Honesty would be Labour's best policy

On Friday, the day the new Labour manifesto was published, two new pieces of information moved prices on the gilt market. First of all there was an opinion poll in the Daily Telegraph showing that the Labour lead had come down from 34 points to 28.5. The markets took this as an early sign of a Tory recovery and marked gilt prices up. The second came at lunch time, when the United States employment figures were published, showing that growth in the States was still as strong as ever. This suggested that US interest rates will be increased in August, if not before, and share and bond prices around the world - including UK gilts - duly fell back again.

Note the two implicit messages here. Despite the Labour assurance that it would set tough new rules for spending and borrowing and so ensure low inflation, the thing that cheered up the professional investors was the prospect that Labour might not, after all, get in. And whatever happens in Britain or elsewhere in Europe, the most important influence on long- term interest rates here was the news that came from Washington, more than 3,000 miles away. As for the economic policy of what will, on the balance of probability, be the next British government, nobody seemed to care either way.

Yet the Labour statement does deserve serious attention by anyone interested in the impact on the economy of a change of government. The political ramifications are discussed elsewhere in this newspaper; despite the fact that it is not particularly radical or new, the economic side should command attention, too.

The most striking thing, reading the document, is how again and again it declares that Labour will not take risks with inflation and that it will not tax and spend. On fiscal policy it repeats the "golden rule" of Shadow Chancellor Gordon Brown that over the economic cycle it would not borrow for current spending, only for investment. On monetary policy, it repeats its pledge to reform the Bank of England, and if the document does not quite say it will give the bank its independence, it does say it will make monetary policy "free from short-term political manipulation".

If we are to believe what we are being told, it becomes conceivable that both fiscal and monetary policy might turn out to be tighter under a Labour government than under the Tories. The surge in public borrowing that took place before the last election would not be possible; and the current easing of monetary policy would presumably not be possible either.

But such a possibility is not at all the market perception; witness the response on Friday morning to that opinion poll. Just as there is a trust deficit with UK voters, so there is a trust deficit with the world's financial markets. Labour is simply not believed. The level of public borrowing is one of the two main factors determining long-term interest rates; inflation is the other. Clearly the markets reckon that either borrowing will be higher than it otherwise would be, or inflation will be higher, or both.

This is a problem. The primary purpose of the manifesto is to convince British voters that, as its first sentence says, "the Labour Party has changed". But if professional investors do not agree, Labour will, so to speak, have to earn the promised low interest rates and lower inflation by operating more restrictive fiscal and monetary policies than the Tories. The world's financial markets are accustomed to coping with all shades of governments everywhere in the world and would have no difficulty in reacting positively to a Labour government if it did indeed follow policies on the lines this manifesto sets out. But they are also much more powerful, relative to national governments, than when Labour was last in office. As a result, achieving credibility matters far more now than it used to.

How might Labour achieve a greater level of credibility in the coming months? There are two obvious areas in which the markets would like to see more specific information.

The first is the likely profile of public borrowing. There are two problems here: the deteriorating fiscal outlook, and the fact that, unlike the Tories, Labour will find it difficult to raise much revenue from privatisation. The graph on the left comes from the last Budget's Public Sector Borrowing Requirement estimates and is already known to be seriously over-optimistic. But were it not for privatisation proceeds it would be even worse. Labour's new document sticks to the idea that a levy on utilities would raise an extra pounds 2.5bn, but that is the same as the privatisation proceeds last year, which were the lowest for more than a decade. This year pounds 3.3bn has been raised already. In effect, Labour would need double the revenue from the proposed utilities levy to get public borrowing to the same position that it would be were the privatisation programme to continue at present rates.

So until Labour brings out some numbers suggesting its preferred profile for reducing the PSBR, it really is not possible to believe what the "tough rules" for government spending and borrowing might mean.

The second area in which people in financial markets want more specific information is tax. It is obviously an important practical issue for high earners in the City, and that will, to some extent, cloud their judgement on the prospect of a Labour government. But it would be naive to believe that London taxpayers determine the market response to British government policies.

The views of New York, Tokyo and the continental centres are just as important, and, in any case, many movers and shakers in the City are, for tax purposes, not domiciled here. Markets need to know about tax because tax is an aspect of international competition. Indeed, one of the most encouraging statements in the Labour document is that taxes will be "internationally competitive", for it shows awareness of this point.

If the graph on the left carries bad news, the one on the right carries good. The forecasts from BZW for growth, consumption and productivity suggest that whichever party forms the next government will do so against a remarkably favourable economic background. Growth, consumption and productivity next year will all be at more than 3 per cent: it is, in many respects, an enviable inheritance and certainly a benign one. This story is developed further by Yvette Cooper below.

I suspect that the aspect of the Labour manifesto that will strike the sourest note in the financial markets is the failure to acknowledge that, in economic terms, the UK is a relative success story. A political document is a political document, and to say that some things might not be too bad suggests either a failure to appreciate real success and hence to understand economics, or a lack of frankness.

The words that describe Labour's approach to fiscal and monetary policy ought to command respect. But we cannot know whether those words mean anything until two things happen. The first is more practical detail on taxing, spending and monetary policy. The second is to acknowledge that the UK economy is performing well by European standards. Labour leaders, of course, know that. While it is unrealistic to expect this theme in the final version of the manifesto, it would underpin the Labour leadership's efforts to establish a reputation for honesty if it could emerge from time to time - even if it has to be gift-wrapped in pink paper.