A Brief Theoretical and Historical Context
I studied economics in the UK in the early 1970’s, a period when the inflation rate went over 20%, and saw British society being ripped apart by this insidious process. I worked as an economist in South Africa from 1977-1996, a period which saw permanent double digit inflation, with even more disastrous social and economic effects. In response I have spent my whole career making the case for the restoration and maintenance of fiscal and monetary discipline. Therefore, when the Tory Party leadership candidates started competing with each other on tax cuts and spending ideas my first reaction was negative – sound public finances have only just been restored and already the politicians are on a spree! Many economists and policymakers of my generation share this attitude, and a number reside in the Treasury. I refer to this group as the “Hawks” (in which I include myself) in the rest of the article.
However, upon reflection, it seems that we Hawks need to re-consider our position on current UK fiscal targets and policy. A great help in reaching this view has been a recent paper by Olivier Blanchard – former chief economist at the IMF – entitled “Public Debt and Low Interest Rates”. Blanchard’s key point is that sustained low interest rates – and specifically interest rates on government debt that are lower than the nominal economic growth rate – radically change the dynamics of public debt.
Blanchard’s paper includes a chart showing US nominal GDP growth and the 10-year US Treasury Bond rate from 1950-2018. The chart shows that the US nominal growth rate was consistently above the 10-year Treasury Bond rate from 1950 until around 1980. This position reversed during the 1980’s and lasted until the 2008-2010 Global Financial Crisis (GFC). Since then 10-year rates have been once again lower than the nominal growth rate. A chart with the equivalent data for the UK shows exactly the same pattern. The current UK government 10- year yield is around 1.25%, while the nominal GDP growth rate is around 3.5%. Blanchard argues that in these conditions public sector debt expansion may have little or no fiscal cost, where fiscal cost is defined as the need to raise taxes in future when debt raised now cannot be rolled over.
It seems intuitively obvious that very low long term borrowing costs for government make it less risky to raise debt. Blanchard is reassuringly able to demonstrate this mathematically – a feat well beyond me. It is not that the Hawks reject this logic, but rather that our mind-set has been conditioned by the experience of the 1980’s and 90’s – we may be like WW1 generals still dreaming of cavalry charges. In this period interest rates were higher than the nominal economic growth rate, sometimes dramatically so, and large scale debt expansion was much more dangerous.
Fundamentally, Hawks need to accept that the present low interest rate environment is likely to be maintained well into the future. This is what the long term futures markets are telling us. After all, current low levels of interest rates are much more the historic norm, not only during 1950-1980 but much further back than that. Under the gold standard there was on average no inflation, and consequently very low and stable interest rates on public debt. Hawks must not let our aversion to debt result in missed opportunities to either ameliorate any economic downturn or raise the economic growth rate.
Blanchard is not arguing that there are no limits on sustainable debt expansion – far from it – and neither am I. He states that although there may be little or no fiscal costs to debt expansion in current conditions, there may be significant welfare costs if public borrowing crowds out private sector investment with high returns on capital. It is not clear if that is the case at present. He also alerts that market sentiment towards debt levels can change so that higher risk premiums are demanded and future fiscal burdens escalated. I would add that fundamental political and social questions relating to the size and role of the state place crucial limits, over and above these narrower economic arguments.
The Current Economic Context
Assuming Brexit is delivered – deal or no deal – by the 31st October, the following key features of current economic conditions will help shape the kind of fiscal expansion justified in a post-Brexit UK economy:
• The global economy has clearly slowed markedly in recent months. The expansion is already long in the tooth by historic standards, and some central banks have been tightening monetary policy significantly over the last year. The Trump tariff “wars” are an additional negative. An outright global recession cannot be ruled out in coming quarters.
• The UK economy is also slowing markedly, in line with global trends. Although the economy has performed much better than Project Fear forecast, the Brexit uncertainty has also clearly started to weigh on growth, and particularly on business investment.
• UK public finances are in good shape, with the overall fiscal deficit having been reduced from over 10% of GDP in 2009/2010 to around 1.5% currently. Excluding interest payments there is now a small surplus (technically called a primary surplus). Total government debt to GDP is relatively high at around 84% of GDP, but on current plans is set to fall steadily over the next few years. According to the (somewhat controversial) work by economists Rogoff and Reinhart the danger level for government debt to GDP ratios is the 90-100% level – at or beyond this point high state debt seems to cause notable declines in economic growth. Blanchard’s recent work suggests that at sustained low interest rates the danger point may be higher than this, though Blanchard does not make this claim himself. In any event the UK has averted the danger level.
• If there is an economic downturn, monetary policy is pretty much out of bullets. Bank rate is already very low, and it is unlikely – and would be unwise – that the Bank of England (BoE) would follow the ECB’s negative interest rate policy. Although the BoE’s Quantitative Easing (QE) policy did not result in inflation – as Hawks thought it might – it has badly distorted the financial system and markets and contributed to the muted post GFC economic recovery. Stimulus will have to come from fiscal policy, especially if Sterling weakens further post-Brexit.
• The UK has a long history of relative neglect of public sector investment. UK Public Sector Investment as a % of GDP has persistently been in lowest 10-15th percentile of OECD countries for the last twenty five years. A similar picture is true for UK Business Investment as well. Although low business investment can partly be explained by the dominance of the services sector in the UK economy – which is inherently less capital intensive – the UK’s low overall propensity to invest is a clear cause of our relatively low productivity growth. As a country we also invest less in R&D than most developed economies.
What is a “Safe” Level of Deficit post-Brexit?
In summary we have a weakening global and UK economy, much improved public finances, very limited scope for monetary stimulus, and a long standing neglect of public sector investment. The economy is about to undergo a major adjustment as we exit the EU. This situation cries out for a more expansionary fiscal policy. How far can policymakers go? This article can only take a broad brush approach to this critical question. We only have scant information about the fiscal intentions of the Johnson government. The author has also learnt from experience that economist’s knowledge of how the economy works and reacts to policy changes is more limited than they often pretend.
What broad parameters are we looking at? First, the nominal GDP growth rate is generally projected to be 3.5% p.a over the next few years – comprising an average inflation rate of 2% and real growth rate of 1.5%. However, it is clear that a Post-Brexit Johnson government would attempt a programme of supply- side reforms, some of which are only possible outside of the EU. Such measures might include: the introduction of free ports; extensive tax reform (the UK tax code is now 11 million words long – a Treasury unit set up to simplify UK taxes could be kept busy for at least 10 years); better regulation free of EU red tape; independent agricultural and fishing policies; improved incentives for research and development; new FTA’s with non-EU countries; and a large programme of infrastructure investment. It seems feasible that such measures could over time raise the long term sustainable real growth rate by at least 0.5% to the 2.0% level and thus the nominal GDP growth rate to 4%.
The current fiscal deficit is around 1.5% of GDP and on current plans set to fall to less than 1% by 2024. If the planned deficit levels were instead raised to 3.0-3.5% over this period this would still allow a small but steady decline in the debt level as a % of GDP( given the 4% nominal growth assumption). In current money terms this would allow room for a combination of tax cuts and spending increases totalling £35-45bn. It is crucial that a significant proportion of this promotes the supply-side of the economy, most notably infrastructure investment. If an economic downturn pushed deficits temporarily above these levels this could be, within limits, tolerated by policymakers. This fiscal stimulus package is very different to the reckless policy followed in the US by President Trump. His programme produced significantly larger deficits but contained very little capital spending, and was started when the US economy was already growing strongly and had a debt to GDP ratio of 100% and rising.
The new Chancellor Sajid Javid has in the past proposed a £100bn infrastructure fund to be invested over a five year period. At an average of £20bn per year this would use up about half of the “headroom”, and would take total public sector investment from the present 1.9% of GDP to around 2.5-3.0% ( more in line with the OECD average). This would also mean that the bulk of the overall deficit comprised capital spending. As long as the projects chosen are ones with high returns on capital this programme will comfortably pay for itself, particularly when borrowing at historically low interest rates. We are not talking here about the apparent white elephant that is HS2, but less glamorous but more worthwhile projects such as those improving connectivity between and within Northern cities and towns, or rapidly delivering full fibre broadband across the country.
This article concludes that there are theoretical and historical grounds – in the context of sustained low interest rates – for a more relaxed approach to public debt than previously acknowledged by the Hawks. Given current economic circumstances, and the likely imminence of Brexit, there is scope to raise UK deficit spending to 3.0-3.5% of GDP –a rise of £35-45bn – in the next few years, providing it is accompanied by supply- side reform and at least half of that increase is spent on public sector infrastructure and/or the promotion of business investment. Let the Hawks take flight!
Robert Lee July 26th 2019