With the former Chancellor Rishi Sunak now confirmed as the UK’s new Prime Minister, economic policy is primed for a shift from a tax cutting ‘dash for growth’ to restoring fiscal sustainability through real spending retrenchment and potential tax increases. Dimitri Zenghelis explains why additional public borrowing still has a role to play in financing the growth-enhancing, sustainable and resilient investment of the future.
Following Liz Truss’s short leadership and ‘dash for growth’ through unfunded tax cuts, Rishi Sunak’s new prime ministerial leadership looks set to restore fiscal sustainability through real spending retrenchment and potential tax increases. Yet fiscal policy can still encourage sustainable growth. At this crucial time for the UK economy, public borrowing has a role to play in financing the productivity-enhancing, sustainable and resilient investment of the future and the new Chancellor and Prime Minister must learn from recent events.
The current Chancellor, Jeremy Hunt (who at the time of writing was expected to stay in post in the new government), last week spoke of the need to take “decisions of eye watering difficulty”. And there are indeed tough choices to be made. Yet policies to promote growth and long-run fiscal sustainability through additional borrowing should not be dismissed as misplaced, so long as there is an opportunity to generate inclusive, resilient and sustainable growth. Such an opportunity exists. Moreover, a careful interpretation of the response of the financial markets to ex-Chancellor Kwasi Kwarteng’s ‘mini-budget’ suggests financial markets would not favour austerity nor regard public borrowing for investment as a fiscal risk at this time.
Market reaction to the ‘mini-budget’
UK public debt to GDP levels are not particularly high, by international standards. A single budget never seriously increased the chances of the UK government defaulting on its debt. Even with higher interest rates, UK debt interest payments are unlikely to breach 4% of GDP at their peak, according to the Institute for Fiscal Studies, thus remaining affordable. More likely, the sizable tax cuts raised concerns for two reasons. Firstly, unlike borrowing to invest, which is more sustainable, tax cuts are more likely to be spent on consumption. Secondly, it prompted concern over the social and economic impact of spending cuts on vital public services, infrastructure and skills, and on social cohesion.
The UK has an operationally independent central bank with an explicit inflation target and mandate. The risk that inflation would be allowed to rise, eroding the value of public debt by stealth, does not accord with the market reaction to the mini-budget whereby implied forward rates rose sharply. This indicated that the market expected an active Bank of England to raise policy rates to offset the inflationary ‘injection’ of spending power from the budget tax cuts.
All else being equal, higher expected interest rates would have elevated the spot value of the pound on foreign exchange markets. This is necessary to ensure what is termed interest rate parity, meaning that if the long-run sterling exchange rate is unchanged, there will need to be an expected future depreciation of the pound to offset the UK’s relatively higher expected interest rates. The long-run equilibrium exchange rate is the rate that allows demand to remain close to supply and the balance payment surpluses or deficits to be sustainable, in the view of market participants.
Yet the pound did not rise. It fell. This tells us that all was not equal and that in fact, the market’s perception is that the UK’s equilibrium long-run exchange rate had declined. This can be interpreted as an enhanced perception that the UK might be less able to pay its way in the world, with the mini-budget having eroded UK growth prospects, or simply raised the riskiness of the UK as an investment destination. This explains the simultaneous rise in 30-year gilt yields.
The markets are therefore demanding some form of additional compensation for the risk associated with investing in the UK over the longer term. This is likely to reflect a range of concerns, including about deficient public and private investment undermining UK performance. In the short run, they are likely to reflect fears of socio-political instability in response to further cuts in overstretched public services, including widespread public sector strikes and political changes of leadership in response to higher mortgage rates and declining real incomes (which is exactly what subsequently transpired). The two are linked: institutional instability and poor governance reduce the likelihood of a stable and forward-looking policy environment. This discourages investment in economicly productive activity.
Most notably, it can be inferred from the actions of market participants that there was no explicit concern about UK debt levels per se. This implies that a budget announcing borrowing to invest would not have been met with the same reaction, provided that some of the investment was funded through measures that did not fuel UK demand and inflation, and that the plan was credible politically. Most importantly, the markets are not pressing for austerity.
The argument for investing in clean infrastructure and skills
The backdrop to recent events is important. Britain is suffering from decades of chronic underinvestment, which has led to stagnant productivity growth. As a consequence, average earnings are forecast to remain below their level in 2009 for years to come. In a recent report I argued with Nick Stern and Charlotte Taylor that the best way to boost prosperity and reduce public sector indebtedness after COVID is to enable investment in clean and resilient infrastructure as well as skills and ideas, even if that means a temporary rise in the ratio of public debt to GDP. Solvent governments such as the UK’s can still borrow at historically cheap real rates, reflecting a surplus of desired global saving over investment. As a result, the neutral level of real interest rates – the level at which an economy is neither overheating nor being reined back, given the stance of fiscal policy – has remained negative.
The rise in nominal interest rates has failed to keep pace with the increase in inflation. This means the Government can continue to ‘borrow for free’ to invest in public infrastructure that is likely to generate a much higher return, boosting income and tax revenues sufficient to lower public debt/GDP. Indeed, history has shown that a prerequisite for public debt sustainability is securing sustainable growth, thereby generating tax revenues and progressively boosting the denominator in the key debt/GDP metric.
The world is in the grip of two economic revolutions, the technological revolution and the low-carbon, resource-efficient transition. We have argued that investment in digitisation, clean energy and energy efficiency is likely to yield significant gains to UK innovation, productivity and competitiveness. Capacity-generating economies of scale in production and discovery have the potential to act as powerful disinflationary forces. For example, the International Renewable Energy Agency (IRENA) estimates that by providing a substitute to expensive gas, renewable power generation capacity added in 2021 is likely to save around $55 billion in global energy costs in 2022.
Provided the investment and growth plan is costed and credible, it should retain the confidence of the markets, limit policy risks and allow the UK to continue to borrow cheaply. This much needed investment will help increase both energy security and resilience to future shocks, lowering costs and allowing early movers to build the knowledge base and supply lines to exploit some of the world’s fastest growing markets. By focussing on cost-reducing investment, it will curtail expectations of higher future inflation, helping to contain the rise in mortgage costs.
Even though tax revenues as a percentage of GDP are high by historical standards, we argued that the multipliers associated with general tax cuts at this time are insufficient to generate debt sustainability, a conclusion implicitly echoed by the UK bond markets in recent weeks. Instead, public resources should be carefully targeted at growth- and revenue-enhancing investment to restore productivity growth and underpin the public finances. This means encouraging investment in future-proofed physical, human and intangible assets, best placed to balance risks and opportunities associated with rapid technological, environmental and social change.
Uncertainty enhances the importance of strong, predictable and transparent public policy to steer private investment and to reinforce expectations of tangible returns from a clean transition. This is why investors reacted negatively to Truss’s unexpected mini-budget. They feared the effects of borrowing to fund consumption and the likely impact on public and private investment as the Government struggled to balance the books while the Bank of England raises interest rates. Let it be hoped that the new Chancellor and Prime Minister draw the right lesson from recent events. Additional public borrowing has a role to play in financing the productivity-enhancing, sustainable and resilient investment of the future.
A version of this commentary was first published by the Grantham Research Institute on Climate Change and the Environment on 25 October 2022.
Image: Prime Minister Rishi Sunak outside 10 Downing Street. (Credit: Lauren Hurley / No 10 Downing Street/Flickr)