Now is the time for the Tories to be borrowing more

16 November 2019

9:00 AM

16 November 2019

9:00 AM

How should fiscal conservatism be defined? George Osborne inherited a fiscal deficit that was clearly unsustainable. During the panic over the possibility of a global depression and concerned for his electoral prospects, Gordon Brown had massively inflated government spending. Only Alistair Darling prevented more excess. As Chancellor Osborne said, there was no choice but to retrench: his expression was ‘there is no Plan B’.

But in fact, there was a viable choice. In an article published at the time, I somewhat cheekily christened the fiscally conservative alternative ‘Plan A+’. My argument was that we indeed needed to retrench on spending. But to avoid the adverse repercussions of a sharp fall in aggregate demand (and the consequent wasted resources of recession) we could offset those reductions in spending by increased investment in economically productive public assets — or infrastructure — financed by debt.

The underlying economics is that debt sustainability depends not upon some arbitrary level of debt relative to the size of the economy, but on the balance sheet. What matters is how the resources generated by extra debt are used. When Osborne took over, the crash in the construction sector, combined with low interest rates, -provided an opportunity to build infrastructure cheaply. I suggested that we should switch the composition of the budget from nice-to-have expenditures like schools and teachers to electorally unappealing but directly productive investments like power stations, roads, railways and airports. Since financial markets could readily distinguish this strategy from populist vote-buying and procrastination, it would not undermine the markets’ confidence in the UK. Indeed, it might well enhance it through strengthening the economy. Of course, this didn’t happen. The coalition braved through austerity, and the public proved willing to accept short-term pain.

We are now back in a scenario in which Plan A+ makes sense. I restated the case for it in my book Future of Capitalism, and this time, perhaps due to the general anxiety, it is getting greater political traction. In a speech last week the Chancellor, Sajid Javid, promised a ‘step change’ in spending on infrastructure, taking advantage of low interest rates. ‘Incredibly,’ he said, ‘we can borrow in real terms at negative interest rates, meaning it is a responsible time to invest.’ He has a point. There is again slack in the construction sector, and since 2011, two developments have reinforced my original argument.

Most obviously, the real interest rate at which the British government can borrow has fallen so low as to become negative in real terms: ie, the interest rate (currently 0.8 per cent for a ten-year borrowing) is below the rate of inflation (1.5 per cent). This is the big monetary change of our time. Rather than being a freak, these super-low rates have been with us for years and are now expected to last for at least a decade. Economists call the savings glut ‘secular stagnation’. With savers willing to pay the government to borrow, it beggars belief that we cannot invest in public assets that have a positive return. More subtly, Britain’s government balance sheet has deteriorated: austerity was partly achieved by reducing net public assets. Compared to other developed economies, we now have an exceptionally low ratio of public assets to public debts.

Is Plan A+ a breach of fiscal conservatism? I think not. The aversion to debt stems from two fallacies. One, influential a decade ago, was the Reinhart-Rogoff result that there was a cliff-edge of public debt at 90 per cent of GDP: beyond that, confidence appeared to collapse. Given massive outliers like Japan, which has been able to borrow for free despite debt of more than double GDP, there were always grounds to be suspicious of this result. But it turned out to be due to nothing more profound than a data input error by a research assistant: there is no cliff-edge. In its place, national balance-sheet thinking is now rapidly gaining ground internationally. A striking and accessible example is The Changing Wealth of Nations, done by the World Bank in 2018, which provides a snapshot for 140 countries.

The other fallacious reason for debt aversion is debt phobia. It is the Polonius nostrum ‘neither a borrower nor a lender be’: even in the 17th century, audiences were laughing at this portentous nonsense. The incitement of debt phobia is most graphically exemplified in Germany. Through powerful narratives and images, leaders build a critical mass of citizen understanding, or misunderstanding. Angela Merkel induced debt phobia with the politically brilliant and economically illiterate analogy between the national budget and that of ‘the Swabian housewife’. Wolfgang Schauble then crystalised it in the powerful visual image of the ‘Black Zero’: a budget in permanent surplus. Germans are atypically susceptible to debt phobia because of folktales of hyperinflation: in surveys Germans place fear of inflation ahead of cancer.

Obviously, no government can run large fiscal deficits to finance recurrent spending without rapidly getting into crisis. But politicians who build defences against such fiscal irresponsibility by inciting debt phobia are burdening society with an unnecessary millstone. Fiscal conservatism should draw a line between the folly of borrowing on a credit card to finance consumption, and the wisdom of taking out a mortgage to buy a house — not lump them together.

Why does it matter? Superficially, debt phobia seems to have helped Germany prosper, but this is misleading. Fears of hyper-inflation are as irrelevant to the realities of modern Germany as the return of Hitler. Due to this mental confusion, Germany has forfeited the opportunity to borrow at super-low interest rates while its infrastructure crumbles. This has not been prudent, it has been foolish, and German economists are at last challenging it. But indirectly, the long-term costs to Germany risk being much higher. In the context of a common exchange rate, Germany’s extreme inflation–aversion has led to an undervalued real exchange rate and consequential competitive advantage over the rest of Europe. In the short term, debt phobia has enabled Germans to do well out of the euro through a transfer from its non-phobic neighbours. But southern Europe and Macron now understand this all too well. The discord will increase to an unpredictable denouement in which Germans are likely to rue Chancellor Merkel’s misleading populism.

With the build-up to the election, Britain looked to be heading for a competition between our two main political parties over which could bribe us most lavishly with our own money. Voters rightly fear such fiscal irresponsibility, and so it is a vital matter that at least one party makes a credible claim to eschew it. But the fiscal conservatism we need is not Merkel-style homilies. In Britain, most people are well able to understand the difference between a credit card and a mortgage. It is political parties, with their obsessive focus on elections, that are sometimes incapable of that.

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