14 November 2019
(Not) the £1.2trn News
What is the problem with borrowing to invest?
by Frank O’Nomics
The first casualty of (electoral) war is truth. Just as outlandish statements in the referendum, regarding additional cash for the NHS of £350mn per week to be generated by Brexit, were impossible to justify, the £1.2trn increase in spending (£650mn per day) that the Tories claim would be the cost of Labour’s planned spending increases, is based on, at best, sketchy logic. Both parties are planning to end austerity with a bang, with policies that imply considerable increases in public spending. To distract voters from their own profligacy, each will try to leave voters with a sound bite of impending doom regarding the other. The key driver for both parties is the consistent low level of borrowing costs. It is currently possible for the government to borrow for 30 years at a rate of 1.25%, compared to 2% this time last year. This rate is below the current level of inflation (1.5%) and considerably less than the targeted level of inflation (2%). So why worry about increased spending funded by borrowing?
Manifestos are still being put together and in many respects will be based on “all things being equal” or even “best scenario” provisos. Nevertheless, both parties are apparently pledging to spend an extra £20bn (Tories) to £50bn+ (Labour) per annum on infrastructure. Even before some of these pledges, the Institute for Fiscal Studies had forecast the budget deficit rising to over £50bn for each of the next 2 years, from £40bn last year – a sum way above the old fiscal target of 2% of GDP. These spending pledges, while they seem profligate, can be justified on economic logic. The first point has already been made – borrowing is very cheap. The more important factor is to look at the potential returns from the investment. UK productivity is at a pitifully low level, with output per hour not registering any increase for each of the last 5 quarters. In international terms it takes us 5 days to produce what the US or Germany produces in 4. Current levels of economic uncertainty make the stimulation of business investment from the private sector unlikely to change the situation. If the planned government infrastructure investment were to be transformational for UK productivity then the additional growth and tax revenue generated may mean that, in the long-term, the deficit implications are nothing like as scary as predicted.
The issue, then, is to assess those long-term economic benefits of infrastructure investments. Additional spending on the NHS should reduce the number of days lost through sickness and potentially free some carers to return to work. Similarly, money spent on education will help to fill skill shortages and facilitate the workforce to adapt to a changing economic environment. The increase in tax and reduction in benefits paid could far outweigh the costs in the long-term.
As ever, we need to understand what could go wrong. Already alarm bells are ringing at ratings agencies, and this week Moody’s reduced the outlook for the UK to negative from stable. This matters because the government’s cost of borrowing is affected by such pronouncements. If the likes of Moody’s and Standard and Poor’s cut our long-term credit ratings it is unlikely that the current 1.25% will persist for long. What happens if costs rise before the spending has been financed? The likelihood is that the grand plans will be pared back considerably. The logic is also undermined if, even if we fund the spending at current low rates, we are unable to generate the returns to repay the debt in 30 years time. If that happens, we are creating a dangerous expensive legacy for future generations. Further, we should not forget that we have an ageing population, where the increased costs of debt servicing could rest on the shoulders of an ever-decreasing number of taxpayers. In addition to all of this we have to be mindful of capacity constraints. It is a circular argument, but if the current infrastructure is constraining investment, it is not going to be easy to spend additional cash as quickly as would be desirable. The returns would then take longer to come through, or the spending could be inefficient and/or expensive. If you need examples then past PFI projects and current rail spending on Crossrail and HS2 will provide as many as needed.
When it comes to looking at the optimal balance between taxation and spending, years of austerity have, according to academics, changed voter perceptions towards public spending at the expense of additional taxation. That may work as an electoral gambit up to a point, but delivering on the promises will be much harder.