My overview to the Policy Exchange fiscal principles paper
This is my overview to the paper that I co-authored for Policy Exchange on fiscal principles.
by Gerard Lyons
The focus of this paper is on UK fiscal policy in the wake of this week’s Statement by the Chancellor and the latest official forecasts from the Office for Budget Responsibility (OBR).
They confirmed what we already knew: that the economy has been hit hard; that unemployment is set to rise; and that the fiscal cost from the pandemic and the approach taken to address it is considerable.
But what comes next is key. The Chancellor said that the
economic emergency has only just begun. He could equally have said that the economy is set to grow strongly next year and in 2022 – and that, supported by the right strategies, future growth can be strong and sustainable. Then, as the economy recovers, we will reduce the debt overhang far quicker than is appreciated.
One clear message, in our view, is the need for a pro-growth economic strategy.
Earlier this year we called for a three-arrowed pro-growth strategy, one arrow focused on monetary and financial stability; one on fiscal policy; and the third on the supply side of the economy, aimed at boosting the UK’s competitiveness through innovation, investment, infrastructure and incentives of lower taxes and smart regulation.
In turn, this would boost prosperity and reduce inequality.
Economic policies should be judged in the economic context of the time, and not be based on a pre-assigned trajectory.
In the face of a global health and economic crisis the UK’s generous fiscal response to the pandemic and its economic impact has been both necessary and justified.
We felt the Chancellor got the balance right between difficult policy choices ahead and remaining alert about the size of the debt.
It is right to use fiscal policy as a shock absorber to avoid premature tightening and to direct spending towards capital investment. Alongside a sizeable increase in infrastructure spending, the annual investment allowance was extended and a new National Infrastructure Bank is to be formed.
The main focus now, as we emerge from the health crisis, has to be on a pro-growth agenda that reduces unemployment and allows the economy to recover. This will allow the ratio of debt to GDP to be reduced gradually over time.
The crisis has highlighted the interdependency between monetary and fiscal policy, both in the UK and globally.
One reflection of this has been the increasing size of central banks’ balance sheets, and their purchase of government debt.
The Bank of England, for instance, has bought in the market about half the government bonds issued since this crisis began.
One worry is that the fiscal numbers may be vulnerable were growth to disappoint, or if inflation were to soar. Currently, low inflation, rates and yields make it easy to finance this debt.
Of course, there is every likelihood that growth will rebound strongly next year, if a vaccine becomes widely available, as alluded to in the OBR’s upbeat scenario. This would be helped by the monetary and fiscal stimulus in the pipeline and also by a rebound in confidence; personal savings, for instance, are high.
Despite this, unemployment will be high, reflecting that some sectors and many firms have been hit hard. The inflation outlook, meanwhile, needs to be assessed closely but is expected by the OBR to remain low.
We would highlight the following:
1. A longer-term focus is needed when assessing the UK’s current fiscal position. The ratio of debt to GDP should be reduced gradually, over time, and that requires a pro-growth
economic policy as the mainstay of policy – balancing the budget should not be the aim of policy but it would be the consequence of a successful policy that sees economic growth recover. Yet allowing the debt to GDP ratio to rise significantly during the crisis is one thing, but it is important to ensure it does not escalate out of control and is reduced, credibly and sensibly, thus keeping financial markets onside over time. Once the economy has started to recover, the debt to GDP ratio will peak and then the budget gap should be closed, ideally through higher tax revenues as the economy recovers.
2. Take advantage of crisis levels of yields to issue very long-dated debt as the Government can fund itself cheaply. The expectation is that this low rate and yield environment will continue, but nothing can be taken for granted. The UK’s maturity of debt is long, leaving it less vulnerable to shifts in interest rates and yields. But the UK should seek to lengthen its maturity of debt, and if, as we suspect, there is demand from funds and investors alike for such debt, then very long dated-debt should be issued. Perhaps, for instance, this could be thirty to fifty years, depending upon where institutional demand is expected to be. The Government announced the establishment of a new National Infrastructure Bank (NIB) this week. Perhaps this could even trigger the issuance of new NIB bonds, whose yield would be attractive to funds, and which could raise significant amounts to fund this infrastructure- focused new institution.
3. Economic policies should be judged in the economic context of the time, and not set on a pre-assigned trajectory. Yet the ability to take advantage of policy flexibility in difficult times requires the need to return polices to something approaching balance in good economic conditions. Unconventional monetary policy and unconventional fiscal policy have been the policy responses to the 2008 global financial crisis and the 2020 global health crisis. There is considerable economic uncertainty now. That helps explain the importance of using fiscal policy as an economic shock absorber and stabiliser. These unconventional policies are likely to allow UK and global growth to rebound strongly in the immediate years ahead. But, as our principles later in this paper outline, in good economic times, the government should aim to return the budget towards far better shape. That seems a long way away, but the longer-term term plans have to be linked to the economy’s future growth potential. Likewise, the current picture of low inflation, rates and yields has allowed policy flexibility. There is always a need to be alert as economic conditions can change.
4. Premature fiscal tightening should be ruled out. We are in a health and economic crisis. It is only once we have emerged from the health crisis that we can make inroads into the economic crisis, and once out of the economic crisis that we can make inroads into the overhanging public debt. Premature policy tightening should be avoided, and this was something to which the Chancellor alluded.
5. We support the stance taken in this Statement on public expenditure: (a) Given the degree of economic uncertainty it made sense to unveil a one-year and not a multi-year spending review. (b) The Chancellor was right to avoid austerity, as Government spending can play a vital role, in helping stabilise the economy now and in achieving balanced future growth. In particular, public investment should rise, especially on R&D, as we emerge from this economic crisis. (c) The need for near-term flexibility on spending plans is understandable and is reflected in the political decision to freeze some areas of public sector pay, and to increase overseas aid spending by less than the pre-set target. (d) While we do not advocate austerity, greater control over future public spending is necessary and is preferable to a free-for-all on public spending.
6. We have concerns about the current debate surrounding future taxes. (a) The Chancellor served notice that some taxes may rise in the future. We agree that the Chancellor should retain the flexibility to tweak specific taxes at any stage and not box himself in over future economic policy. The danger in announcing that tax rises have been delayed is that this may deter people from spending now, thus damaging the recovery. (b) In our view, tax-rises should be avoided during this stage of the economic cycle. (c) We also would challenge the view that the future trend for taxes is inevitably up. We disagree. The margin of error on one-year ahead fiscal projections is huge, never mind projections over decades. The key is the future trajectory of the economy. While taxes are needed to support public services, in a globally competitive world they need to remain low enough to spur investment, innovation and economic growth.
7. Replace fiscal rules with principles to guide policy. Fiscal rules are not needed but some
principles may help guide future policy. We outline ten fiscal principles that should help guide fiscal policy, both now and in the future, as we emerge from this crisis.
The scale of the increase in government spending this year has, naturally, led to questions about how we will pay for the impact of, and response to, the pandemic and has triggered fears of higher future taxes and pressure for increased expenditure on other important areas. It is important for a clear plan to reduce the debt to GDP ratio in the future in a credible and understandable way; that the weakness of the economy has necessitated such spending; that the combination of low inflation, rates and yields has reduced debt servicing so much, to allow it; and that the consistency between monetary and fiscal policy is an important part of this policy mix. Key is that economic growth rebounds and that inflation does not soar. In coming years there should be scope to grow our way out of this fiscal situation, as we did after the Second World War, when the ratio of public debt to GDP was even higher than it is now.