UK.

McFadden has hit the nail on the head. The UK is constantly scrambling for tax revenue to match the inexorable rise of not only an ageing population’s need for greater pension and NHS outlays, but also a rising tide of benefit spending. Given the heavy reliance of public finances on work-related taxes, those taxes will continue to rise to pay the swelling bills.

Disability benefits rising
Attempts by the Starmer government to tackle the mushrooming of benefit payments in mid-2025 were torpedoed by backbench Labour MPs, costing about £5bn a year. The OBR forecasts that spending on disability benefits will rise by almost 60% between 2024/25 and 2030/31, from £41.4bn to £65.5bn. Not all disabled people receive benefits, and many remain in employment. Nevertheless, the rapid increase in disability-related claims has become a major driver of welfare spending.

Chart 1: A quarter of UK working-age adults are disabled

Source: Family Resources Survey

Unstoppable rising pension spending
Pension spending is escalating not only because of the rising number of retirees but also because of the “triple lock.” Under that provision, pensions will rise by the maximum of the inflation rate, the earnings growth rate, and 2.5%. The triple lock is expensive even in normal times. Following an inflation shock, it becomes exceptionally costly because pensions benefit first from higher inflation and then from the subsequent catch-up in earnings growth.

Let’s take a simple example in which inflation is initially at the 2% target and wages increase by the previous year’s inflation rate plus the productivity growth rate. If inflation accelerates to 6% for one year, then over the four-year period, prices rise by 12.5%, wages by 16.9%, and pensions by 20.3%. That’s exactly the sort of shock we had post-COVID and are experiencing now.

There are almost 13 million pensioners in the UK, 19% of the total population. That’s over a quarter of those registered to vote. Older people have a high turnout rate. Given Britain’s fragmented party loyalties, the chances of any party proposing dumping the triple-lock and alienating this group look remote.

Chart 2: Voter turnout by age, 2024

Strong upward pressure on NHS spending
Similarly, use of the NHS rises with age, with the over-60s accounting for over 40% of the NHS budget, which makes NHS spending restraint politically difficult to achieve. Healthcare suffers from what economists call Baumol's cost disease. Productivity growth is often slower than in manufacturing and many services, yet wages must broadly keep pace with the rest of the economy. As a result, the cost of providing healthcare tends to rise faster than economy-wide inflation. Between 2020 and 2025, the government health spending deflator rose roughly 10 percentage points more than the GDP deflator. So, either the quality of health services must decline, NHS staff must see a relative wage decline, or the share of the nation’s economic resources devoted to the NHS must rise, or some combination of the three.

Cutting Spending is off-limits, so taxes must rise
If spending control is off-limits, increased taxes are the only alternative for reducing the public sector deficit. Even without a deficit reduction, however, higher taxes look inevitable given the virtually irresistible upward pressures on social spending.

Where the money comes from
Income Tax and National Insurance together account for 48.9% of all National Accounts tax receipts in 2026/27, according to the OBR. up by about three percentage points from 2023/24, the fiscal year before Labour took over the reins of government.

Chart 3: Almost half of total taxes come from taxing incomes (2026/27).

Source: OBR

Between 2024/25 and 2030/31, the government plans to increase the tax take as a share of GDP by a mind-boggling 4 percentage points of GDP.
Of this, 1.5 pp is income tax (much of it due to fiscal drag arising from the freezing of allowances), 1.0pp is NICs, and 0.9 pp is taxes on capital, an increase of 64%! “Sin taxes” on alcohol, tobacco, and fuel are set to shrink as a share of GDP, so good news for drunk drivers who smoke, if for no one else.

Chart 4: Nearly three-quarters of the increase in tax revenues comes from Income Tax, National Insurance, and Capital Taxes.

Source: OBR

Where the money goes

Chart 5: Half of spending is on health and social protection

Source: HMT

The largest slug of spending is on “social protection,” of which about half is the state pension, a quarter is Universal Credit and legacy benefits, and a seventh is the rising share of disability benefits.

Chart 6: Pensions are half of “Social Protection”

Source: HMT

Some unpleasant fiscal arithmetic
The dynamics of the government’s fiscal problem are grim. First, pension spending is set to rise faster than nominal GDP (and therefore the tax base) due to an ageing population and the triple-lock. NHS spending is set to rise faster than GDP due to an ageing population, low productivity growth, and an adverse relative price effect. The trend in disability points to the number of people claiming Personal Independence Payments (PIPs) continuing to climb.

With defence spending slated to increase its share of GDP and the government’s budget deficit already excessive, fiscal pressures are ever-present in the UK.

A harsh reality
The uncomfortable reality is that Britain's fiscal debate is increasingly about demographics rather than ideology. We must expect higher pension and healthcare spending and, under current policies, rising welfare spending. Electoral considerations make the first two toxic to deal with, and Labour Party politics rules out tackling the third. The only fiscal deficit off-ramp is higher taxes.

Politicians may argue over which taxes to raise, but the arithmetic is becoming harder to escape. Almost half of tax revenues already come from Income Tax and National Insurance, and most of the projected increase in revenues comes from those same sources. Resorting to smaller tax categories would require massive rate increases to deliver similar revenue gains, as we see with capital taxes. In practice, Britain is taxing work ever more heavily to finance pensions, benefits, and healthcare. Until the growth of those spending commitments is brought under control, taxes will continue their march to record levels.

But before prescribing a cure, it is worth asking a simple question.

Does Britain actually look like a neoliberal country?

The neoliberal model is one of low taxes, limited government, strong property rights, flexible labor markets, relatively light regulation, and a presumption that individuals and businesses are free to act unless there is a compelling reason to stop them.

Yet modern Britain increasingly resembles the opposite. The disappearance of neoliberalism has not been dramatic. British neoliberalism has been like the slowly boiled frog - people haven't realized what has been happening. Certainly, Burnham fails to appreciate the reality.

The swollen public sector

Public borrowing hasn’t been below 4% of GDP since 2019/20. Taxes are at their highest sustained level since the Second World War. Public spending exceeds 40 per cent of GDP. Government debt is close to 100 per cent of GDP. The state regulates labor markets, housing markets, energy markets, financial markets, and increasingly even consumer behavior.

Britain's tax system contains one of the most notorious tax traps in the developed world. Between £100,000 and £125,140, the withdrawal of the personal allowance creates a headline marginal income tax rate of 60 per cent. Once National Insurance, student loan repayments, and benefit withdrawals are taken into account, some workers face effective marginal deduction rates exceeding 70 percent. This is not what most people imagine when they hear the phrase "low-tax neoliberalism."

If this is neoliberalism, what exactly would socialism look like?

Labour markets: increasingly governed by the state

One of the defining features of a neoliberal economy is a flexible labour market in which employers and employees are largely free to negotiate the terms on which they work.

Britain has been moving steadily in the opposite direction.

The National Living Wage has risen from around half median earnings fifteen years ago to roughly two-thirds today. Restrictions on zero-hours contracts are expanding. Employment rights are being strengthened. Dismissal procedures are becoming longer and more complex. Employers face increasing obligations regarding consultation, discrimination, health and safety, parental leave, workplace monitoring, and employee wellbeing.

Even dealing with persistent absenteeism or poor performance can take months of formal procedures, meetings, reviews, and appeals.

This is not a criticism of every individual measure. Some may be justified. But it is difficult to describe an economy in which the government increasingly determines the terms and conditions of employment as an example of neoliberal deregulation.

If this is neoliberalism, what exactly would socialism look like?

Welfare: the ever-growing state

A second characteristic of neoliberalism is a limited state. Yet Britain has moved steadily towards a larger and more expensive system of income support.

Millions of working-age adults now receive some form of welfare payment. Four million receive Universal Credit without a requirement to look for work. Long-term sickness claims have risen sharply since the pandemic, and Britain spends more on health and disability-related benefits than on defense. Housing support remains extensive. State pension spending rises year after year under the triple lock.

The British state is not retreating from economic life; it is becoming increasingly embedded within it.

If this is neoliberalism, what exactly would socialism look like?

Property rights: ownership without control

Neoliberalism places great emphasis on property rights.

Yet landlords increasingly face restrictions on how they use their own property. The Renters’ Rights legislation reduces the ability to recover possession. Energy-efficiency requirements continue to expand. Short-term letting restrictions are becoming more common. Landlords face licensing schemes, inspections, compliance requirements, and increasing legal obligations.

Homeowners face similar constraints. Governments increasingly dictate which forms of heating may be installed, how households dry their washing, how they heat their homes, which environmental standards must be met, and which modifications require approval.

Ownership increasingly means holding legal title to an asset while government determines many aspects of how it may be used.

If this is neoliberalism, what exactly would socialism look like?

Consumer choice under supervision

Modern governments increasingly regulate personal behaviour.

Advertising restrictions govern tobacco, alcohol and food. Sugar taxes seek to influence purchasing decisions. Environmental regulations determine which appliances can be sold. Petrol and diesel vehicles are being phased out. Gas boilers are being discouraged. The government proposes banning future generations from purchasing cigarettes altogether.

Again, one may support or oppose any individual measure.

But it is difficult to reconcile a growing willingness to regulate private choices with the claim that Britain remains in the grip of a radical free-market ideology.

If this is neoliberalism, what exactly would socialism look like?

COVID: Inured to the intrusive state

Covid exposed the hollowness of the claim that Britain is somehow governed by neoliberal dogma. During the pandemic, the state told businesses when they could open, whom they could serve, where citizens could travel, how many people could meet together, and, in some cases, whether individuals could leave their own homes. The government paid the wages of millions of private-sector workers through furlough and effectively took responsibility for large parts of the economy. Whatever lessons one draws from that period, it is difficult to reconcile such extraordinary state power with the notion that Britain suffers from an excessive faith in markets and limited government. The acceptance of those restrictions illustrates how inured the British have become to an intrusive state

If this is neoliberalism, what exactly would socialism look like?

Free speech is hate speech

A classical liberal society generally assumes that adults are free to say things that others may find offensive, objectionable or even deeply unpleasant, provided they are not threatening violence or inciting others to commit it. Britain has increasingly moved towards a different model, one in which the state, regulators, employers and online platforms play a growing role in determining which opinions are acceptable and which are not. The trend is towards managing speech rather than merely policing threats. A country that increasingly regulates what people may say is difficult to reconcile with the caricature of a society supposedly dominated by neoliberal ideas about individual freedom and limited government.

Energy: perhaps the least neoliberal sector of all

Britain’s energy market is among the most heavily managed parts of the economy.

Prices are capped. Production is taxed through windfall levies. Investment is shaped by subsidies, mandates, and carbon pricing. Governments decide which technologies should expand and which should disappear. Electricity prices are heavily influenced by political decisions and regulatory structures.

The idea that Britain’s energy sector operates as some kind of free-market paradise would come as a surprise to almost anyone involved in it.

If this is neoliberalism, what exactly would socialism look like?

The planning system: where neoliberalism goes to die

Strong evidence against Burnham’s argument shows in Britain’s inability to build things.

The defining principle of a liberal economy is that people are generally free to act unless specifically prohibited. Britain increasingly operates on the opposite principle, where people are prohibited from acting unless specifically permitted.

Want to build a house? Obtain planning permission, try to avoid zoning restrictions introduced 70 years ago. Want to build a reservoir? Prepare for years of consultation. Want to expand an airport? Expect public inquiries, legal challenges, and ministerial intervention; prepare to wait for decades. Want to build a tunnel under the Thames? Produce hundreds of thousands of pages of documents, wait decades, spend hundreds of millions. Want to add 18 miles of dual carriageway to a trunk road? Wait 15 years for completion.

Want to build energy infrastructure? Prepare for a maze of regulators, environmental assessments, and statutory consultees.

Britain has developed a system in which almost every interest group possesses some form of veto. The result is visible everywhere: housing shortages, infrastructure delays, energy constraints and chronically slow delivery.

The famous £100mn HS2 bat tunnel has become a symbol of the problem. A country that struggles to build homes, roads, reservoirs, and railways somehow finds itself spending extraordinary sums navigating environmental requirements and legal processes. The issue is not whether bats matter. The issue is whether Britain has created a system so complex that economic development has become the exception rather than the rule.

A genuinely neoliberal system begins with the presumption of liberty. Modern Britain increasingly begins with the presumption of permission.

If this is neoliberalism, what exactly would socialism look like?

The real question

This brings us back to Burnham’s argument.

If government spending above 40 per cent of GDP is neoliberalism;

If continued engorged budget deficits are neoliberalism;

If taxes at post-war highs are neoliberalism;

If public debt near 100 per cent of GDP is neoliberalism;

If labour markets are increasingly regulated;

If welfare spending continues its relentless ascent;

If property owners face growing restrictions;

If energy markets are managed by mandates, subsidies, and regulations;

If torturous planning permissions are required before almost anything can be built;

If the state can constrin waht you say and dictate what you do’

If this is neoliberalism, what exactly would socialism look like?

Perhaps Britain’s problem is not too little government but the opposite. Perhaps it is that government is now everywhere. Britain has evolved into something stranger than either capitalism or socialism: a high-tax, high-spending, heavily regulated economy in which private ownership remains but state direction grows steadily more pervasive. Burnham would take that further - hopefully, that would be sufficiently dramatic to provoke a backlash because the British public hasn’t realized that they are the frog being slowly boiled to death.

The mystery is not why Britain struggles to get things done.

The mystery is why so many people still think this system is neoliberal.

Britain’s North Sea Policy Is Economically Illiterate

The UK’s policy of refusing to allow significant new North Sea oil and gas development is built on an idea that sounds morally compelling but collapses under scrutiny. The objective is straightforward enough: reduce UK fossil fuel production in the hope of lowering global emissions and accelerating the transition away from hydrocarbons.

The problem with this is that it confuses where energy is produced with how much energy is consumed. Those are not the same thing.

The government’s central argument is that new North Sea drilling will not materially reduce household energy bills because oil and gas prices are set on global markets. Ed Miliband repeats this frequently, and he is correct. Additional UK production is far too small relative to the global market to materially affect the world price of oil or gas. If it doesn’t affect the global price, it can’t affect global consumption of hydrocarbons, so what is the point? Do we seriously believe that this policy of consciously reducing UK GDP will make an iota of difference to the energy policies of China, the US, or India?

Production cuts do not equal lower consumption

The UK still consumes large quantities of oil and gas. The difference is that an increasing share now comes from abroad rather than from the UK’s North Sea sector. That matters enormously.

A chart of UK natural gas consumption, production, and imports shows that when domestic production falls, imports rise. What matters to the UK’s emissions is demand, not supply.

Britain has not stopped using hydrocarbons, but it has increasingly stopped producing them. This distinction matters because emissions are determined primarily by what the world consumes, not by whether hydrocarbons are extracted in Aberdeen, Norway, Qatar, or the United States.

If UK production disappears while UK consumption remains broadly similar, global production simply shifts elsewhere. The atmosphere does not care whether the LNG originated in the UK North Sea, the Norwegian North Sea, or the Gulf.

The meaningful way Britain reduces emissions is by reducing fossil fuel use:

• electrification,

• nuclear power,

• renewable deployment,

• efficiency improvements,

• better housing insulation,

• industrial innovation.

Reducing domestic production without materially reducing demand achieves very little environmentally while imposing high economic costs.

It seems bizarre that a government supposedly intent on reducing the UK’s emissions continues to hold road fuel duty (e.g., tax on petrol) flat. There has been no increase in the duty since 2011, when it accounted for 50% of petrol's price. Now it is about a third. Private car use accounts for the largest share of oil consumption in the UK, with goods vehicles and buses second.

Thus, the government’s policies have encouraged hydrocarbon demand but punished supply, turning the sensible policy structure on its head.

The ignored economic damage

The costs of the supply policy are not abstract. Lower North Sea production means:

• lower investment,

• fewer high-paying industrial jobs,

• lower UK profits (but higher profits abroad),

• weaker supply chains,

• reduced tax revenues,

• lower export earnings and a worse trade balance,

• weaker sterling, so higher prices for everything else

• and further erosion of Britain’s engineering and industrial base.

At a time when the UK already suffers from chronically weak productivity and poor investment, deliberately shrinking one of the country’s remaining globally competitive industrial sectors is extraordinary. Britain still needs oil and gas during the transition, so the practical effect is to offshore production rather than eliminate consumption.

This is not climate leadership; it is the geographical relocation of production accompanied by domestic economic self-harm.

The contradiction at the heart of policy

The strangest part of the current debate is that ministers simultaneously argue that UK production at the margin is too small to affect global prices or emissions, yet ending UK production is somehow an important climate policy.

Since British production is genuinely immaterial to global markets (especially if swing producers have a target price), then ending drilling cannot materially alter global emissions trajectories either. The policy, therefore, imposes substantial domestic economic costs for negligible global environmental gain.

Britain should instead focus relentlessly on reducing the carbon intensity of what it consumes, rather than imposing symbolic restrictions on what it produces.

A serious climate strategy would focus on:

• lowering demand for hydrocarbons,

• building abundant low-carbon electricity,

• reforming electricity pricing,

• accelerating nuclear and grid investment,

• and improving efficiency.

What Britain currently has is something different:
an economically damaging production policy delivering little measurable climate benefit.

It deserves to be abandoned. Drill, G B, drill.

Stuck in the literal sense: low growth, low productivity, collapsing public confidence, exhausted institutions, falling ambition, and a political class that increasingly behaves like a risk-management committee rather than a governing elite.

The striking thing about British politics is not that people disagree. It is that almost nobody with a realistic shot at power appears willing to attempt anything genuinely transformative.

That is why Andy Burnham matters.

Not because the markets would welcome him. Quite the opposite, the markets would probably be terrified. And that may be exactly why Britain needs him.

Why would the markets fear Burnham?

The fear would not be irrational. Investors, business leaders, and financial institutions would likely worry that a Burnham premiership could mean:

• Greater state intervention in the economy

• Stronger trade union influence

• Expanded public ownership or quasi-nationalisation

• More aggressive labour protections

• Higher public spending

• Higher taxation on wealth, property, and capital

• Constraints on private utilities and infrastructure operators

• Regional redistribution at the expense of London

• More borrowing for industrial strategy and infrastructure, though he says he will stick to the fiscal rules

• A weaker commitment to Treasury orthodoxy

• Greater political hostility toward large corporations and private equity

• Planning systems tilted toward political objectives rather than market outcomes

• An erosion of the post-1980s economic consensus

Markets generally prefer predictability, managerialism, and continuity. Starmer succeeded Corbyn as Labour leader precisely because he was boring and unthreatening - the bland leading the bland. He won a landslide victory in 2024, but Larry the Downing Street cat could have beaten the inept Conservatives after fourteen years in office. The market fears that Burnham is less beige than Starmer and so threatens change. He has convictions and an identifiable worldview. He has political instincts that are recognisably ideological rather than technocratic. Whether you agree with him or not, there is at least a sense that he wants to move the country somewhere. That alone now makes him unusual in British politics.

Whether he could actually achieve significant change is open for question. Many Labour MPs are fearful of being out of a job at the next election, the markets might vomit, and the electorate is fickle. Has Burnham got what it takes to push through a programme more radical than the manifesto Labour was elected on? If he hasn’t got those intentions, he’s wasting his time even contemplatingthe job - he would be just another manager of decline.

Britain’s deeper problem is timidity

The UK has spent years under the rule of administrators pretending to be leaders. Rishi Sunak governed like a spreadsheet. Keir Starmer often governs like a timid transactional lawyer trying to minimise legal exposure. Every decision carries a caveat; every reform is hedged. Every announcement is process-driven, stakeholder-reviewed, consultation-heavy, and carefully de-risked. Since there is a stagnant cake, reforms almsot invariably make some group worse off. And with a fickle electorate and diminished party loyalty, politicians hate to upset anyone - a recipe for immobility.

This is not entirely the fault of individual politicians. It is systemic. Britain’s institutions and voters increasingly punish boldness and reward caution; the cumulative effect has been disastrous. Starmer diagnosed the disease correctly: a “tepid bath of managed decline”. But he governs like a man wedged in his own tub, unable to break free.

The country has drifted into a culture of helpless decline that features the highest tax take since WWII, low growth, sub-par investment, pathetic productivity growth, overregulation, housing paralysis and nimbyism, excessive dependence on the state, tortuous planning processes, inadequate infrastructure, and a pervasive fear of disruption. Britain is a “can’t do” country, no longer attempting great things. It feels like a country trying to avoid making mistakes, or even making an effort; that is not a formula for renewal.

A third runway at Heathrow has been discussed for nearly a quarter of a century, since initial airport consultations in 2003. After decades of dithering and U-turns, the government formally adopted a plan targeting 2035. The sorely needed Defence Investment Plan (DIP) was initially expected to accompany the Strategic Defence Review (SDR) released in mid-2025. The DIP outlines the 10-year funding and capabilities strategy for the armed forces. It’s now overdue by nearly a year, as it remains in limbo and has yet to be officially published by Downing Street. Putin must be trembling - with laughter.

Radicalism is now unavoidable

The uncomfortable truth is that Britain’s problems are not solvable through incrementalism. The post-war consensus is exhausted; the Thatcherite reforms are exhausted; the Blairite model is exhausted. Yet Westminster - with a huge Labour majority - still behaves as though another carefully calibrated policy paper and another three regulatory agencies might somehow restore dynamism.

They won’t. What Britain arguably needs now is a genuine rupture — political, economic, and institutional. Burnham is feared because he appears capable of creating radical change, though not the one the markets want to see. His critics see danger in what he wants to do. They may well be right.

The case for taking the risk

One of the strangest features of modern British politics is that almost everyone agrees the country is failing, yet very few politicians behave as though the situation requires extraordinary action. The problem is that the Brits don’t seem to have the appetite to see through policy change that makes anyone worse off today for benefits tomorrow. The “no pain, no gain” mentality is totally lacking.

Since 2016, the UK has had six prime ministers.

1. David Cameron: May 2010 to July 2016

2. Theresa May: July 2016 to July 2019

3. Boris Johnson: July 2019 to September 2022

4. Liz Truss: September 2022 to October 2022

5. Rishi Sunak: October 2022 to July 2024

6. Keir Starmer: July 2024 to Present

With an average tenure of 17 months, it is no surprise that Prime Ministers are unwilling to take on any political pain to achieve lasting gains for the country. Regicide is the norm in the Labour and Conservative parties, and PMs clearly spend an excessive amount of time and emotional energy thinking about self-preservation.

Burnham at least appears willing to attempt something larger, though the Truss experiment showed the limits of political radicalism that fails to carry the Establishment and elites with it. Politically, the conditions are favourable for Burnham to take a radical approach.

Go large or go home

Labor took a drubbing in May’s local elections and will almost certainly lose power in the next General Election, scheduled to be held at the latest in 2029. What has Burnham got to lose? Labour won’t want to go through more turmoil after Starmer is made to walk the plank, so Burnham would be safe until 2029. The odds are that Labour will lose the next election and Burnham will then be out. More managerialism won’t win the day, but a radical program might give him a chance and would, in any case, allow him to achieve something he believes in. Go large or go home might well be his motto.

More ineffective government awaits in 2029

After the 2029 election, Britain will quite likely enter an era of coalitions, fragmented mandates, and permanent compromise politics. That would almost certainly produce drift, paralysis, endless negotiation, and more managerial centrism. In other words: more of what Britain has already had for decades. This may therefore be the last window for genuinely radical government for at least a decade.

What if Burnham fails?

Perhaps Burnham’s policies would end badly, and perhaps markets would revolt, with sterling plunging, borrowing costs rising, investment stalling, and Britain experiencing a full-scale economic crisis. But even that possibility raises an uncomfortable question:

Would a crisis be worse than stagnation?

Britain today resembles a motorist trapped on the M25, with no speed, no momentum, no off-ramp, no gas in the tank, and no clear destination; the country feels immobilised. Sometimes systems become so seized up that only a significant shock can force change and improvement. Britain is already at that point.

A severe crisis could compel the reforms that the political system currently lacks the courage to attempt: deregulation, state restructuring, tax reform, planning liberalisation, welfare overhaul, and a renewed entrepreneurial culture. Paradoxically, failure itself might break the paralysis. That’s what happened in 1979 when the country had had enough of the 1970s failures and went for the radical alternative of Margaret Thatcher

Why Burnham matters

The strongest argument for Andy Burnham is not that he is guaranteed to succeed. It is that he is one of the few plausible leaders who might genuinely alter Britain’s trajectory — one way or another. In a country trapped in decline and drift, movement itself begins to acquire value.

Britain does not merely suffer from bad policy. It suffers from exhaustion, caution, and an elite culture that increasingly mistakes the avoidance of risk for the art of government; it is obsessed with process at the expense of product.

For many, Burnham is the wrong kind of radical, but radicalism of some description is what Britain needs and is probably coming, eventually. Better to have it now than ten years down the track. The real danger for Britain now is not choosing the wrong direction. It is remaining exactly where it is.

Some doves favor an extended hold and no hikes
Here are some of the perspectives

Alan Taylor, “An extended hold would probably be enough restrictiveness.”

Clare Lombardelli, “Holding rates provides an appropriate degree of restrictiveness, “ referencing that there had been “a tightening in monetary policy and financial conditions.”

Sarah Breedon, "financial conditions have tightened significantly,” and “When government bond yields rise sharply, financing conditions tighten across the economy,” taking the view that, “This provides sufficient restrictiveness to guard against the current risk of second-round effects.” She indicated that action would be warranted if second-round effects materialized, supporting the apparent stance of the Governor, Andrew Bailey, that the Bank can wait and see if they emerge.

The doves are wrong on three counts
There are three aspects of the doves’ argument that are worth taking issue with. The first is that the doves are concentrating on nominal rates. The second is that the focus on new borrowing rates overlooks that two-thirds of outstanding mortgages were taken out at 5-year fixed rates, with the effective real mortgage rate now negative. The third is whether waiting and seeing is a sensible policy.

Real rates are what matter
In 2022, Turkey had interst rates of 14%. Pretty high. But not when inflation was 80%. It is real rates, not nominal ones, that determine whether interst rates are restrictive. Perhaps the doves believe that economic agents in the UK expect the BoE to deliver 2% inflation. Not over horizons relevant to economic decision making, they don’t. The breakeven inflation rates on 2.5-year and 5-year gilts have surged this year. About two-thirds of outstanding UK mortgages are 5-year fixed, while most new mortgages are 2-year fixed.

This year, the two-year breakeven has risen by 1.5% and the 5-year by about half that. The policy rate has remained unchanged in nominal terms since last December. If we subtract the two-year breakeven from the policy rate, the policy rate has eased by about 150bp this year. How is that a tightening?

Nominal mortgage rates have risen for new mortgages, but real rates are little changed. Fixed rates for new two-year and five-year mortgages have risen. The five-year has risen slightly in real terms, while the two-year has fallen slightly.

Interest rate 2-year fixed-rate mortgages (%)

Source: Bank of England

Interest rate 5-year fixed-rate mortgages (%)

Source: Bank of England

The nominal effective mortgage rate has hardly budged
However, the effective rate (i.e., the average rate on outstanding mortgages) has hardly budged. At around 4%, it is half a percentage point below two-year breakevens. How is a negative real rate restrictive?

Effective interest rate of fixed-rate mortgages (%)

Source: Bank of England

Softer sterling signals softer policy
Meanwhile, sterling’s effective exchange rate has softened. If there had been a significant tightening of monetary conditions, as the doves assert, we would have expected sterling to have appreciated since UK rates have risen more than in other countries. It has not appreciated, quite the reverse. Thus, the foreign exchange market is telling us that UK monetary conditions have eased. Higher inflation expectations push sterling lower while elevating gilt yields.

Sterling effective exchange rate index

Source: Bank of England

While households may postpone borrowing for cash-flow reasons, hurting the housing market, there is no significant tightening of real rates. And real rates have declined for those already holding a mortgage. Since sterling has softened, the doves are massively overplaying the market-imposed monetary restriction on the economy.

The extent of the rise in UK market rates reflects higher breakevens, which in turn reflect a lack of credibility in the Bank's ability to control inflation over 2- and 5-year horizons. It is ironic, therefore, that the Bank’s doves interpret this rise in rates as a reason to do less than otherwise, since the extent of the rise represents their own lack of credibility. That’s exactly why breakevens have risen so much, and far more than in the US.

Waiting for the horse to bolt
Inflation responds to monetary policy only with a significant lag, though expectations effects can shorten the adjustment period. Many on the MPC want to wait and see how inflation evolves before deciding whether to raise rates. This is akin to waiting to see if the horse will bolt before closing the stable door. By the time those second-round effects emerge, more will already be baked into the dynamics of the system, and a sustained inflationary overshoot will be guaranteed. It seems that some MPC members have learned little from too-slow central bank responses in 2021 and 2022. They also seem to be willing to ignore institutional factors such as the indexation of the minimum wage and what the breakevens are telling us - the UK will not bring inflation back to 2% on a policy-relevant timescale.

Is 2% really the target?
UK CPI inflation has been at or blow 2% in only two months since May 2021. If market pricing is to be believed, it will be at least another five years before we see another instance. The Bank appears to care a lot more about growth relative to inflation than its formal mandate would suggest. I also have a growing suspicion that it cares too much about the impact of higher rates on public finances, both through activity effects and more directly through interest on debt. OBR ready-reckoners suggest that a 1% rise in short rates would add about GBP 8bn to the fiscal deficit in year one; this compares with about GBP 10bn of “fiscal headroom” the OBR calculated that the Chancellor would have in 2029/30. The most significant long-run fiscal help the Bank could provide to the government is to raise rates and demonstrate its commitment to the inflation target. This would lower inflation expectations, lower inflation (thereby lowering payments on inflation-linked debt), reduce future short rates, and subdue gilt yields. Unfortunately, that sort of long-run calculation has gone out of the window since the start of this decade.

The K-shaped economy
The well-known reason for this is the K-shaped economy—the top 10% of households by income now account for half of US consumption. The lower-paid are struggling to make ends meet, yet those who have invested in stocks, especially in tech, have seen their wealth soar; they are also significantly more optimistic about their future income and pensions. The rich get richer, and the poor get poorer (the Matthew effect).

Michigan responses show widening income group divergences
We can rehabilitate the Michigan survey as a predictor of consumption by exploiting its more granular data. The Michigan data split responses by income tercile - the top, middle, and bottom third of the overall response. Plotting the difference between the top third and the overall aggregate shows that the top third has improved its relative position over the last two or three years. This more favorable outlook for the better off shows up in both flow variables, such as current and expected finances, expected nominal income, and the probability of an income gain, and in stock variables such as stock wealth, housing wealth, and the perceived adequacy of future pensions.

Adjusted Michigan helps us understand recent aggregate consumption
Modeling the relationship between consumption and the Index of Consumer Sentiment (ICS) shows the importance of the differences between income groups - a simple average misses the disproportionate share of income and consumption of the better off. To avoid overfitting, I constructed models using training data through the end of 2024 and then evaluated forecasting performance from 2025 onward. The model that accounts for differences between the better-off and the average showed a significant improvement in forecast performance compared with a model based on ICS alone. Nonetheless, the inflation challenge felt by everyone may signal a gradual deceleration in consumption growth, though that might change if oil prices fall significantly.

Wealth is driving a lower savings rate
Given the redistribution of income away from the lower-paid and towards the better off, we might have expected the saving rate to rise - the better off have a higher propensity to save out of income. In fact, the saving rate has fallen to a level not seen since the GFC and the period leading up to it.

It is clear that wealth effects and greater optimism among better-off households about incomes and pensions are significant in explaining this slower saving rate, as preliminary regressions confirm; stock market wealth is in the driving seat. If the stock market continues to perform well, consumption should benefit from a sustained decline in the saving rate. Bottom-up earnings estimates have recently seen a significant upturn, helping to explain stocks’ performance. A lower savings rate will help maintain economic strength and boost earnings in the consumer sector, particularly for high-end products and services.

The economy is vulnerable to a significant stock correction
However, the lower the saving ratio goes, the more vulnerable is the economy would be to a stock correction. Higher-income households’ wealth would decline, along with confidence in future pensions, and the saving rate would rise, spreading weakness throughout the economy. The lower-paid would experience job losses and lower incomes.

A significant stock correction does not look imminent, given buoyant earnings expectations. One of the most likely flags for a possible challenge to stock market optimism would be disappointing earnings reports from firms in the AI/tech sectors. Upcoming mega-IPOs may prove a temporary challenge, depending on how much stock is initially floated, since selling other stocks may be a means of financing purchases of new issuance. Geopolitics also has the potential to upset the applecart, though wars in Ukraine and the Gulf have had little lasting impact. Mounting tensions over Taiwan would be another matter entirely. Finally, watch inflation, which could prompt a tighter monetary stance than the market expects; a 50% chance of a hike is priced in by the December meeting.

Source: CME

The Tribune MPs correctly identify several genuine problems. Britain has become excessively dependent on property inflation and consumption rather than productive investment. Living standards have stagnated. Infrastructure delivery is poor. Treasury centralisation is excessive. The country feels economically exhausted. On much of that diagnosis, they are right.

…pity then that it rests on misdiagnosing Britain’s ills
The problem is that their proposed cure rests on a profound misdiagnosis of what is actually wrong with the British economy.

Re-dividing the cake, not increasing it
At root, this is a programme for redistributing the existing cake rather than enlarging it. Indeed, some of the proposals may well result in the cake growing more slowly. Throughout the document there is remarkably little serious engagement with the question of productivity growth, private investment, incentives, capital formation or supply-side performance. The assumption appears to be that Britain’s central problem is distributive: that output already exists and merely needs reallocating more fairly. But Britain’s deeper problem is that it has become progressively worse at generating output in the first place.

More government spending will take resources away from elsewhere
This matters because resources in an economy are finite. If government spending rises substantially and lower-income consumption rises alongside it, then something else must fall. That “something else” will be private investment, private consumption elsewhere, savings, and future productivity growth. Yet the blueprint largely ignores these trade-offs, as though resources can simply be transferred without affecting the economy’s productive capacity.

Views on the “rentier” class
The treatment of wealth and capital is particularly revealing. Much of the Tribune argument implicitly rests on the view that capital owners are essentially a rentier class drawing income for no socially useful reason, and that wealth can therefore be taxed more heavily without significant economic consequences. But capital and labour are not enemies in the production process; they are complements. Workers become more productive when they have more and better capital to work with. Reducing returns to capital reduces the incentive to accumulate it and use it effectively. Over time, that means lower investment, weaker productivity growth, and ultimately lower output and wages than would otherwise have existed.

Does Britain really need less saving?
Nor is it enough to say that the wealthy will merely spend less. Higher earners also save disproportionately more, and those savings finance investment across the economy. The beneficiaries of redistribution generally consume most of what they receive rather than save it. One can support redistribution on moral or political grounds, but one cannot pretend there are no consequences for capital formation.

Let’s pretend there are no fiscal constraints for a decade
The same problem appears in the fiscal proposals. Moving fiscal targets from five years to ten years may be presented as enlightened long-termism, but markets are unlikely to interpret it that way. They will correctly see it as removing any meaningful fiscal constraint on the current government. A parliament lasts roughly five years. A ten-year fiscal horizon effectively means the difficult balancing of the books is always postponed onto some future government, long after the current ministers have departed office. In practice, it becomes a mechanism for deficits now and promises later.

Let’s also assume the gilt market will swallow more issuance
At precisely the moment Britain already has some of the highest bond yields in the developed world, this seems extraordinarily complacent. More government borrowing and more lending through public financial institutions must ultimately be financed somehow. Where is that financing supposed to come from? Domestic savings are likely to weaken if capital and higher incomes are taxed more aggressively. Foreign capital supply to the UK is not infinite either, and Britain is unlikely to become more attractive to overseas investors if growth prospects weaken, deficits rise, and fiscal credibility deteriorates.

Basket case status will worsen
The danger is that Britain ends up in the classic trap of a fiscally weak, externally dependent economy. Higher deficits weaken sterling. A weaker currency raises imported inflation. Higher inflation forces interest rates higher. Higher rates crowd out private investment. Growth slows further. Fiscal sustainability then deteriorates further still. Britain is not the United States. It does not possess unlimited room for fiscal experimentation without market consequences.

Psst, anybody thought about the supply side?
Perhaps the greatest weakness in the Tribune approach, however, is its near-complete failure to engage seriously with state capacity and public-sector productivity. Britain has already devoted vastly greater resources to the public sector since 2019, yet measured public-sector productivity is appalling. More money has not automatically produced better outcomes. That does not prove public spending is undesirable. It does suggest that institutional effectiveness matters at least as much as resource allocation.

Weak state capacity means throwing good money after bad
The Lower Thames Crossing is an almost perfect symbol of the problem. Britain now struggles to build infrastructure at anything resembling a reasonable cost. The planning expenditure alone on the crossing (running to 359,000 pages) exceeded the entire construction cost of the world’s longest road tunnel in Norway. That is not fundamentally a problem of insufficient spending. It is a problem of bureaucracy, regulation, incentives, and administrative dysfunction. Without reforming the machinery of the state itself, simply allocating more public money risks producing more waste rather than more growth.

Tribune has the problem backwards
In that respect, the Tribune Group actually has the problem backwards. Britain’s central weakness is not that it borrows too little or redistributes too little. It is that the country has created a system of weak incentives, poor regulation, low productivity growth, and declining state effectiveness. The economy underperforms because both the market economy and the state function badly.

A naive blueprint for a financial crisis
That is why the blueprint ultimately feels naive. It identifies many genuine frustrations but misdiagnoses their underlying cause. As a result, the proposed remedies are liable not merely to fail, but potentially to intensify Britain’s deeper structural weaknesses: weaker investment, slower productivity growth, higher borrowing costs, reduced fiscal credibility, while creating a significant risk of a sterling and fiscal crisis.

The UK needs a rethink - but not this one.
The tragedy is that Britain does need a serious economic rethink. But that rethink must start with the question of how the country becomes more productive, more investable, and more governable — not merely with the question of how existing output should be divided.

The Fed: steady on the surface, shifting underneath

Jerome Powell kept the message deliberately calm. Inflation risks are rising, but uncertain. Growth remains resilient. The Fed is well-positioned to wait-and-see. But the vote adds a layer markets shouldn’t ignore: three dissents pushed back against maintaining an easing bias (with one predictable vote for a cut). That’s not a pivot, but it is pressure. The three dissents give a strong guide to which way the wind is blowing without either tying Warsh’s hands or rocking the markets’ boat, which a straight drop of the bias would have delivered.

Fed messaging suggests the Fed is no longer comfortable with a soft stance. The center of gravity is shifting and will shift further when Uber-dove Miran departs, with Warsh assuming the Chair. June will likely see the bias to cut jettisoned and replaced by balanced forward guidance, opening the way, as needed, for a rate hike or rate cut before the year is out.

The ECB: preparing the ground

Christine Lagarde was more direct. Inflation risks are now clearly to the upside. Growth is weaker, but not weak enough to stop action. Crucially, she rejected the idea that Europe is sliding into stagflation. A cynic might suggest she wants to get a hike in before weaker growth stymies her.

Thus, the ECB believes it still has scope to tighten, and is preparing markets for that possibility as soon as June. Rate hikes are back in play, and the messaging is clear about that. The ECB isn’t reacting to markets - it’s guiding them.

The BoE: the most worrying outlook - and the least movement

The Bank of England stands apart. Andrew Bailey delivered the bleakest macro picture of the three:

• Inflation risks are the highest.

• Growth risks are the most troubling.

• Downside labour market scenarios are emerging.
  

Despite this, rates are unchanged, there is no clear tightening path, and there’s only one dissent in favour of a hike. The Bank of England is describing a worsening problem, but without a clear signal about how it plans to respond.

The Bank’s scenario analysis is, as usual, of minimal use to markets. One scenario (Scenario B) is so close to the main case that the interest rate and market implications differ only marginally. Scenario C lies in the tail of the distribution of possible outcomes and is therefore of tangential interest to markets: stress test, yes, policy informative, no. The result is a gap where the most policy-relevant outcomes actually lie. This tactic is to avoid tying the Bank’s hands in case one eventuates - it doesn’t want to provide something that might appear to be a conditional pre-commitment.

In other words, the plan is to have no plan, or at least not a public one.

The real divide: growth

All three central banks expect inflation to rise. The split is over growth, and how much of it they can afford to lose, with the difference explaining the contrasting rhetorical stances:

• The Fed still believes growth will hold.

• The ECB sees a slowdown, but not a constraint.

• The BoE sees a genuine downside risk.

What this means for markets

This is a story of diverging reaction functions. In the US, the bias is slowly turning more hawkish. In Europe, the path toward tightening is being laid out. In the UK, the economic outlook is the worst, but the policy outlook is the most uncertain and the least clearly priced. Markets can handle bad news. What they struggle with is unclear policy direction. At present, that’s a UK problem that risks pushing the currency down and the term premium and gilt spread up.

The UK’s parlous fiscal position may also be leading the Bank to overemphasize growth. After all, a downturn that might crimp inflation would sink the public finances below the waterline, while, given non-indexation in the tax system, higher inflation boosts revenues.

Bottom line

Three central banks. One shock. Three very different responses:

• The Fed is starting to split.

• The ECB is priming for action.

• The BoE is still dithering.

This may help to explain why the UK has the worst inflation problem of the three.

Growth and output assessment unchanged, inflation assessment worsened
While the statement previously described inflation as “somewhat elevated,” now it’s “elevated,” which is more concerning. Ascribing part of inflation to recently higher global energy prices might sound too much like “transitory” to the hawks, even though it’s a fact, not a judgment. Since the growth and labor market assessments remain unchanged, the statement was more hawkish on the economy.

More uncertainty
Like last month, the statement emphasizes uncertainty about the outlook, though it has now cranked up a notch from being “elevated” in March to “high level” in April. The statement said, as in March, “The Committee is attentive to the risks to both sides of its dual mandate.” The hawks may have wished for an assessment that paid more attention to inflation risks.

The easing bias remains…
The easing bias has been there for months and months, and the Gang of Three feel it’s sell-by date is well and truly passed. The text continues to include, “In considering the extent and timing of additional adjustments to the target range for the federal funds rate” (my emphasis). That’s an easing bias because the most recent moves have been cuts, so “additional” means “more cuts.”

… which is what the hawks object to
Given the upsurge in energy prices and inflation, the hawks’ position is that the balance of risks has shifted, especially regarding inflation, and therefore presuming the next move is a cut is too dovish. However, the rest of the FOMC clearly see the current supply shock as bad for growth and inflation, with Stephen Miran voting for a cut. The majority of the FOMC is in wait-and-see mode, whereas the hawks feel we’ve already seen, earlier this decade, how this movie ends.

Dissent signals more change to come
What does the split mean for the Fed’s future policy stance? With Jerome Powell deciding to stay on the Board after his term as Chair ends, Stephen Miran, the uber-dove on the committee, will be out. On the reasonable assumption that Warsh will be less dovish than Miran, the bias of the committee will edge more hawkish, by how much depending on Warsh’s stance.

While split votes are not decisive, they have been the precursor to policy shifts in the past, important examples being:

• 2007-2008. Dovish dissent. Before the Fed started aggressively cutting during the financial crisis, there were internal disagreements about how serious the downturn was.

  Some officials wanted to cut sooner as risks mounted. Fred Mishkin wanted an easing bias at the August 2007 meeting. Others were still focused on inflation risks. Result: dissents increased, and the Fed pivoted to rapid rate cuts in September.

• 2014-2015. Hawks dissent. During the recovery after the Great Recession, several regional presidents dissented because, becoming more confident in the economy, they wanted rate hikes earlier than the still-cautious majority. The first dissent was James Plosser in August 2014. Result: the Fed began its first rate hikes in December 2015.

• 2018. Doves dissent. Pre-pandemic, disagreements emerged, more in tone than votes, in mid to late 2018, with some policymakers warning of over-tightening while others supported continued hikes. Result: within months, the Fed paused and then reversed course in July 2019.

The evidence suggests that while turnarounds in rate action can follow hot on the heels of a dovish dissent prompted by financial stress, a turnaround can take time - central bankers don’t want to flip-flop, especially when uncertainty is high. The shortest gap between the last cut and the first hike is 6 months; the last cut in this cycle was in January.

Dissents are important information because they reflect differing interpretations of the weight of emerging evidence. Some participants feel the evidence is conclusive enough to change their view. For others, the necessary threshold has not been reached for that, but that does not mean that they have not shifted in the same direction. Three dissents at the April meeting suggest that others may well be close to the edge in wanting to remove the easing bias. The FOMC may be even more data-dependent than normal.

June FOMC: bye-bye easing bias
Given the impasse over the Straits of Hormuz, which may require further military action to break, and the possibility of infrastructure damage, news on inflation between now and the next meeting will be poor. Unless there is a big shift in growth dynamics or market stress, softer news on the real economy will not offset that. Thus, my assessment is that the news will be sufficient to persuade more members to remove the easing bias. My judgment of the chances of the June outcome is:

• Easing bias removed -80%

• Easing bias language toned down - 15%

• Easing bias unchanged - 5%

The next FOMC is June 16-17; the Senate vote on Warsh’s appointment on May 11, and Powell’s term ends May 15, with yesterday’s press conference being his last. Will Warsh be comfortable removing the bias, given his view that AI will reduce the neutral weight and that rate policy might need to ease to offset the shrinkage in the Fed’s balance sheet that he wants to see? Or would he see a continued pause as useful credibility building, allowing him to cut rates later without adverse term premium implications? How would that tie in with the President’s desire to see lower rates, especially ahead of the midterms? We’ll get a firmer steer on the new Chair’s views not only at the June FOMC but also in the semi-annual testimony to Congress in late June/early July.

Removing the bias would take easing off the agenda for a few months, unless the economy worsens dramatically, because the Fed will not want to remove the easing and quickly put it back in without compelling evidence. But it would not put hiking on the agenda. Essentially, it would be a formalization of the Fed’s current wait-and-see stance. That would be useful for the Fed as it weighs options for the balance sheet and how that should mesh with rate policy. During that period, the Chair can carefully steer market views to help avoid future surprise decisions.

Uncertain outlook times uncertain reaction function = uncertainty squared
The debate about which is the larger risk - inflation or growth - is unlikely to be settled in the near term, so the tension we have seen weighing inflation against growth risk is likely to continue. That may unsettle markets. How do you price long-term assets if one of the fundamentals of the assessment, the Fed reaction function, is up in the air? When uncertainty about the economic outlook is multiplied by the uncertainty concerning the Fed's response to that outlook, the overall uncertainty in the system increases exponentially. That is a recipe for a potential accident in markets. Warsh needs to make his stance clear and to avoid a damaging split on the FOMC

On Monday, the Guardian reported that Chancellor Rachel Reeves was considering a plan to freeze private sector rents for a year to ease the cost-of-living crisis. On Tuesday, the Chancellor was asked in the Commons, in what looked like a planted question, whether she would consider a freeze. She responded that she would do everything in her power to help people renting their homes in the private sector: hardly a rebuttal. On Wednesday, the Housing Minister said, “We are not looking at rent controls.”

Have we heard the end of this? Maybe, but maybe not, so I want to explain why this would be a thoroughly bad policy. Its attraction to the Chancellor is that it would be a policy that gets headlines, which are in desperate need ahead of upcoming local elections, looks like it might help with the cost of living, and costs the government very little upfront. It would be popular with some sections of the Labor Party. On the downside, it solves almost nothing, while storing up bigger problems down the road. For a Chancellor with her back against the wall, however, the view might prevail that tomorrow can wait.

The UK Engineered a More Violent Price Shock
Britain’s cost-of-living crisis is not just global inflation washing ashore. It is amplified domestically. The UK’s electricity market prices power at the marginal cost of gas generation. Even when renewables dominate output, gas sets the price. The consequence is brutal: spikes in global gas prices multiply as they pass into household bills.

If The State Could Spend, It Would
A government with fiscal room would respond with direct support, such as subsidies, transfers, and energy price controls. That’s what we see in Europe. Instead, in the UK, we get a proposal for rent controls. That tells us that the fiscal cupboard is bare.

Arbitrary Relief — And Large Groups Left Out
A rent freeze would help renters, but the shock is economy-wide. Pensioners are a significant group who would miss out on a rent freeze. Almost 30% of households in England are “older households” (65+). Of those, 75% own outright, 6% rent privately, and 15% are in social housing. That means almost all older households - many painfully exposed to energy costs – would get zero benefit, as would those in social housing if those rents were not frozen too.

This raises an obvious question: why adopt such an arbitrary compensation mechanism?

If the objective is to offset an energy-driven income shock, rent controls are a blunt and misaligned tool. They create winners and losers based not on need, but on housing status. It is hard to defend that distributionally — and harder still to justify it as coherent policy.

Another Hit to a Shrinking Rental Market
The private rented sector has already been destabilised by reforms like the Renters’ Rights Act. Even considering a rent freeze compounds that pressure. Landlords are forward-looking. They don’t just see a one-year freeze — they see a regime shift towards intervention. That matters because housing is a long-duration asset. Expected returns depend heavily on policy stability. Once that stability is questioned, capital pulls back.

The direction of travel is obvious: less supply, lower investment, deteriorating quality. Even if no freeze comes, damage has already been done.

“Temporary” Is Not Credible
Rent freezes have a habit of lingering. If the government allows rents to jump back to market levels after a year, it creates a visible inflation spike — politically toxic. If it caps the rebound, the policy extends. Either way, this would not be a clean one-year intervention. It would be the start of a process, especially as a freeze would require monitoring and enforcement across every local authority. Those new recruits would lobby to keep their jobs.

Without an extension, the policy wouldn’t even solve the problem — it would just delay it. Inflation would be shuffled forward, not reduced, prolonging the period of elevated price growth and increasing the risk of it becoming embedded.

The Inflation Impact Is Small — and Slow
Even taken at face value, the disinflationary effect would be tiny when people need help the most – now.

Private rents account for roughly 8% of the CPI basket. Suppressing a 3.5% increase implies about 0.3% off the CPI. Not nothing – eventually - but minuscule in month one. Rental inflation feeds through gradually as tenancies reset, so 0.023% off in the first month. Moreover, tenants feel the benefit over the coming twelve months. The cost-of-living squeeze, driven by energy bills, is immediate.

This is a slow policy aimed at a fast problem.

The Political Economy: Why This Still Happens
If the policy is so flawed, why pursue it? Because it is politically efficient.

Renters are a large, visible, and increasingly vocal constituency. They are also more likely to feel the squeeze immediately and acutely. By contrast, the groups excluded - including a large share of older, outright-owning households — are less directly tied to rents, even if they are financially vulnerable. A rent freeze creates a clear, communicable “win” for a defined group, even if it is arbitrary in economic terms.

The major plus is that it is off-balance sheet. Unlike fiscal transfers, it does not immediately worsen public borrowing figures, except for extra recruitment for enforcement. The cost is instead passed on to landlords — and, over time, to future renters via reduced supply.

In short: concentrated benefits, diffuse costs, and minimal upfront fiscal impact. That is a politically attractive combination, even if it is economically suboptimal.

The Historical Pattern: We’ve Seen This Before
This is not new territory. The 1970s UK rent controls offer a clear precedent. Tight controls reduced incentives to invest in rental housing, contributing to a long-term decline in supply and quality. Short-term relief for incumbents, but reduced availability and higher rents for new entrants over time.

Rent control rarely fails immediately. It fails gradually.

The Real Signal: Policy Credibility Is Eroding
Once discussed, rational landlords will assume there is a higher probability of future action. That reduces expected returns today. That’s how you get a slow-burn supply problem — and, ultimately, higher rents in the long run.

Conclusion: A Policy That Buys Time — and Little Else
A rent freeze would not be a solution. It would be a deferral.

• It does not address the root cause (energy pricing).

• It delivers limited and delayed relief.

• It arbitrarily excludes large, vulnerable groups — including most older households.

• It risks shrinking housing supply.

• It undermines policy credibility.

Above all, discussing it as a possibility reflects a government operating under severe fiscal constraint, substituting controls for capacity.

Poorly constructed, poorly timed, and with adverse long-run consequences, this would be less a serious economic intervention than a signal of something more troubling:

Britain has run out of room to respond to shocks, whether energy shocks or the need to defend itself, and is beginning to contemplate policies that trade future stability for present optics.

However, the spread has been widening for six years, so we don’t need to attribute it to particular events. The era of QE drove yields to unusually low levels across the board, but especially in the UK, distorting relative rates. Part of the rise in the gilt-Treasury spread over recent years is due to normalization, as this note will explore more fully below. The spread is now back in the range seen before the GFC. We should be careful not to over-extrapolate the trend now that normalization may be more or less complete.

Sterling appreciation challenges the fiscal credibility story
A challenge to the fiscal-credibility (or lack thereof) explanation for the widening spread is the behavior of GBPUSD. The debacle over the Truss/Kwarteng “mini budget” in 2022 shows that a fiscal credibility event manifests as a jump in gilt spreads and a sharp fall in sterling’s value against the USD. However, since 2023, the widening gilt spread has accompanied a strengthening of sterling against the dollar, not a depreciation. That pattern suggests that other, non-fiscal, forces explain the recent widening of the spread, with a relative trend rise in UK real rates since 2022, as a process of normalization, being a likely candidate.

US budget projections are less favourable that the UK’s
Moreover, if we compare the debt and deficit projections from the CBO and the OBR, the UK’s fiscal prospects are in some ways less worrisome than those in the US, though they remain troubling; we should also remember that the OBR tends to be overly optimistic. The UK’s projections show a declining budget deficit and debt-to-GDP stabilizing, whereas the US has a deficit continuing at about 6% of GDP and a rising debt burden.

The monetary explanation for the spread
The coincidence of recent upward trends in the gilt spread and GBPUSD, both symptoms of tighter conditions, points to relative monetary policy as the likely explanation for the spread.

The next two charts strongly suggest it is the case. They show the relationship between the 10-year spread and the 2-year spread; the 2-year reflects not just current monetary conditions but also the expected policy stance over the next 24 months. The first chart illustrates a persistent relationship between the two over twenty years, while the second focuses on the most recent period. The current 2-year spread reflects the market pricing in that the UK’s Bank Rate may rise over the balance of the year, whereas in the US, the expectation priced in is for unchanged fed funds rates, with a chance of a cut.

The short-end, heavily influenced by monetary policy, drives the 10-year spread
Using weekly data, regressions show that the 10-year spread moves strongly with the 2-year spread, both immediately and over the following few weeks. The front end appears to lead the long end, but not one-for-one; roughly speaking, a 1-point widening in the 2-year spread is associated with about a 0.7-point cumulative widening in the 10-year spread over the next 12 weeks, about 0.5 of this coming in the first week, and most of the rest in week 2.

Inflation drives policy, drives the 2-year, drives the 10-year
The 2-year spread reacts to policy developments and to expected policy, with inflation as a key driver. UK core CPI inflation rose later and less sharply than in the US in 2021. Its plateau lasted longer, and its decline set in later than in the US; UK inflation is stickier downward than in the US. While the US and UK core rates declined over the last six months, the extent was greater in the US. Over the last six months, average core inflation in the UK has been 0.6pp higher than in the US; the most recent spread between UK gilts and US Treasuries is just over 50bp.

A nominal spread that broadly reflected expected inflation differences would be consistent with the established finding that there is a common factor behind real interst rate developments in advanced countries.

Real rates and breakevens
Examining the split between real rates and breakevens in the gilt and Treasury markets helps explain why the nominal UK spread has been widening for years and, for a different reason, why it has widened recently.

UK real rates were massively distorted downwards
The era of ultra-low rates in the UK drove real interst rates to as low as -3%, whereas Treasuries troughed close to zero in 2020. While the Bank of England’s QE was similar in size to the Federal Reserve’s relative to GDP, its impact on gilt yields, nominal and real, was more pronounced, reflecting the smaller market, heavier duration exposure, and the UK’s large stock of index-linked debt.

When UK policy rates began to normalize in December 2021, and the US followed in March 2022, with both countries’ balance sheet operations shifting in 2022, the real rate in both countries began to rise. Since UK rates had been suppressed much more than in the US, this process of normalization has narrowed the UK-US real interest rate spread to basically zero, which is where one would expect it to be, given the gravitational pull of a common global real interest rate. As an aside, the chart helps us understand why the Truss/Kwarteng mini-budget had such an adverse effect on gilts: it came at a time when real yields were already in a sharp period of adjustment from massively distorted levels, akin to throwing fuel on a fire.

The Iran war has spiked UK breakevens
The start of the Iran/Israel/US war has seen US breakeven rates rise slightly to around 2.4%, which remains slightly below last summer's levels. In the UK, however, the 10-year breakeven has risen from around 3% at the turn of the year to 3.5% at the end of March, close to the level in spring 2024, thereby unwinding the gradual decline in breakevens in the intervening period.

The behavior of the UK breakeven since late February tells us that the market views the shock to UK inflation as both significant and persistent, to a greater extent than in the US. Important reasons for this expected substantial effect are that: the structure of the UK energy market makes it particularly vulnerable to energy price shocks, pushing up not only oil and natural gas prices but also electricity prices; sharper rises in energy prices trannsmit more fully into broader prices; indexation of the minimum wage and welfare benefits fully transmit price shocks into the bottom end of the wage structure, with spill-overs into other wages; and the Bank of England lacks credibility, meanin that inflation expectations are not well-anchored.

Conclusion
Commentators and investors are rightly concerned by the UK’s fiscal position. However, the US fiscal outlook is no better and, indeed, in some respects worse than in the UK. Moreover, the behavior of GBPUSD relative to gilt yields is not consistent with the hypothesis that fiscal worries are driving the gilt-Treasury spread wider. An important part of the widening spread over recent years is normalization, whereas the fiscal story would lead to UK real rates above a justifiable level. If that were the case, UK real rates would be well in excess of those in the US, not on a par with them.

The far more convincing argument is that, in addition to the normalization of real rates, the gilt-Treasury spread largely reflects differing expectations of relative UK and US short-term interest rates. Shifts in relative rate expectations reflect the market’s view that inflation in the US and UK will respond differently to a global price shock. This argument is supported by movements in breaks over recent months. The transmission of oil price shocks into domestic inflation is more substantial in the UK and is likely to last longer than in the US - that’s what the wider gilt spread tells are the inflation and rate consequences of the war. Thus, the gilt-Treasury spread is likely to remain wide given the likely inflation gap and could expand further, depending on how the price shock emanating from the war in the Gulf evolves.

Debt service in context
The OBR estimates that debt service recorded in the fiscal accounts will cost GBP 110 bn in 2025/26. By comparison, the November Budget showed the following path for defence spending.

Thus, the UK spends twice as much on debt service as on defence. In 2022/23, servicing inflation-linked debt alone cost more than the defence budget. Between 2019/20 (pre-COVID) and 2025/26 in the budget plans, defence expenditure will have risen by GBP17bn. Expenditure on debt service will be higher by GBP 70bn, roughly four times the increase in defence spending.

Debt interest has soared
The following chart shows the increase in debt interest outlays since COVID. The increase of over GBP 70bn from 2019/20 to 2022/23, from 1.7% of GDP to 4.4%, was a massive shock to the public finances.

Chart: Central Government Debt Interest

Over-reliance on inflation-linked debt
Part of the reason for the disastrous UK fiscal performance in recent years and for the outsized vulnerability of the public finances to inflation is the composition of government debt. Quite simply, it has far too much inflation-linked debt to deliver a stable public deficit performance.

Inflation-linked debt pays a coupon, linked to the Retail Prices Index (RPI), and also links the value of the principal to the RPI. While the coupon uplift is not paid until maturity, its accrual is recorded in the fiscal accounts on a year-by-year basis as debt interest. When inflation is high, as in 2022/23, that uplift can be very substantial, destabilizing the public finances.

The UK’s high share of inflation-linked debt
Inflation-linked gilt debt (aka linkers or IGs) in the UK comprises about 25% of the government debt stock. In other OECD countries, the average is 3%. While the UK has a long average life of its debt, helping to limit refinancing risk, the UK share of inflation-linked bonds in its total debt stock is three times that of the US and almost ten times that of Germany. This leaves the UK public finances very exposed to inflation risk, which is transmitted directly into fiscal risk.

The UK used the era of ultra-low yields to extend maturity. It also reduced the share of index-linked issuance in the total, with the current year’s plan below 10%. However, inflation has boosted the value of the stock outstanding, leaving the share stubbornly high at around 25%.

While the share of linkers in total debt has been stable, the UK’s rising debt/GDP ratio means that the linker/GDP ratio has also been rising - exposure to linkers is increasing, not stable. While Sweden has a share of linkers in total debt close to the UK, the ratio to GDP is far smaller, representing less risk to the Swedish budget deficit/GDP ratio than in the UK.

Why did the UK issue so many linkers?
The high share of linkers in total debt that the government aimed for in earlier years reflected two main factors. First, significant demand from defined benefit pension funds to match inflation-linked assets to their inflation-linked liabilities. Second, the government thought inflation-linked funding would be relatively cheap. With a conventional gilt, the purchaser bears the inflation risk. With an index-linked gilt, the government takes the risk, effectively selling inflation insurance to the purchaser, which the purchaser pays for by accepting a lower real yield. Index-linked borrowing lowered ex ante borrowing costs, thanks to the “insurance premium,” but at the price of exposing the public finances to tail risk — and that tail risk materialized.

When is it a good deal for the government to issue index-linked debt?
Whether issuing index-linked debt turns out to be cheaper or more expensive than conventional debt depends on how the breakeven inflation rate at the time of sale compares with realized inflation over the life of the bond. If the breakeven rate exceeds the realized rate, the government has made a wise choice: it pays out less than the premium justified. If the realized inflation rate exceeds the breakeven at issue, then the investor has received more inflation compensation than they paid for - a bad deal for the government.

How have the costs and benefits of index-linked debt shifted over time? Assuming a 10-year bond and monthly issuance at actual market rates, I compared the break-even inflation rate with the subsequent 10-year realized rate through 2015. Bonds issued after that would not have reached maturity, so I assessed them on a “so far” basis.

When good bonds turn bad
The chart shows that in the first few years after linkers were first issued in March 1981, they were a great deal for the government because actual inflation turned out well below the breakevens they were sold at; the UK sold debt in a high inflation regime and paid it in a low inflation regime (more on regimes below). Linkers issued after 2001 were a slightly poor deal, but not disastrous. From 2012 to 2015, index-linked debt was about 1pp more expensive for the government than conventional debt. That additional cost rose to an average of about 2pp over the next four years, but exceeded 3pp for issues in 2020 and 2021. While it is early days for the bonds issued since 2022, they have not performed as badly - so far. Given the current unanticipated inflation shock, already-issued linkers will prove expensive this year.

The experience of bonds issued at different dates boils down to this: when bonds were issued in a high-inflation regime but paid in a low-inflation one, linkers were cheap. But issuing in a low-inflation regime, as we were in in 2020 and 2021, but paying in a high-inflation one, as in the subsequent years, turned out to be expensive.

The next chart, based on a Markov-switching process, shows the probability of being in a high-and-variable inflation regime or a low-and-stable one. We can see that in the early 2020s, we flipped from low and stable to high and volatile. That’s why the linkers issued earlier this century turned out to be so expensive - too much was issued when breakevens were low.

Index-linked debt has increased debt service volatility
It is not only the average cost of index-linked debt that is a concern, but it’s also the volatility it injects into debt service costs.

The following table shows the split of debt interest between conventionals and linkers. In the days of low inflation, linkers’ share of debt interest (including uplift) was lower than their share in the total stock of gilts. COVID changed that. In 2022/23. Inflation-linked debt, about a quarter of the total, accounted for more than half of the total interest expense.

If the UK debt composition had been in line with that of Germany, debt interest in 2022/23 to 2024/25 would have been tens of billions less than the UK actually paid.

Debt interest in 2025/26 is likely to be broadly back in line with the share of IGs in the overall portfolio. That lower bill may not last because inflation will rise sharply due to the Iran war's effect on energy prices, with natural gas prices quickly passing through to electricity prices, reflecting the structure of electricity generation in the UK. OBR has calculated that a 1pp rise in the inflation rate will add GBP6.5bn to debt interest in the first year and GBP7.5bn in the second (the difference is due to the uplift applying with a lag).

What should the UK aim for with index-linked debt?
There are several considerations to take into account when deciding whether and how much to shrink the share of inflation-linked debt in the UK government’s portfolio. including:

1. The optimal composition of the debt to meet the “preferred habitats” of investors. Given the reduction in defined benefit pension schemes, this suggests a lower share of inflation-linked debt than previously. However, as we saw in 2022, the gilt market can react violently to sudden shifts in policy, so any shift in composition needs to be gradual. At the same time, the role of regulation and possible alternative assets needs to be explored to wean pension funds off linkers over time.

2. The amount of insurance the government is willing to write compared with the level of premiums that the private sector is willing to pay. This is a strategic decision about the long-run cost-benefit of issuing linkers, as distinct from a more tactical view of market pricing relative to the government's short-term inflation view. Both the post-COVID inflation spike and the current Iran-war spike are the result of external shocks, including from geopolitics. The low inflation regime following the GFC was also imported rather than home-grown. Should the government be writing insurance on global geopolitical and supply shocks? It might be justifiable if it is better able to do so than the private sector and if it is adequately compensated to do so. Avoiding writing insurance against global inflation shocks suggests scaling back linkers.

3. The risk to the public finances of potential variability in inflation and the government’s ability to absorb fiscal shocks. The government deficit and debt stock are already too high. The Chancellor has frequently found that the “headroom” built into the fiscal plans is inadequate, leading to market pressure for unplanned corrective measures that can be macroeconomically disruptive. The markets are sensitive to adverse deficit surprises, as we saw in 2022, October 2024, and now. The volatility that index-linked debt introduces into public finances is excessive, given the government’s lack of fiscal space and credibility. This is the main reason I would like to see a much smaller share of debt in linkers.

4. A view of market pricing of breakevens relative to the future likely inflation regime. If we believe that the current 10-year break of around 3.5% reflects a reasonable estimate of future average inflation (taking into account the RPI-CPI wedge), then the choice between linkers and conventionals is a toss-up. If we see an era of relatively high and unstable inflation ahead, with the likelihood of significant supply-side shocks, linkers need to be scaled back. On the other hand, we might aim for more stability in the linkers’ share if we expect inflation to subside to the inflation target. This would be something of a regime shift since the compounded rate of RPI inflation over the last quarter-century is 3.5%. The Markov-switching model suggests that we are in a high-and-variable inflation regime. If we believe this will not last, linkers might actually be a good sell for the government right now.

5. The shape of the distribution of future inflation risks. Actual inflation over various sub-samples in history shows leptokurtosis -the distribution has a high, sharp peak around the mean and fat tails, pointing to a higher probability of outlier events compared to a normal distribution. Past distributions are also right-skewed, i.e., towards high inflation. With increasing geopolitical risks and higher probabilities of supply shocks, we might expect the future distribution to be more leptokurtotic than the past. This argues for the government reducing the share of linkers to reduce the likelihood of significant adverse debt service cost shocks and to avoid the fiscal deficit becoming even more unstable.

6. The correlation between the cost of inflation-linked debt and other government costs, including pensions, welfare, and the remuneration on bank reserves linked to APF holdings.

7. A tactical view of inflation break-even pricing relative to our inflation expectations over the next year. This is not a factor in determining our base portfolio, but could influence our short-run deviation from it.

It is clear that the current high share of linkers in the UK government’s debt portfolio is expensive and risky, both in terms of cost and fiscal credibility. Normally, entities are paid for taking extra risk, but with index-linked debt, the government is paying to take on more risk. The share of linkers needs to fall significantly.

The DMO plans to allocate about 10% of issuance to inflation-linked debt in the year ahead. If that share continues in every future year, we’d eventaully converge on a 10% share in the stock, which seems a reasonable target. However, given the maturity profile, we’d only get halfway there in a decade, which looks slow. And positive inflation surprises could block that reduction because the IG principal would rise with prices.

Unexpected inflation could help maintain or even increase the share. Further cutting the share in new issues, say to 5%, would help, but only slowly, and might damage the liquidity and functioning of the linker market, which is a quarter of the total. Ceasing index-linked issuance would be even more disruptive and undesirable. Buybacks or exchanges into conventional are ways to move more quickly, but costs, market disruption, overturning pension fund and insurance company long-term planning, and the market’s likely interpretation of what the move would signal about the government’s inflation intentions argue strongly against it.

The UK is stuck with the risky exposure of index-linked debt
Thus, it looks likely that the UK will have to live with an excessive level of expensive and volatile inflation-linked debt for many years, reducing the risks only slowly over time. The current episode may not be the last when the UK has to pay for its past funding mistakes.

Basket Case Status is not New
If the UK were newly a basket case, why has it recently tracked the EUR’s path against the greenback? And why is sterling actually a whisker stronger against the euro than at the start of the year? Of course, being no more of a basket case than the euro area doesn’t mean it’s not a basket case.

Source: FRED

October 2024 entrenched the negative view of UK fiscal policy stemming from 2022
The behavior of sterling against the euro suggests that the recent consolidation of the view that the UK is a fiscal basket case, starkly revealed by the 2022 “mini budget,” coincided with Chancellor Reeves’ first fiscal statement in October 2024. That showed how dire the fiscal situation was, with the forecast deficit in 2024/25 revised up from a hopelessly unrealistic 3.1% under the previous government to 4.5% of GDP, which was still three-quarters of a percentage point too optimistic.

Since then, successive fiscal events have revised up the deficit for the first three years, except for the March 2026 Budget, which saw a welcome degree of stability in the fiscal forecast compared with the November 2025 forecast. This lack of further slippage probably won’t last. In any case, the market has a jaundiced view of the government’s fiscal credibility. The energy price shock will only make that worse, helping to explain Chancellor Reeves’ comment at the IMF meetings this week, criticizing the war: her fiscal plans have been torpedoed.

Source: OBR

Vulnerability to inflation shocks
The UK's fiscal basket-case status partly rests on, and is reinforced by, its vulnerability to price shocks. Inflation caused by an energy price shock is a particular vulnerability. The UK imports over half of its gas (Norway and the US being the most prominent suppliers).

Source: OBR

NIESR Director David Aikman reported a much higher sensitivity of UK inflation to an oil price shock than its European peers.

Source: NIESR

UK electricity generation relies heavily on natural gas, and the electricity price is determined by the prices of the marginal producer - gas-fired generators. Following the Russian invasion of Ukraine, these amounted to about 1.5 percentage points of GDP. Households also rely heavily on natural gas boilers. Wholesale gas prices increased from 78p a therm pre-war to about 160bp, but have now fallen back.

Additionally, indexing the minimum wage and out-of-work welfare benefits puts upward pressure on all wages, requiring higher interest rates to contain the inflationary effects of higher costs.

Vulnerability of the public finances to Inflation
The adverse effects on the budget come from at least five directions:

1. Higher debt interest on inflation-linked gilts (IGS).

2. Higher increases in indexed welfare benefits, most importantly, pensions.

3. Lower growth reflecting lower real incomes and higher interest rates.

4. Higher interest rate effects on debt interest.

5. Discretionary measures to shield households from the effects of higher energy prices.

Building up the fiscal cost
The IMF’s WEO revised down UK growth by 0.5pp this year, the largest reduction in the G7, due to the oil shock, which could add 0.1pp to 0.2pp of GDP to the public borrowing depending on the timing of the growth hit.

The DMO’s financing remit for 2026/27 is GBP320bn. A half point higher than otherwise, interest rates could add about 0.8bn to the PSNB in the first year (assuming financing is smooth through the year), but more in the second.

Of more immediate effect, the Bank of England would be remunerating GBP550bn of accumulated QE-driven bank reserves at a half-point higher rate from day 1, adding GBP 2.7bn.

The OBR reckons that a 1% inflation rate would raise the welfare budget by GBP1.5bn to GBP2bn, though that would apply only from next April.

One big hit would come from the uprating of index-linked debt. There, the OBR reckoned that 1pp on the rate of inflation could add GBP6.5bn to the costs of index-linked debt in the first year and more later.

Based on these figures and my assumption of 1% higher inflation as a result of the oil shock and 50bp higher interest rates than otherwise, the additional spending this year could be GBP 10bn or about 0.3% of the UK’s GDP of GBP3.2trn. Adding lower receipts due to weaker growth gives me a ballpark estimate of about 0.4pp to 0.5pp of additional public borrowing in GDP, eliminating about half of the Chancellor’s “headroom.” However, I have not included any allowance for household support, which would be highly likely and highly costly if the shock persists.

As a check, the OBR’s July 2025 Fiscal Risk and Sustainability Report suggests that if there were a sustained shock, “PSNB increases by 0.7 percent of GDP and, if new support measures were maintained in response to persistently high prices, the impact on borrowing could more than double, with PSNB around 1.5 percent of GDP higher compared to the baseline.”

The following OBR chart shows that energy support in the UK was one of the most expensive in Europe in the wake of the Ukraine war, costing over 4% of GDP over time. If this energy supply shock persists, energy support measures could push the UK's budgetary cost of the war to 1% of GDP this year and to significantly more than 1% next year.

Source: OBR

Conclusion
As a result of the energy price shock, the UK’s borrowing needs could worsen by t 0.5% to 1% of GDP this year, depending on whether households are shielded from the effects of higher energy prices, relative to plans, unless the oil shock quickly recedes. A persistent shock would lead to an upward revision of more than 1% of GDP.

There are several policy mistakes that have increased the vulnerability of the UK’s public finances to an energy inflation shock:

• Excessive reliance on natural gas, mostly imported, with little storage capacity.

• An electricity pricing mechanism that is extremely sensitive to natural gas prices.

• Thus, UK inflation is extremely sensitive to a global energy price shock, implying that growth is significantly more sensitive than in most advanced countries due to a more substantial effect on living standards.

• Past inflation slippage allowed by the Bank of England risks volatile, unanchored inflation expectations, requiring firmer rate action than in other countries.

• A high inflation sensitivity implies a greater need to raise interest rates to reduce inflation risks than in other countries. This hurts growth and revenues, and raises debt interest costs.

• An excessive reliance on inflation-linked debt, the cost of which is linked directly to headline inflation.

• A shift in recent years towards increased exposure to short-term interest rates, including the build-up of GBP 500bn of QE-linked bank reserves.

• The “triple-lock” for pensions, which insulates pensioners from an energy shock, whereas the UK as a whole suffers a significant terms of trade loss. Other welfare recipients also receive price indexation.

• Pressure to insulate households from the consequences of an energy price shock, whose effects are magnified by decisions on energy supply.

• Restrictions on the UK fossil energy supply, which deliver lower-than-otherwise revenues when oil and gas prices surge, result in a more substantial terms-of-trade loss.

Although its debt-GDP ratio and budget deficit are not the worst in the G7, at the margin, the UK is way out in front of other advanced countries in being the basket case when an energy price shock hits.

The IMF’s chief economist, Pierre-Olivier Gourinchas, says that even if the Straits of Hormuz open immediately, the current shock is, “in some ways the biggest shock to the global economy since the 1970s oil shocks.”

Yet, the Fund’s April global growth forecasts have been revised down by only 0.2 percentage points in 2026. And advanced economies, as a group, have seen no downgrade, even though all the big country forecasts have been trimmed individually, with the UK taking a particularly big hit. “Other advanced economies” saw an upgrade, which explains why advanced economies as a group saw no change.

Back in 2022, the April downward revision to that year’s growth forecast was 0.8 percentage points in response to the war in Ukraine. If, as Pierre-Olivier Gourinchas argues, the current shock is larger, why is the revision now so much smaller than it was four years ago (and arguably too small even then)?

Part of the answer lies in assumptions about duration. The Ukraine shock was treated as persistent, whereas the current one is framed as temporary. Policy settings also differ. Then, monetary policy was tightening into already elevated inflation, with the energy shock reinforcing downward pressure on growth. Now, the shift in policy expectations is not towards further tightening, but rather the absence of previously anticipated rate cuts.

These differences in both assumed persistence and policy response go some way to explaining the more muted revision. But they also raise questions about whether the current forecasts are understating the current shock's scale.

How to tie a little change in forecasts to the statement of as big a hit as in the 1970s? One explanation is that the world economy's energy intensity is lower now. The second is that, so far, there is no major crisis, unlike the Latin American Debt Crisis we saw half a century ago. The third is that the US is now self-sufficient in energy, avoiding the adverse terms-of-trade effect on the economy. The fourth is that central banks are more credible now, helping to contain inflation more than in the 1970s. The fifth and crucial reason why the IMF’s central forecast changed only slightly is that it assumes the disruption, especially to energy markets, is temporary and contained. As a result, the long-term impact on global growth is limited in the baseline scenario.

However, it seems to me that the words of the chief economist go more with the Fund’s adverse scenarios than with the soothing music of the central case.

The IMF’s small downgrade isn’t evidence of political pressure so much as institutional habit. The Fund builds its central forecasts around contained shocks and mean reversion, even when senior officials acknowledge the scale of the disruption. That creates a consistent bias: tail risks are acknowledged rhetorically but excluded from the baseline. Gourinchas’ comments reinforce that view - this forecast is too sanguine.

Direction of the next 2026 growth revision in the Fall? I’m not betting on an upgrade…

This note does not touch the Iranian side of the equation or speculate on the political response in the US. It sets out the effects of various levels of oil prices on US gas prices and headline CPI inflation, without allowing for pass-through effects beyond the gas pump.

Contributions to the cost of a gallon of gas
The following shows EIA’s estimate of the contributions to the cost of a gallon of gas in 2022 and 2025. Only about half of the cost is accounted for by crude oil, though that share rises as oil prices rise, assuming the other contributions do not move in line.

24 cents on the gas price for each $10 on WTI
The EIA reckons that the cost of a gallon of gas rises by about 24 cents for each $10 rise in the oil price. This is calculated by dividing $10 by 42, the number of gallons in a barrel of oil. It assumes the per-barrel cost increase is equally spread across all products, not just gasoline, which is consistent with historical relationships.

Fluctuations in the non-oil costs of gas can drive a wedge between WTI and the gas price, but over the last decade, we can see that a simple relationship linking the log of the gas price to the log of the oil price works well. The gas price responds to oil with a lag of a couple of weeks, with the long-run elasticity just under 0.6%, which at
$100/bbl and $4.13/gallon is around 24 cents.

The current average gas price is $4.13 according to AAA, but the rise in oil prices over the last month has yet to fully feed through, and even if oil prices were to stay static, we should see a further rise by the end of April. EIA said recently that they expect a peak of about $4.30 this month.

The future oil price and its impact on gas
At this stage, no one knows how long the Straits will be closed or how high oil prices may rise. Some suggest the oil price could rise to $200 a barrel, though others see $150 as a critical line where oil demand starts to break down because of the severe effects on activity of such high prices.

A new peak for gas prices?
The EIA recorded a peak gas price of $5.02 (all grades) in mid-June 2022. We may exceed that this year.

My calculations, based on the EIA rule of thumb of a 24-cent rise in gas prices per $10/bbl rise in oil, indicate that if WTI reaches $140 a barrel, that record will be broken, since we will reach $5.09. The equation-based approach gives $5.06. Given the weight of gas is just under 3% in the CPI, the rise would be adding about 1.8pp to the headline y/y rise in the CPI in June, and 2.0pp if we get to $150 a barrel, compared with a contribution of only 0.6pp to the 3.3% y/y rise in the overall CPI in March.

Beware refining margins
It could be even worse, because I have assumed no change in the other contributions to the cost of a gallon of gas. In a tight supply situation, crack spreads (i.e., refining margins) could rise, especially as the US driving season approaches. Based on the 2022 experience, crack spreads might widen by around 50 cents a gallon, taking us to $5.60 a gallon of gas with an oil price of $140 a barrel, and possibly over $5.00 even with WTI at $120.

Conclusion
Closing the Straits of Hormuz is a US strategy to avoid permanently damaging or destroying Iranian energy infrastructure while still applying maximum pressure to Iran’s revenues and economy. It makes sense because it will affect oil prices in the short term, whereas bombing Iran’s oil production would raise prices for years. However, it is a double-edged sword, pushing up gas prices and hurting affordability in the US. A new record for gas prices would be a significant political blow for the President. Since both countries will lose from the closure, hopefully, they will be motivated at least to find an interim solution. However, in the immediate period ahead, the risk is that the disruption will persist, damaging both global growth and inflation.

That hope is misplaced.

Both Iran and Israel see this conflict in existential terms, and each views compromise as a form of exposure. What one side calls de-escalation, the other experiences as vulnerability, which means the most likely outcome is not resolution, but a tense, incomplete, and inherently unstable stand-off, and a possible deadline extension.

Prepare for the talks to stall or break down.

If they do, the consequences follow quickly: the Strait of Hormuz remains partially constrained, oil prices stay elevated, and markets struggle to reprice risk. Energy dynamics tighten rather than ease, and pressure builds on Donald Trump to escalate or step back and accept that there is no clean resolution within grasp..

Mutually inconsistent core positions
The talks won’t fail because the details are complicated. They will bog down because the core demands on each side directly contradict what the other side believes it needs to survive.

Israel’s perspective on nuclear
Start with the nuclear issue, because everything flows from it. From the U.S. and Israeli perspective, the logic is brutally simple: if Iran can enrich uranium, it can eventually build a nuclear weapon. If Iran builds a nuclear weapon, the risk is no longer theoretical; it’s existential. Israeli strategy has long been shaped by the belief that certain threats cannot be managed, only prevented.

Iran is not just another rival state because, since 1979, its leadership has rejected Israel’s existence. Combine that with nuclear capability, long-range missiles, and a network of armed groups across the region, and the fear becomes straightforward: one day, Israel may face a threat it cannot survive. It cannot afford to lose, even once. Thus, Israel cannot allow hostile states to acquire weapons that could destroy it. From that perspective, “no enrichment” isn’t a negotiating position. It’s a minimum safety requirement.

Iran’s point of view on nuclear
Now flip it. From Iran’s perspective, enrichment isn’t aggression, it’s insurance. It’s the difference between being permanently vulnerable and having a deterrent. The lesson Iranian leaders draw from recent history is not subtle: countries without strategic deterrence get pressured, isolated, and sometimes overthrown, like Libya and Iraq. Countries with it, like North Korea, don’t. So when Iran insists on enrichment, it isn’t asking for leverage. It’s refusing to give up what it sees as a basic guarantee of survival. Having been attacked twice in under a year, having its leaders killed, and being threatened with the end of its civilization, and being pushed back into the Stone Age, will have reinforced the perceived need for nuclear insurance.

The mirror logic applies to Hormuz, missiles, and non-state groups
The same mirror logic applies beyond nuclear. Israel looks at Iran’s missile program and regional networks and sees a coordinated effort to surround and pressure it. Iran looks at those same tools and sees something else entirely: the only way to impose costs on a militarily superior adversary. Strip them away, and Iran becomes easier to strike. Leave them in place, and Israel faces a multi-front threat environment. Both interpretations are rational, but lead to opposite conclusions.

Then there’s the Strait of Hormuz. From Washington’s perspective, Iran’s restrictions on global shipping are unacceptable coercion. From Tehran’s perspective, it’s one of the few levers it has in an otherwise unequal system. Again, the same structure: one side sees destabilization, the other sees leverage, and both see necessity.

The irreducible demand meets the irreducible fear
Put all of this together, and the real shape of the negotiation becomes clear. The United States and Israel are asking Iran to give up its nuclear hedge, its asymmetric military capabilities, and its economic leverage: in other words, the tools that allow it to deter stronger adversaries. At the same time, Iran is being asked to trust that those stronger adversaries will not exploit its vulnerability when it has been attacked twice in a year.

On the other side, Israel is being asked to accept: continued enrichment, continued missile development, and continued regional pressure, while trusting that none of those will ever cross a line into something irreversible.

This is why the talks will get nowhere. Each side is asking the other to accept a future in which it becomes dangerously exposed to a hostile nation it does not trust. From Iran’s perspective, that looks like disarmament under threat. From Israel’s perspective, anything short of full rollback looks like living with a ticking bomb.

Perceptions of irreversible risk
This is where much outside analysis goes wrong because it treats the problem as one of incentives - more pressure, more concessions, better sequencing. However, this is not simply about incentives but about irreversible risk: the risk that Iran will be defenseless and the risk that Israel will be too late. Neither fear is irrational, which is why any deal that does emerge will feel partial, incomplete, and unsatisfactory.

A middle ground won’t be reached because there is no middle ground
There is no version of these negotiations where Iran gives up everything and feels safe. Neither is there a version where Israel accepts a fully unconstrained Iranian program and feels secure. The problem is that in trying to reach a permanent solution, there is no middle ground between Israel’s minimum demand and Iran’s maximum offer. There cannot be a satisfactory bargain because there is no bargaining range where the minimum demand and the maximum offer overlap.

Giving too much could be fatal. Literally
Thus, the only possible outcomes are to reduce risk rather than remove it. This could come through partial limits, monitoring regimes, and temporary arrangements. Negotiations cannot go beyond a temporary halt because they accurately reflect a situation in which both sides believe that giving in, even a little too much, could be fatal. Literally.

Fudge, uncertainty, and more tension are inevitable
So, the most likely outcome is that the talks stall, or break down, the deadline gets pushed back, or they produce something thin enough to delay rather than resolve anything. That should not be mistaken for an endpoint. If this were a boxing match, it wouldn’t be the end of the fight. It would be the bell between rounds.

Both sides go back to their corners; they adjust, they recover. Then, they come out again with slightly different tactics, but the same underlying objective. Nothing fundamental has been settled, because nothing fundamental can be settled - not yet, not under these conditions, not while each side sees the other as a potential existential threat. The pattern will be: pressure, escalation, negotiation, pause. And then back again. Meanwhile, insurers will be reluctant to cover ships, and shipowners will be fearful. Oil and LNG supply will remain constrained, markets will remain nervous about risks, and pressure will increase on President Trump either to escalate or step back and accept that there is no clean resolution within grasp.

Trump’s US sees NATO as a bargain
From the other end of the telescope, the one held by Donald Trump, the community of shared values aspect looks small, not magnified. A transactional President strips away the language, and to him, NATO looks like something else: a bargain.

The United States provides security. In return, its allies provide alignment.
That alignment is not just rhetorical. It shows up in votes, in sanctions, in military support, and—crucially—in whether allies back the United States when it decides to act. For decades, this bargain has endured, not perfectly, but well enough.

Europe, asleep at the wheel for a decade until 2022
The United States underwrote European security during the Cold War and after. In return, Europe aligned - sometimes reluctantly and unevenly, but broadly consistently - with U.S. strategic priorities. The alliance functioned because both sides saw the exchange as worth it and in their interests. Where Europe went wrong was in not reacting when it saw that the US's interests were changing. Hilary Clinton, in the Obama Administration, wrote “America’s Pacific Century,” published in Foreign Affairs in October 2011. The other big warning sign was Russia’s seizure of Crimea in 2014. Europe did not react sufficiently to either development.

Free riding within Europe as well as outside it
Europe was more concerned about its internal problems – the euro crisis and Brexit - than an existential external threat and an Atlantic alliance that was wearing increasingly thin. It was only when a crisis struck in 2022 with the invasion of Ukraine that it woke up to reality. Since then, it has significantly increased defense spending, but from a low base; it is still far too low. Countries have not responded equally. Italy and Spain, far from the eastern border, in peninsulas, and constrained by excessive debt, have lagged and will continue to do so. Europe has been a free-rider on American defense, and some European countries are likely to free-ride on the defense spending by others more directly threatened by Russia.

European defense spending needs to rise by 1.5% of GDP
If the US withdrew from European defense, Europe would need to spend an additional €250 billion annually (roughly 1.5% of EU GDP) and mobilize an additional 300,000 troops to counter Russia, according to a February 2025 study by Bruegel and the Kiel Institute. Only Poland is spending close to what is needed.

Meanwhile, UK policy is to reach 2.5% of GDP by 2027 and 3.5% by 2035. Who knows, the UK might even have an operational destroyer by then, the only currently operational one having had to return to dock for repairs. Let’s hope President Putin is as leisurely as Keir Starmer.

What happens when alignment starts to break down?
That is the question raised by Europe’s reluctance to support a U.S. confrontation with Iran—and by Donald Trump’s willingness to threaten NATO in response.

From a realist perspective, this is not a crisis of values but a stress test of the bargain itself. If the United States provides security, it, and especially President Trump, will expect alignment. If alignment disappears, so does the logic of the guarantee. Security guarantees are not unconditional, and they are not charity. They are sustained by shared interests and, when necessary, enforced by leverage.

Europe wants to have its cake and eat it
Europe, for its part, increasingly wants to separate the two and to retain the security guarantee while reserving the right to diverge on major strategic questions, whether in the Middle East, China, or elsewhere.

That is understandable. European interests are not identical to American ones. Geography, economics, and domestic politics all pull in different directions.

From Washington, the calculation looks different.
From President Trump’s perspective, why should the United States continue to bear the primary burden of European security if Europe is unwilling to align when it matters most? Why maintain a costly forward presence, provide high-end capabilities, and extend deterrence guarantees—only to find that allies opt out when U.S. priorities shift? These are not abstract questions, but go to the core of how the United States’ President evaluates

For years, this tension has been managed rather than resolved. Europe has increased defense spending, but not enough to eliminate dependence. The United States has signaled a pivot to Asia but has not yet disengaged from Europe. Both sides have avoided forcing a clear choice, but that may no longer be sustainable.

What the US gets out of NATO
It would be wrong to characterize NATO as a charity, as it is a mechanism that allows the United States to translate military dominance into strategic advantage. It provides forward bases and infrastructure across Europe, allowing the U.S. to project power into Russia’s periphery, the Middle East, and North Africa more cheaply and quickly than it could alone. European allies, while often criticized for under-spending, still contribute hundreds of billions in defense outlays, including on US equipment, host U.S. forces, and support operations, thereby sharing part of the burden. Just as importantly, NATO anchors a large, economically powerful bloc that broadly aligns with U.S. policy, amplifying American influence globally. In that sense, the alliance embodies a simple bargain - security in return for alignment - but the growing concern in Washington is that while the benefits remain real, the returns are diminishing as Europe aligns less, moves slowly, and offers limited help in the Indo-Pacific.

Europe needs to step up its game
If Europe wants greater autonomy, it must accept the consequences: less automatic U.S. support and greater responsibility for its own defense. If it wants to retain the full benefits of the alliance, it will face continued pressure to align more closely with U.S. strategy. There is no stable middle ground where Europe is both fully protected and fully independent: that is the reality behind the rhetoric.

The art of the deal
NATO is not just a community. It is a deal. Like any deal, it depends on whether both sides believe they are getting enough in return.

The US no longer believes that, with President Trump saying, “NATO wasn’t there when we needed them”. So, if US expectations on alignment are not met, what could the US get in replacement? There are episodes in history where countries paid others to provide defense.

There are clear examples where this security payment has worked. During the Napoleonic Wars, the United Kingdom subsidized continental allies, helping sustain coalitions that ultimately defeated Napoleon Bonaparte, though all shared that interest. Currently, Japan and South Korea pay the US $1.4bn and $1bn annually to defray the cost of the US stationing troops there, though there is also a clear alignment of interests given the threat from China.

However, there are examples where things didn’t work so well. The Byzantine Empire frequently paid off potential adversaries to avoid attacks. It often worked in the short term, but it encouraged further demands and exposed weaknesses. The late Roman Empire went further, outsourcing defense to paid allies - only to find that those same forces could turn against it. Anglo-Saxon England’s Danegeld bought temporary peace from Viking raiders, but ultimately encouraged more attacks, greater demands, and eventual conquest.

The client state must contribute, militarily, politically, or strategically, to reinforce the protector’s interests: the relationship must be grounded in alignment, not just in financial transfers. Remove those conditions, and payment shifts from being a guarantee to a lever. It ceases to be a stabilizer and morphs into an invitation to pressure. It might help to extend the US commitment to NATO while Europe gets its defense act together, but it could not be a long-term solution and might undermine Europe’s willingness to build up its defenses.

What is the deal the President wants?
The President's social media posts, in the context of his disappointment, suggest he is considering another deal. A one-off. He said, “It all began with Greenland. We want Greenland, and they don’t want to give it to us... and I said, ‘Bye-bye!’” This Greenand theme is almost certain to come back as the condition for NATO continuing. But would a one-off deal buy the enduring alignment of interests that are the prerequisite for alliances to endure? It could, in fact, weaken them because the US early warning systems, missile tracking, and space surveillance facilities on Greenland would no longer be on a self-governing territory under Danish sovereignty. The US would need Europe even less.