Don't panic: put worries about current fiscal policy in context
This article appeared in ConHome on Tuesday 25th January, 2022
Dr Gerard Lyons is a senior fellow at Policy Exchange. He was Chief Economic Adviser to Boris Johnson during his second term as Mayor of London.
There is no need to panic about the UK‘s fiscal position. This does not mean we should be complacent about it either. The budget deficit and debt are high, but are now on an improving trend.
As a result, the Government has the ability to provide further assistance to help people through this cost-of-living squeeze. The Chancellor has hinted at a likely £500 one-off payment. That makes sense.
There is also the ability to reverse this spring’s rise in national insurance. This could be justified in economic terms, especially as it is a tax on jobs, and not implementing the increase would also help to alleviate the cost-of-living squeeze. However, such a reversal seems unlikely, since the hike was portrayed as a way to fund social care, and instead targeted measures to those most in need may be preferred.
The deficit and debt are never far from the centre of the current economic and political debate. Judging from the last few days, this is likely to be the case from now until the next election – with an increased focus on both the Government and the Opposition’s fiscal plans.
The key measure of the budget deficit is public sector net borrowing, excluding public sector banks (PSNB-ex). The latest data is for the end of November and, in the first eight months of this fiscal year, the PSNB-ex was a sizeable £136 billion – the second highest total ever, but still £116 billion less than a year earlier.
Continued budget deficits add to the outstanding national debt, which had climbed to £2.32 trillion at the end of November.
When measured in pounds, the debt continues to rise as long as we run budget deficits – which the UK has done in all but six years since 1970. The key, though, is what happens to the debt as a proportion of GDP.
Public debt currently stands at 96.1 per cent as a ratio of GDP – the highest since 1963 when it was still on a falling trend from its high at the end of the Second World War. The national debt peaked in 1946-47 at 251.8 per cent of GDP.
That is, at just over two and a half times the size of the economy. It then fell every year until 1973-74, when it was only 45.2 per cent of GDP. After then rising, it was only following the Lawson Boom that it reached its post-war low of 27.1 per cent in 1990-91.
At that time, I correctly pointed out that the fiscal position gave a misleading impression of economic health, as it needed to be seen in the context of the overall economy. Then, household debt was rising sharply, following the easing of credit controls. Furthermore, we were shadowing the Deutshemark in the late 1980s and then within the Exchange Rate Mechanism until 1992, thus not setting monetary policy to suit our domestic economic needs.
There are many lessons from that time, not least the obvious need to focus on sustainable growth and not to look at single measures of economic health in isolation.
The Lawson Boom became a bust – as did the booms of three other post-war Chancellors: Maudling, Barber and Brown. Of course, Lawson instigated many supply-side reforms that incentivised the private sector and helped transform the economy.
By the time of the global financial crisis in 2008, the ratio of debt to GDP was still low, at 34 per cent. It rose sharply in the wake of that crisis and during this pandemic to its current position.
The lesson from the post-war period is that it is possible to bring the ratio of debt to GDP down steadily, over time. This needs to be borne in mind when judging fiscal options now.
While the Chancellor’s sizeable and targeted fiscal measures during the pandemic made sense, it would be a mistake to conclude from the last two years that increased Government spending is the response to all our challenges. I am a strong believer in the effectiveness of a pro-active fiscal policy, but for the right reasons and at the right time.
It would also be wrong to believe that, because the tax take is already high, there is nothing to stop it heading higher. As I pointed out in a co-authored report for Policy Exchange, Fiscal Principles for the Future, while taxes are needed to support public services they need, in a globally competitive world, to remain low enough to spur investment, innovation and growth.
Because of their current scale, how to bring the public finances back into shape has emerged as an issue.
The options are straightforward: borrow, squeeze spending, raise taxes or create fiscal space through stronger economic growth. We are, effectively, trying a combination of these now.
To inflate the debt away is not a credible policy option. While slightly higher inflation may make it easier to repay debt, it is easy to lose control if inflation rises sharply, with higher interest rates and borrowing yields adding to debt servicing costs.
The margin of error on official projections of the budget deficit is huge. Recognising this should have allowed a challenge last autumn to the tax hikes unveiled for this spring. For instance, in the first half of this fiscal year the budget deficit was already a sizeable £43.5 billion better than the forecast made by the Office for Budget Responsibility last March.
Higher taxes are not the route to favour; policymakers should instead be aiming for stronger sustainable growth.
However, the Treasury sees itself primarily as a finance ministry, with its main task to balance the budget and in which a pro-growth or pro-entrepreneurial agenda takes second place.
Another challenge is the economic consensus is far too pessimistic about UK growth prospects.
This implies that more of the budget deficit is explained by structural and not cyclical factors. It is the equivalent of being in a hole and being told to dig deeper, as higher taxes or a squeeze on spending is seen as necessary to close the structural budget gap.
By contrast, if the deficit is seen as cyclical, then austerity or tax hikes are not the solution, and the deficit can be closed by a rebound in growth. Clearly, the stronger growth is, the less need there is to take other corrective measures.
The narrative that is coming to define post-Brexit economics – from those who were the key actors in Project Fear and wrongly said that jobs would be shed – is that taxes are unavoidable. However, this is not the case. The current tax take is high, largely to address social case and the sheer cost of the pandemic. But it again highlights the importance of delivering on a pro-growth economic vision.
Our trend rate of growth fell sharply in the wake of the 2008 global financial crisis and remains low. We must become a high productive, high wage and high growth economy, but this requires a three-arrowed pro-growth approach based on: first, supply-side reform, which should include sensible regulation and low taxes; second, a sound monetary and financial policy; and third, a credible fiscal strategy. Such a strategy would feed, too, into realising the post-Brexit dividend. There is much to do on each but, as we now emerge from the pandemic, the opportunity is there.