Call of the wild  Animal spirits can go down as well as up

Sir Keir’s government took over after a period of near stagnation in real incomes per head. The malaise has endured: it has its genesis just before the onset of the Great Financial Crisis of 2008. This sclerotic growth greatly complicates Labour’s mission to improve public services – one of the main reasons those who voted for it chose Labour at the 2024 General Election. Lower growth means a lower path for tax revenues, and less money for public services.

One way to interpret Sir Keir’s call of the wild is as a reference to a term economist John Maynard Keynes used to describe the susceptibility of economic activity and the stock market to shifts in views about the state of the economy – now and in the future. Keynes argued that what people do may be “a result of animal spirits – of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by
quantitative probabilities.”

Boom and bust

Keynes’ preoccupation in his 1936 book The General Theory of Employment, Interest and Money was with the Great Depression. An old tradition in economics that we might term ‘classical’ – and has survived intact to the present day – took the view that economic outcomes were always efficient, the best that could be achieved. The theory held that government intervention in times of slump would simply make things worse, akin to paying farmers to harvest when their crop was wet.

Keynes’ mission was to help people understand that busts are inefficient and unnecessary – and that government policy can help reverse or prevent them. And one possible reason for an inefficient slump was ‘a spontaneous urge to… inaction’, perhaps because of increased pessimism about the future.

This way of seeing booms and busts is related to how we understand the fragility of finance and banking. Even healthy banks can be vulnerable to shifts in views about whether they are solvent. These shifts cause people to withdraw deposits, forcing banks to call in loans prematurely, realising losses that they otherwise would not have, leading to the prophecy of insolvency becoming fulfilled.

The rise and fall of regions or cities – for example the growth, decline and renaissance of Detroit – can be seen the same way. The benefits of one business staying in a city depend on whether it thinks other businesses and customers and workers are going to stay; whether they stay depends on what they think everyone else is going to do. If there is a prophecy that people are going to leave, it will become self-fulfilling as it is then rational to leave.

The first draft of this article was written a few days before the announcement of Trump’s tariffs on other countries’ exports to the US; the discussion of retaliation by Canada, the EU and China; a second round of responses from the US – and the reaction to all this in financial markets. While I was writing a second draft, Trump announced what much of the media described as a ‘pause’ in these tariffs, comprising: immediate 10% tariffs on all except China – which received an increased 125% tariff; and 25% tariffs on all steel and cars entering the US from countries other than China. The UK-US trade deal has since reduced or removed tariffs on some goods.

Before all this happened, the situation in the UK did not look like one in which the outlook needed a boost from ‘animal spirits’, since it had been experiencing a return to the inflation target from previous excesses. The trend indicated that aggregate demand was coming back into balance with the UK’s supply capacity. Thus, Starmer’s promise to ‘unleash’ the UK’s animal spirits seemed inappropriate.

Yet, following the fall in the stock market from 4 April, the partial rally following the tariff ‘pause’, and the gyrations in US government bond yields, the outlook has changed completely. It has made the notion of animal spirits highly relevant – although not for reasons Starmer could have anticipated when he was writing.

The tariff on most UK to US exports is 10%. Total exports to the US are about £60 billion, or around 1/40th of GDP. So while they are unwelcome, the direct effect of tariffs on real incomes is insufficient to precipitate a
big recession.

Self-fulfilling panic

But the likely eventual impact on the UK could greatly exceed this. First, we are affected by the overall reduction in global demand caused by the higher tariffs on other countries, if the ‘pause’ is not extended indefinitely. Second, we remain prone to the effects of retaliation by China, EU, Canada (and possibly our own retaliatory tariffs, at the time of writing not ruled out). Third, there is the added effect of the uncertainty about what Trump will do; whether he might back down, or just how far tit-for-tat responses could escalate. Fourth, once the falls in share prices reach a certain point there is the risk of financial fragility – note that shares in banks have been caught up in the sell-off – and a self-fulfilling panic.

A fall in demand that exceeds the fall in supply caused by tariffs is therefore a distinct possibility. At that point Starmer’s government will need to be ready to operate the traditional fiscal levers – to stabilise ‘animal spirits’.

At the time Sir Keir was writing, he might have meant the ‘animal spirits’ term a little less literally. Not referring to the need to counter a depression caused by pessimism, but instead to changes the government would make that improved the business climate and underlying growth.

The government has outlined several policies that bear on the growth outlook. Some of these ambitions are encouraging, some less so. Labour’s ambition to deregulate planning is one most previous governments have shared – including the ill-fated Truss administration – and it remains to be seen what that delivers (see page 16).

Labour has expressed an ambition for a ‘reset’ of its relationship with the EU. But assuming it sticks to its repeated promise not to breach the ‘red lines’ of Brexit by rejoining either the Customs Union or Single Market, there is little or no scope to make significant dents in the cost of Brexit with any other deal. Pivoting to the EU may also conflict with Labour’s hope to do some kind of deal with the US to mitigate the effects of – or cancel – the new tariffs on UK exports.

The government has signalled an intention to reduce net migration into the UK, and at the time of writing was seemingly set on tightening rules for granting visas to foreign students. This will be unambiguously bad for the UK, speeding parts of the university sector into bankruptcy, shrinking education exports and research – at a time when there was an opportunity to harvest flows of research staff and students that are being displaced from the US.

Labour has also turned its attention to the competition and financial regulators, hoping that looser regulation might stimulate growth. But this is just as likely to lead to lower competition (which can be growth inhibiting) and more financial risk (which can later crystalise into a damaging crisis, as 2008 reminded us). Labour has inherited Sunak’s bullish attraction to artificial intelligence to transform economic performance and public service provision. Time will tell whether this optimism proves founded or not.

Prone to populism

Labour also hoped to change the business climate by ushering in a period of stability and policy realism after years of populism and fiscal and financial instability, culminating in the short-lived premiership of Liz Truss. But it is failing. Labour has fallen back in the opinion polls since the general election; Reform has risen; and Badenoch’s leadership of the Tory Party has adopted populist tactics and talking points.

Strands of opinion within Labour itself seem to think that the best way to fend off the populists is to become more populist. One Labour MP, envious of Trump’s political success, and hoping that UK Labour would emulate his style was quoted recently as saying ‘it doesn’t even matter whether your announcements are going to happen’. The probability of populist policies after 2029 is high. Businesses know this and are bound to factor it into their long-term planning when thinking about investing in the UK.

The UK – and the rest of the former western alliance – faces new threats to the business climate from Donald Trump’s withdrawal of the commitment to defend Europe against Russia (most immediately with the attempt to coerce Ukraine into conceding a peace favourable to Russia); and with the on-off tariff wars. These developments are highly consequential for the business climate in the UK. Both the tariff wars and rearmament are going to make us feel poorer and reduce consumption. They will also restructure production, away from trade with the US, and non-military goods, towards domestic goods and trade with other countries. Some companies will lose, others will gain.

One view of how the US escaped the aftermath of the Great Depression is that it was aided by the US military build-up and prosecution of WW2. If rearmament were embarked on, this would be a test of whether it somehow galvanised both demand and supply. But the UK government is not yet going down this route. It is being held back by the need to keep to previous fiscal promises, including the fiscal rules; and by either an institutional Atlanticism, or a perception that somehow avoiding a public distancing from the US can extract special treatment from Trump, or persuade him to stick with some features of the longstanding Nato defence promise. The trajectory of the war in Ukraine might yet force Labour to change its stance.

Since the tariff announcements there has been flight from US government bonds. This is unusual. At times of financial fragility, US government IOUs are normally treated as a safe haven. But this time the source of uncertainty is US institutions, whose inclination and capacity to respond to the crisis are now in doubt.

There is ongoing sabotage to financial regulators and even tax collection under the auspices of Elon Musk’s Department for Government Efficiency. Will the independence of the Federal Reserve hold and secure a normal monetary policy and inflation response? Trump has both said he wants to try to fire and not fire Fed Chair Jay Powell. He cannot – currently – fire him legally, but the US government is doing many things in the face of legal convention, so who knows what would happen if Trump tried to get rid of Powell. Would the Treasury now have the capacity or desire to support private financial institutions that got into difficulty? Unclear.

There is little the UK authorities can do to elevate global ‘animal spirits’. But they can help efforts by countries outside the US to coordinate to reduce trade barriers between themselves – to mitigate the effects of US tariffs. And they must be ready to operate the usual fiscal and liquidity support levers if the crisis causes a UK recession, or difficulties for UK financial institutions.