Regime Change

Thoughts on Poland's MAGA president, Ukraine's stunning attack, Trump's weaponisation of finance, why Starmer is right to fear Farage, and how to tweak Britain's fiscal rules

Photo by Ross Findon on Unsplash

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I will be in Madrid this week where I am looking forward to speaking at the Aspen Institute Espana about The End of the Economic World as we Knew It. Details can be found here. It would be great to meet any subscribers who can make it.

In this newsletter:

• Poland’s MAGA president: Bad for Europe

• Slava Ukraini!: Now seize Russia’s assets

• Weaponising finance: Regime change?

• Waiting for Nigel: Why Starmer is right to be worried

• A Modest Proposal: How to fix the fiscal rules

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1. Poland’s MAGA President

The victory of Karol Nawrocki, the right-wing candidate in Poland’s presidential election, is certainly a blow to the pro-European, centrist government of Donald Tusk. The Polish prime minister had been counting on a win for his colleague Rafał Trzaskowski to overturn some of the more egregious efforts by the previous Law & Justice (PiS) government to undermine the rule of law by packing the courts with crony judges. But beyond this, Polish politics will likely continue much as before, with the president continuing to frustrate the Tusk government’s reforms, with the goal of paving the way for a PiS win in the next general election.

The greater significance of Nawrocki’s win is what it says about the state of European politics. For the last four months, Europeans have been able to comfort themselves with thought that no matter how bad Donald Trump may be for the world, he was the kiss of the death for the electoral hopes of right-wing populists. But Nawrocki has bucked the recent trend, winning with the explicit endorsement of the Trump administration, following the egregious intervention of Homeland Security Secretary Kristi Noem on the eve of the poll.

More broadly, Nawrocki, a 41 year-old historian, amateur boxer, football hooligan and alleged procurer of prostitutes, has now become a leading light in the continent-wide alliance of eurosceptic right-wing parties that gathered at the weekend for the Conservative Political Action Committee conference in Hungary. A flavour of this grouping’s antipathy to the EU and to any moves towards deeper European integration was clear from Hungarian prime minister Viktor Orban’s speech to the conference, where he accused Brussels of “hijacking” the European dream with a plan to “centralise Europe under the pretext of war”:

If there is a war, there is more Brussels, and even less sovereignty… In their minds war will be the engine of the economy. Collective debt, central control and a war chest. The key to the liberal plan is Ukraine. Ukraine’s accelerated European Union membership is a convenient pretext for Europe’s war-oriented reorganisation. The liberal plan will lead to a Europe at war, centralised and mired in debt - with no freedom, but subservience.

As it happens, Orban made his speech just days after Christine Lagarde, the president of the European Central Bank, had given a thoughtful speech in which she set out what the EU needed to do to boost the international role of the euro and thus enjoy some of the benefits of reserve currency status. They included boosting the EU’s geopolitical presence by strengthening its security capabilities and military partnerships; deepening single market integration to make the EU more attractive to global capital and by using the EU’s fiscal capacity to issue more safe assets in the form of common bonds; and by reforming EU governance to enable more qualified majority voting and reduce national vetoes.

It is hard to imagine a speech more calculated to antagonise Orban. Indeed, what these two speeches highlight is the huge and widening ideological divide in European politics between those who see deeper European integration as the key to greater security, prosperity and autonomy and those who see in European integration only a loss of sovereignty and growth-sapping bureaucracy.

It is ironic that in this ideological battle, it is the anti-Europeans that are by far the most united, best organised and well-coordinated. The right-wing nationalists that gathered in Budapest for CPAC have emerged as a genuine pan-European movement, if that is not a contradiction in terms. Another irony is that despite being avowed sovereignists, their agenda hinges on American support. As Orban said: “We need America”. No wonder Trump backs them.

Meanwhile, as Zsuzsanna Végh, a programme officer at the German Marshall Fund of the United States, notes for EUObserver, the transatlantic mainstream has no answer of equal spectacle and scale to rival CPAC.

Democratic, centrist actors rely on high-level fora, such as the Munich Security Conference and various other think tank conferences, for exchanges that do not resonate with broader electorates. Unless democratic forces craft a similarly engaging platform and supporting network, they will continue to fight in an asymmetric information battle.

That seems to me the real lesson from the Polish presidential election. Those attending the CPAC conference last week are already anticipating the Czech elections later this year, elections in Hungary next year, and France in 2027. With every electoral success, they make it harder for the EU to move forward or respond to common challenges, which in turn undermines its legitimacy. The question is whether those who actually believe in European integration can build their own pan-European movements to take their arguments on?

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2. Slava Ukraini!

The stunning Ukrainian military operation that saw it destroy up to 40 Russian bombers in a mass drone attack deep inside Russia could not have come at a better time. It came just before the two sides met in Istanbul for the latest rounds of “peace negotiations” at which Moscow presented its latest surrender terms.

It also comes as Europeans are giving up hope of convincing America to keep backing Ukraine. Donald Trump said last week that he would know in the next couple of weeks whether Russia was serious about peace and what to do about it if not. But he has been saying such things for months and never acted on them.

But the success of this assault not only took out a significant Russian capability that has been used to attack Ukraine. It will also have lifted morale, demonstrating to Ukraine’s allies that it can win this war, that it can carry on fighting even without US support, and that it has no reason to accept the kind of humiliating surrender that Trump and Putin have been trying to impose on it. Above all, it should galvanise Kyiv’s European allies to step up their own support.

The most important way that they could do that is to seize Russia’s frozen assets to hand them to Kyiv to help pay for its defence and, in time, its reconstruction. Such a move would signal to Moscow that Kyiv has the resources to keep fighting for several more years, if it needs to, even without Washington’s backing. In a notable intervention last week, Thorsten Frei, the head of the German Chancellery, told a German newspaper that the EU should "take a much closer look at the issue of Russian state funds than we have so far."

Nonetheless, some European countries remain wary, fearing outright seizure of the assets would be illegal and could undermine global trust in the euro. That is understandable. At a time when America is acting lawlessly on multiple fronts, sowing doubts about its willingness and capability to continue to anchor the international financial system, the EU has an opportunity and an obligation to act as a custodian of the global rules-based system.

But as I noted a couple of weeks ago, one way of circumventing these issues is to provide Kyiv a “reparation loan”, in which Ukraine agrees to repay the loan out of future reparations from Russia. As Hugo Dixon, one of the authors of the plan, explains in this piece for Breakingviews, if Russia refuses to pay up, the lenders would then be legally justified to seize the assets as collateral.

Nor would such a loan require the EU to cross any red lines. After all, the G7 agreed at last month’s summit of finance ministers that “Russia’s sovereign assets within our jurisdictions will remain immobilised until Russia ends its aggression and pays for the damage it has caused to Ukraine”. All that remains is to hand Kyiv the money so that it can continue to defend itself - and convince Russia to come to the negotiating table with serious proposals for peace.

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3. Weaponising Finance

For a few days last week, it looked as if an end might be in sight to another war that is engulfing the world at the moment. But hopes that the US Court of International Trade had pulled the rug from under Donald Trump’s trade war by declaring all the “reciprocal tariffs” that the president announced on April 2 to be illegal were quickly dashed. The Court of Appeal reinstated the tariffs while it considers the case. It has since become clear that the administration could implement most of its tariff policies under different legal authorities.

Meanwhile Trump, perhaps goaded by jibes about the TACO trade (“Trump Always Chickens Out”) announced a new 50 percent tariff on steel and aluminium imports. He then took to Truth Social to complain that China had “TOTALLY VIOLATED ITS AGREEMENT WITH US!" Indeed, the escalating war of words between the two sides is raising questions as to whether the ceasefire agreed in Geneva two weeks ago can hold. At the core of the dispute seems to be that China has not relaxed its export restrictions on rare earths, which could soon cause serious problems for US defence production and other tech sectors.

On top of this, investors must also now confront the possibility that Trump’s trade war is about to be extended to the financial sector. Section 899 of the “big, beautiful, budget bill” passed by the House of Representatives last week would give the Trump administration the power to impose additional taxes on companies and investors from countries that it deems to have unfair tax policies. The WSJ insists it is no big deal. But as GaveKal warns:

The problem is that before Trump has a chance to use the new tool, its very existence may unsettle bond markets. The list of countries that have already imposed a digital services tax includes the UK, Canada, and several European countries. The tally for those that have signed up for the global minimum corporate tax is far longer. Anyone managing assets in one of these countries must be rethinking their US asset holdings—which may soon be subjected to a punitive tax on interest and dividend income.

Indeed, this weaponisation of the US capital markets will only further undermine the attractiveness of the dollar at a time when the US is reliant on huge inflows to fund its twin current account and budget deficits. The unusual recent market moves, with the dollar falling even as Treasury yields have risen, has raised questions about the safe haven status of US Treasures. Among those now talking of diversifying away from US assets are German pension funds, Dutch pension funds, Canadian pension funds, and the Hong Kong Monetary Authority.

Where might all this lead? One risk now is that further declines in the dollar could become self-perpetuating, not least because so many foreign investors are unhedged, warns ReutersBreakingviews noted this week. Japan’s giant Government Pension Investment Fund had invested almost a third of its $1.7 trillion portfolio in American assets as of March 2024. The cost of insuring these exposures against dollar falls could drive the currency down further.

At the same time, these unusual US market moves are creating stresses elsewhere in the international financial system. Taiwanese insurers, for example, reporting a $620 million loss in April alone on their US assets. Then, a surge of as much as 8.5% in the value of the Taiwan dollar over two days in early May raised the prospect of $18 billion in currency losses for their unhedged US investments. In Japan, bond yields soared after a weak bond auction last week.

Of course, some of the biggest risks may lie within America’s own financial system. As The Economist notes, this has become “dauntingly opaque”, dominated by powerful new financial giants whose balance sheets are stuffed with private assets that that are highly illiquid and thus potentially mispriced. Worse, the Trump administration is preparing to embark on financial sector deregulation, unpicking globally agreed post-crisis reforms which, as Hung Tran at the Atlantic Council warns, will not only make the US system itself more risky but make the global system more dangerously fragmented.

Many in the markets seem determined to look through these risks, seeing Trump’s trade wars as simply another economic variable to be factored into their forecasts, rather than the start of a wider regime change. But it is hard to believe that Trump’s aggression towards allies and adversaries alike, his uncoordinated and unilateral unpicking of agreed global rules, and his assault on the rule of law can remain limited to the sphere of trade and will not spillover deeper into the financial system, raising as it does profound questions about global governance.

The big question that has been dominating discussion in the markets since April 2 has been how far does the dollar need to fall and/or Treasury yields need to rise to entice foreign investors to continue to fund America’s twin deficits? But underneath it lies an even bigger question: can the US still be relied upon to act in the interests of global financial stability, including extending financial lifelines to the rest of the world in a crisis? Or will Trump seek to exploit any crisis to exert further leverage? If so, then we are in a very different world indeed.

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4. Waiting for Nigel

Why did Sir Keir Starmer scrap a planned trip to Germany last week to travel to the north west of England to give a speech attacking Nigel Farage’s economic policies? Sure, Farage’s policies are nonsense. Starmer was right to denounce the package of giant tax and spending giveaways to be unfunded by equally giant but unspecified public spending cuts as “fantasy economics” and label him "Liz Truss 2.0". But Labour has a parliamentary majority of 165 and is more than four years away from the next election, while Farage’s Reform party has just four MPs. Wasn’t Starmer according Farage more respect than he deserves?

Much of the commentary has focused on the political risk that Farage poses to Starmer, not least among Labour MPs unsettled at Reform’s surge in the polls that threatens many of their seats, including in the Welsh assembly where elections will be held next year. But Reform’s success poses a more immediate economic threat to Labour too. According to a reader in the City, international investors are starting to ask what impact Reform’s recent success in the local elections might have on Labour’s investment plans as well as the prospects that Reform might make it into government after the next election.

Investors are right to be concerned. Reform has, for example, threatened to use its control of 10 councils to do whatever it can to obstruct green energy projects - a core element of Labour’s growth agenda. And while there may be only a slim chance that Reform forms the next government (according to this post by Ben Ansell), the spectre of Farage can still have a wider macro-economic impact.

One of the big problems hanging over the UK economy is that since the Liz Truss debacle, the government must still pay a risk premium on its borrowing relative to other G7 countries, as this chart from Simon French, chief economist at Panmure Gordon, shows. That reflects concerns that the UK is susceptible to “fiscal fatigue” and won’t be able to stick to plans to bring down debt. Those fears can only be heightened by the prospect of Farage waiting in the wings.

Of course, it doesn’t help that Labour has itself been making its own spending pledges, promising to reverse some of its cuts to winter fuel payments and suggesting it might remove the two-child cap on universal credit. Whatever the merits of the arguments - and the two-child cap is particularly cruel - it hardly suggests a government willing to take “tough choices”.

True, the government has said it will announce details at a fiscal event and remains committed to its fiscal rules - but it’s hard to see where the money will come from without tax rises which will only dampen growth and fuel support for Farage. Yet as the International Monetary Fund noted last week, it is important that the government “stays the course” on deficit reduction, given the risks arising from global economic uncertainty and volatile markets:

Materialization of these risks could result in market pressures, put debt on an upward path, and make it harder to meet the fiscal rules, given limited headroom.

All this is contributing to gloom in the City, even as business confidence picks up after last year’s budget. As the chairman of one major financial services firm, not unsympathetic to Labour and the appalling legacy it was left by the Tories, said to me last week, the government had one shot to revive growth ahead of the next election and it looks increasingly as if it has missed. The Spending Review later this month will, alongside deep departmental cuts, provide around £100 billion of public investment - but any boost to growth is unlikely to arrive in time.

No wonder, investors are already starting to ask “what comes next?”

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5. A Modest Proposal

I recently sat down to discuss the state of the UK economy with Nick Cohen, one of the best writers on British politics on Substack, for his The Lowdown podcast. He asked me what I thought the government should be doing to boost Britain’s growth prospects. I’m afraid I can’t claim to have been able to offer any magical solutions. I think the government is broadly doing the right things in seeking to improve the supply side of the economy via trade deals, reform of the planning system and public investment in infrastructure and science.

The reality is that there is no lever that the government can pull that easily offset the huge negative shocks delivered to the UK economy over the last decade and a half via the global financial crisis and Brexit. The damage done to the supply side the economy in the form of higher trade barriers and the difficulties that this has caused for economic policymaking was the subject of a speech given by Andrew Bailey, the governor of the Bank of England, in Dublin last week.

Nonetheless, if there is one thing that I think the government could and should be doing better, it is to focus on the national balance sheet. I wrote about this frequently before and after last year’s general election. Indeed, Rachel Reeves herself talked about paying more attention to the national balance sheet in her Mais Lecture before becoming chancellor. At the time, I thought it was a significant and encouraging intervention. Since then, she has barely mentioned it.

That is a pity. After all, if the state owns assets that might very conservatively be valued at 100 percent of GDP them just improving the yield on these assets by one percentage point, whether through cutting costs or improving revenues, could deliver a significant boost to the public finances.

For example, the government owns and operates a vast road network, which creates significant costs for the state but generates no revenues. A balance sheet approach would suggest that the answer is a national road-pricing scheme, easily achievable with modern technology. Similarly, the British state in various guises own large amounts of council housing. So why not sell the assets to an insurer or pension fund that would pay a high price for the annuity income and use the proceeds to build more council houses? That way the national balance sheet remains the same but the country gets twice as many affordable houses.

So here’s my modest proposal. In its report on the state of the UK economy last week, the IMF suggested a tweak to the fiscal framework to avoid the situation Reeves found herself in earlier this year when she felt obliged to undertake a mini-budget in response to revisions in Office for Budget Responsibility’s economic forecasts. The problem is that it is very hard for the government to stick to its sensible intention to have one budget per year when the OBR issues two forecasts, since the chancellor will come under political and market pressure to spell out immediately how she will fill any shortfall under the fiscal rules.

The obvious solution is to scrap the second OBR forecast. But why not replace the Spring Statement that usually accompanies the forecast with a balance sheet statement instead? The OBR already publishes an annual Fiscal Risks and Sustainability Report which contains lots of data on the national balance sheet, while the National Audit Office is responsible for publishing the annual Whole of Government Accounts, which provides a comprehensive national balance sheet on the basis of accrual-based accounting standards. Yet currently these important documents play next to no part in the national economic policy debate.

An annual balance sheet statement would enable Reeves to deliver on the promise of her Mais Lecture. More importantly, it would enable her to present what the government is doing in terms of public investment in the context of improving public sector net worth. The most recent Office for National Statistics estimate is that the UK’s public net worth was minus £716 billion at the end of 2023. Past IMF analyses have suggested the UK’s net worth was the second worst of any advanced economy after Italy, in part because of unfunded public sector pensions.

Indeed, a national balance sheet statement focused on measures to improve the country’s public net worth could rebalance political debate away from short-term growth towards long-term wealth. It could open the door to more radical policy options to the political debate by introducing a more commercial framework. Above all, it would force the political class to think seriously about long-term stewardship of national resources rather than simply how to appropriate the cashflows. That would be the best response to populists like Farage.