A shift in the fiscal debate?

Good morning from New Economy Brief.

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A debate is raging about public investment ahead of the Budget next month, and there have been significant interventions over the last few weeks that have transformed that debate’s character. 

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The Office for Budgetary Responsibility (OBR) has released two papers with big implications for the politics of public investment and fiscal sustainability, while some of the most respected economists from all over the political spectrum have called on the government to reform their fiscal rules.

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This week’s New Economy Brief dives deep into the political economy of public investment, and explores a new campaign seeking to reform the UK’s fiscal framework: Invest in Britain.

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Trapped in a political cycle of underinvestment

The Labour government has talked up the benefits of public investment, but the positive rhetoric is set against a gloomy policy background. In order to claim ‘fiscal responsibility’ ahead of the election, Rachel Reeves committed to stick to the previous government’s central fiscal rule – that debt must always be forecast to fall as a percentage of GDP in five years time. To do this, Labour’s current plans imply cutting public investment from 2.4% of GDP to 1.8% by the end of the Parliament. But this will harm their ability to grow the economy and service debt in the long run. 

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How did we get here? Many economists feel that OBR’s current mandate makes it an actively unhelpful force in our fiscal policy debate by forcing it to scrutinise the short-term impact of decisions but ignore their longer-term impact. For example, the OBR itself accepts that raising or cutting public investment affects growth hugely over the long term. But this does not show up within the five-year time horizon over which it assesses government policy decisions. (We have previously covered the OBR’s role in our fiscal framework, locking us in a cycle of underinvestment and economic stagnation).

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How the OBR calculates the effects of public investment. Labour have argued that the OBR should take a longer-term view of public investment decisions, and as it happens the OBR recently released a paper doing just that. It outlines how they model the impact of raising public investment by 1% of GDP. The authors find that the impact of public investment on the supply side of the economy increases over time. After five years they think such an uplift in public investment increases GDP by 0.5%, but over 50 years that rises to 2.5%. This is really useful information from the OBR, but the reality is that our short-termist fiscal rules simply don’t take this impact into account. In fact the benefits of public investment on GDP are at their lowest point after five years, meaning the OBR’s approach likely artificially suppresses public investment. 

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Political implications for our fiscal rules. The OBR paper also considers the return on investment from public investment. It finds that on average a 1% increase in public investment has a 1.7% return for the government and a 8.7% return for the wider economy over 10 years. Crucially, this is higher than the government’s borrowing costs – so borrowing to invest is worth it on average. Yet once again, despite this evidence that public investment is good value for money for the government, our fiscal rules are still set up to ignore everything after the next five years . This means most of the economic benefits of public investment are artificially excluded. By ignoring the positive impacts of public investment, these rules encourage governments to cut it, and this damages long term growth and traps us in what many have termed the fiscal ‘doom loop’.

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Longer term fiscal risks and debt sustainability 

It turns out big OBR reports are like London buses, because no sooner had that first report been digested than a second even longer one appeared. This was the latest of its regular 'fiscal risks' reports, which examine longer-term sources of danger for the public finances, such as climate change, declining health, and demographic shifts. (These reports get much less attention than the OBR’s Budget assessments and are not used to assess government fiscal policy choices.) Their 2021 Fiscal Risks report found that long-term debt:GDP ratios could rise to 289% by the end of the century without action to stop climate change. A slower transition to net zero would cost the government and the economy more than acting quickly, through economic disruption, loss of export potential and more need to import new low-carbon technologies from abroad. IPPR’s Carsten Jung highlighted that the latest fiscal risks report, released last week, shows that “fixing these societal problems can hugely boost fiscal sustainability”. 

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We can reduce tomorrow's fiscal pressures with more targeted spending today. In the OBR’s words: “limiting the rise in global temperatures to… 2°C rather than 3°C could alleviate around 10 percentage points of upward pressure on the debt-to-GDP ratio” and “improving the health of the population could reduce the rise in debt by a further 40 per cent of GDP”. Perhaps most significantly: “boosting the productive capacity of the economy…could make the biggest difference of all, with every 0.1 per cent increase in productivity growth reducing the rise in the debt-to-GDP ratio by 25 percentage points.” They note that returning to pre-financial crisis rates of productivity growth could keep debt below 100% of GDP for the next 50 years. Taken together, the OBR’s two latest reports show that failing to tackle these fiscal risks, for example by investing in decarbonisation or improving the health and productivity of the workforce, is grossly fiscally irresponsible. 

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Reform the rules and Invest in Britain

Following hot on the heels of these reports, a new campaign has launched aiming to give the government an escape route from the fiscal doom-loop. Invest in Britain coordinated a joint statement from eight of the country's most senior economists – including Lord Jim O’Neill, Lord Gus O’Donnell, Mariana Mazzucato, Mohamed El-Erian and others – urging the government to change its approach. Commenting on the public investment cuts inherited from the last government, they warned that “To follow through on these plans would be to repeat the mistakes of the past, where investment cuts made in the name of fiscal prudence have damaged the foundations of the economy and undermined the UK’s long-term fiscal sustainability”. Former Bank of England Chief Economist Andy Haldane made similar arguments over the weekend.

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Escape the doom-loop. The campaign has provided a briefing collating resources and key stats and showing broad public and establishment support around the new economic consensus for raising public investment and reforming fiscal rules. The briefing concludes: “Given the circumstances they have inherited, a fiscally responsible approach for the new government which focused on the long-term health of the economy would involve: 

1. Cancelling the planned public investment cuts and setting out a strategy for significantly raising public investment as a percentage of GDP across the parliament. 

2. Implementing a pro-investment fiscal framework, which recognises the vital role of public investment in long-term debt sustainability.” 

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Political space? Taken together, the reports from the OBR and the interventions from a range of economists appear to have given the government a little political room to move away from the restrictions of the debt rule, while still being able to argue that their approach is fiscally responsible and in line with mainstream economic thought. There have already been hints that the government might look at the definition of debt in the fiscal rules, but could something more substantial be on the cards? All eyes will turn to the Chancellor’s conference speech on Monday to see if there are any clues.