Against a background of supply side shocks, there IS a case for increasing borrowing. But only if it buys something really worthwhile….​

 

On Tuesday it was confirmed that the next budget will be delivered on 11 March. Following the decisive election victory of the Conservative Party in the December general election and the resignation of Mr Javid,expectations are high that the new man in the Treasury, Rishi Sunak, will loosen the purse strings to boost growth. The case that, when interest rates are low, borrowing can be boosted in certain circumstances was made forcefully in Olivier Blanchard’s Presidential Lecture to the American Economic Association in 2019.[1]

 

Cebr’s view is that this should only take place if two conditions hold:

 

(1) The Financial Market Condition: The levels and scale of increases in both borrowing and debt should be such that they do not cause the financial markets to raise interest rates or cut the exchange rate significantly or lead to inflation getting out of control; and

 

(2) The Economic Viability Condition: The projects on which the money is spent should be such as to lead to sufficient additional growth after taking account of any activity crowded out to justify the additional expenditure. In theory this should apply to tax cuts as well as public spending.

 

Both in the US and Japan, relatively high levels of both borrowing and debt have been absorbed with comfort by the financial markets without boosting inflation to unacceptable levels so far, though this might change in the US in the coming year.

 

The difficulty of additional borrowing either to increase infrastructural spending or to allow lower taxes is that once fiscal rules are loosened politicians are tempted to try all sorts of crowd-pleasing stunts that do little to help the economy and fail to satisfy the Economic Viability Condition. Moreover, it appears that the public sector in the UK now has great difficulty in managing public sector projects at a reasonable cost, so that many intrinsically viable projects become unviable because of cost overruns.

 

Cebr, therefore, proposes two institutional reforms which we believe would reduce the risks of higher borrowing having negative consequences in the financial markets and for economic growth.

 

Reform 1: The OBR and the MPC jointly make an assessment of any proposed Budget’s impact on interest rates and the exchange rate. This won’t be perfect and the temptation would be to be cautious. This assessment needs to be made public. Any borrowing beyond what they jointly agree to be prudent would be likely in practice to be badly received in the markets and this would impose a budget constraint.

 

Reform 2: The Treasury has been praised for its macroeconomic management but criticised for many of its micro decisions. A much harder headed method of assessing the micro effects of tax and expenditure changes is needed than currently seems available within the UK public sector, probably using independent experts. These experts should be forced to put their reputation on the line when they make such assessments. This should enable the Treasury to be much more solid when making assessments of whether policies pass the Economic Viability Condition. In particular, major infrastructure projects and tax changes should be subject to such independent assessments.

 

Without such reforms, there is a danger that the short-term fiscal flexibility permitted by the current state of the world economy will be frittered away in projects that do little to help economic performance.

 

[1] Public Debt and Low Interest Rates Olivier Blanchard American Economic Review Vol. 109, No. 4, April 2019 (pp. 1197-1229)

 

Contact: Douglas McWilliams dmcwilliams@cebr.com phone: 07710 083652