In its election manifesto the Conservative party committed itself to following a fiscal rule to ensure a balanced budget by 2022/3. While that may have made sense as a tactical election decision to create clear water between the Conservatives and the reckless spending promises of the Labour manifesto, it creates a problem for post-Brexit fiscal policy in the current economic context. The true cost of borrowing is now negative: in other words, lenders are offering to pay the government to borrow from them. Furthermore, Brexit will bring reforms on trade, regulation and immigration and should create faster future growth in the long term – even if most officials and many private sector economists who backed Remain still take a gloomy view. Finally, there is a need for fiscal policy to give the economy a boost not just to put an firm end to Brexit uncertainty, but also to cut taxes to stimulate entrepreneurs, to raise essential spending on public services, and, last but not least, to push interest rates higher to a range where monetary policy can get traction again.
For these reasons we need fiscal policy to become more expansionary over the next decade. The issue of how to square this with the manifesto commitment can be dealt with quite easily, since the fiscal rules include the ‘golden rule’; that investment can be funded by borrowing. ‘Public investment’ is in the process of being redefined in ongoing technical discussions between the ONS and Treasury. It has never made sense to limit it to infrastructure and other physical investment when ‘human capital’, the discounted present value of people’s productivity, is ever more important. A significant proportion of current government spending contributes to or directly creates human capital, notably the two departments of health and education. Arguably, most if not all public spending invests in ‘human capital’, since its aim is to empower, train, and keep safe the country’s population, enhancing their ability to work and produce.
By redefining current spending, we can shift the focus of ‘fiscal limits’ to where they belong: the long-term sustainability of plans for debt, spending and tax. In other words, are these plans consistent with the solvency and health of the long-term government balance sheet? All these policy areas are at the heart of democratic decision-making, so to try and short-circuit decisions on them by imposing ad hoc short-term operating rules is both lazy and damaging.
Let us, therefore, get back to the substantive issue of what fiscal policy should be.
The most serious aspect of the situation we are in relates to the crisis of monetary policy. Western central banks, including our own Bank of England, allowed a big credit boom before the financial crisis. Then when it predictably hit the buffers of resource constraints and caused big bank losses, instead of injecting enough liquidity into the banks to ensure survival, feebly – and apparently under political pressure – central banks allowed Lehman to go under, and caused the financial crisis.
Then, just when they needed to get banks up on their feet, lending strongly for the recovery, they hit banks with a huge regulative whammy, requiring big rises in expensive equity capital. Recovery and credit growth duly stalled and the deflationary threat took over, with interest rates falling to zero. Since then central banks have twisted and turned, rolling out quantitative easing, a gigantic programme of printing money to buy government and corporate bonds, which has made it an easy financial world for governments and big companies, and a tough world for SMEs, as loans to them force extra high capital needs, and for savers. These policy failures have caused weak growth and rising monopoly power, with falling productivity growth.
It is a terrible mess and a dreadful record. But how to get out of it? With monetary policy powerless until interest rates return to normal levels, where world savings do not dwarf world investment, we need a period where fiscal policy is highly expansionary to shift the world balance back towards a savings shortage and to drive up rates. Fortunately, this is the approach of Donald Trump and could well be, and certainly should be, that of Boris Johnson too, though unfortunately nowhere else yet.
Now turn to what this Conservative government could do and the long-term prospects this could help unleash.
My calculations from our Cardiff research suggest the government could spend or cut taxes by an extra £100 billion a year (about 5% of GDP) quite safely by borrowing more. The programme could comprise of – a £24 billion a year spend on public services and infrastructure; a 10% cut to corporation tax, costing £32 billion p.a., abolishment of the very top additional 5% rate (costing £1 billion), cutting the top rate of income tax to 30% (costing £15 billion) and a 5% cut to the standard rate of income tax (costing £28 billion).
According to the Liverpool supply side model of the UK, every 2% off the average tax rate, or equivalent cost reductions via public spending, creates a long-term 1% boost to GDP by making the economy more competitive. On this basis, we could assess that this programme would raise growth by around 1% a year over the next decade and a half. This would come on top of the gains from Brexit which we can put at about 0.5% per annum. By achieving higher interest rates, the government would reduce the market value of its existing, but mostly long term, debt by around £500 billion.
What could this do to the long-term government balance sheet? By the end of the 2020’s the ratio to GDP of debt at market value would be around 55%, comfortably below the 60% ratio usually regarded as safe. The government, with a much higher GDP, would be spending 40% of GDP on programmes including debt interest, with tax revenues running higher at around 41%. All this is highly sustainable.
It may well seem that with the Covid-19 virus threatening world recession, this is not a good time to launch such a bold programme. On the contrary, such economic uncertainty needs to be confronted with a strong fiscal stance, to ensure uncertainty does not become self-reinforcing. Rishi Sunak needs to scotch all talk of new taxes, pledge to underpin the economy with any necessary short-term borrowing and chart a new course to unleash this country’s economic potential.