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The writer, an FT contributing editor, is chief executive of the Royal Society of Arts and former chief economist at the Bank of England
In 1981, Thomas Sargent and Neil Wallace published an influential and challenging paper on “some unpleasant monetarist arithmetic”. The unpleasantness arose because, in a high-debt, high-inflation economy, tightening monetary policy to squeeze inflation widened fiscal deficits and so necessitated looser monetary policy — and higher inflation — over the medium term.
Today’s major policy challenge is fiscal rather than monetary but, on the face of it, no less unpleasant. In a high-debt, low-growth economy, how should fiscal policy be set to lower debt without jeopardising growth? This is the dilemma facing many western economies. In the UK, this month’s Budget will bring it into sharp relief.
Fortunately, there is a path to salvation. History tells us that you grow, rather than cut, your way out of a debt problem. So the key to solving the fiscal conundrum comes from working forwards from the mission of higher growth — not backwards from the budgetary constraint of fiscal rules.
Starting from the mission, weak growth across many western economies is easy to explain. It derives from sustained under-investment in technology, infrastructure and people. In the UK, investment rates have been 3 percentage points below the OECD average since 1990, an investment gap of about £35bn per year. This spans virtually every investment category and sector.
Because this under-investment has lasted decades, the true capital gap is larger still. A recent report from EY, based on a project-by-project assessment, put it at about £1.6tn. The UK’s capital stock per worker is about half the levels of the US, France and Germany, putting our capital gap at several trillions of pounds.
To begin closing it, let’s say we were seeking an extra £2.5tn of investment in the UK over the next 25 years, or about £100bn per year — roughly an extra 4 per cent of GDP annually for the next quarter-century. This is similar in scale to the additional investment need identified by Mario Draghi in his recent report on the future of European competitiveness.
But that scale of extra investment sits uneasily with the debt-based fiscal rules currently in place in many countries. In the UK, public investment is projected to fall, from 2.5 per cent to 1.7 per cent of GDP, over the next five years in order to meet the debt rule. I doubt any country in human history has seen growth pick up at a time of falling public investment from an already too low base. Were that path followed, with the fiscal tail wagging the growth dog, the dog’s days would be numbered.
Asking instead what fiscal path best serves the UK’s growth mission generates much more encouraging arithmetic. Estimates suggest public investment yields a handsome growth dividend. Recent analysis by the UK Office for Budget Responsibility (OBR) suggests a permanent increase of 1 per cent of GDP in public investment boosts the level of potential output by 0.5 per cent after five years and over 2 per cent after 10-15 years. A lasting 4 per cent of GDP per year investment boost could raise national income by 10 per cent in perpetuity.
The implied return on that investment, at about 9 per cent per year, is well in excess of borrowing costs. Indeed, OBR analysis suggests that, for plausible discount rates, the higher tax revenues from improved growth could meet these costs. This means public investment is eventually self-financing. It also means that higher public investment, by significantly raising output while leaving debt unchanged, would materially lower debt ratios over the medium term.
If public investment helps escape the high-debt, low-growth trap, the next question is what fiscal rule best enables the investment necessary to harvest this twin dividend? Returns on public investment are highest for illiquid assets such as houses, schools and roads. But these returns take a decade or more to accumulate. That is why debt-based fiscal rules — which ignore illiquid assets and measure over short horizons — are inimical to both growth and, interestingly, debt.
The most growth-friendly fiscal rule is, by contrast, one which recognises the illiquid assets yielding the highest growth and tax dividend. This is defined in terms of public sector net worth. That would create about £50bn of extra fiscal headroom per year — more if the time horizon for meeting the fiscal rule was a more sensible 10 years rather than the current five. With a private-to-public capital ratio of 4:1, using even half of that headroom would be sufficient to meet the UK’s investment needs.
Of course, this pleasant fiscal arithmetic is undone if higher borrowing leads to sharply higher debt servicing costs. But this is the siren voice of the pennywise. And fortunately, international evidence tells us these views are pound-foolish. It is net worth, not gross debt, that determines international bond yields. Investors, in countries as companies, value rising income and assets. So the investment strategy proposed here would more likely lower rather than raise sovereign bond yields.
On the face of it, high debt and low growth make for hard fiscal choices. Yet the fiscal arithmetic facing many countries provides an immaculate escape route. If in the upcoming Budget, chancellor Rachel Reeves puts her money where her mission is, she could simultaneously and significantly (if not instantaneously) transform prospects for growth and the nation’s finances. The alternative — penny-wise tinkering with rules, taxes and spending — would make it mission impossible.
