Unpleasant fiscal arithmetic hindering UK growth

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The writer is a contributing editor to the FT, chief executive of the Royal Society of Arts and former chief economist at the Bank of England.

In 1981, Thomas Sargent and Neil Wallace published an influential and challenging paper on the unpleasant arithmetic of monetarism. This malaise occurred because in an economy with high debt and high inflation, tightening monetary policy to reduce inflation would lead to an expansion of the fiscal deficit, making monetary policy easing and rising inflation inevitable in the medium term.

Today's major policy challenges are fiscal rather than monetary, but on the surface they are not that unpleasant. In a high-debt, low-growth economy, how should fiscal policy be set to lower debt without jeopardizing growth? This is the dilemma facing many Western economies. In the UK, this month's budget will significantly ease this.

Fortunately, there is a path to salvation. History tells us that the way out of our debt problem is by growing rather than cutting. The key to solving the fiscal challenge therefore lies not in retreating from the budgetary constraints of fiscal rules, but in advancing toward the mission of higher growth.

Starting with the mission, the weak growth of many Western economies is easy to explain. This stems from a continued lack of investment in technology, infrastructure and people. The UK's investment rate has been three percentage points below the OECD average since 1990, an investment gap of around 35 billion per year. This spans almost all investment categories and sectors.

Because this underinvestment has persisted for decades, the real capital gap is still larger. According to a recent EY report based on project-by-project assessments, it amounts to approximately $1.6 trillion. The UK's capital stock per worker is about half that of the US, France and Germany, resulting in a capital gap of trillions of pounds.

To kick things off, let's say we're looking to invest an additional $2.5 trillion in the UK over the next 25 years. That is, let's say we're looking to invest an additional $100 billion (about 45%) per year for the next 25 years. This is similar in scale to the need for additional investment identified by Mario Draghi in his recent report on the future of European competitiveness.

However, this scale of additional investment does not fit with the debt-based fiscal rules currently in place in many countries. In the UK, public investment is expected to fall from 2.5% to 1.7% of GDP over the next five years to meet debt mandates. It is doubtful that any country in human history has ever recovered growth from levels already so low that public investment has declined. If you follow that path, your dog's days will be numbered as the financial tail wags the growing dog.

Asking instead which fiscal path is best suited to the UK's growth mission produces much more encouraging arithmetic. Estimates suggest that public investment provides significant growth dividends. A recent analysis by the UK's Office for Budget Responsibility (OBR) found that a 1% permanent increase in GDP in public investment increases potential output by 0.5% after five years and by more than 2% after 10 to 15 years. A sustained increase in investment of 4% of GDP per year could result in a permanent 10% increase in national income.

The implied rate of return on that investment is about 9% per year, far exceeding the cost of borrowing. Indeed, the OBR analysis suggests that, for a reasonable discount rate, increased tax revenues from improved growth could cover these costs. This means that public investment ends up being self-financing. This also means that increasing public investment by significantly increasing production while keeping debt the same will significantly lower the debt ratio in the medium term.

If public investment can help us escape the high-debt, low-growth trap, the next question is what fiscal rules best enable the investments needed to reap these two dividends. Public investment returns are highest for illiquid assets such as homes, schools, and roads. However, it takes more than 10 years for these returns to accrue. This is why debt-based financial rules that ignore illiquid assets and measure them over the short term are detrimental to both growth and, interestingly, debt.

In contrast, the most growth-friendly financial rules are those that recognize illiquid assets that provide the highest growth and tax dividends. This is defined as public sector net worth. A more reasonable 10-year period to meet the fiscal rules than the current 5 years would create about $50 billion more fiscal space per year. With a private to public capital ratio of 4:1, using just half the available space would be enough to meet the UK's investment needs.

Of course, this pleasant financial arithmetic is undone when increased borrowing leads to sharply higher debt service costs. But this is Pennywise's siren sound. Fortunately, international evidence shows that this view is absurd. It is net assets, not total liabilities, that determine international bond yields. As a business, the country's investors value growing income and assets. Therefore, the investment strategy proposed here is likely to lower government bond yields rather than increase them.

On the surface, high debt and low growth are making financial choices difficult. But the fiscal arithmetic facing many countries offers a perfect escape route. If Prime Minister Rachel Reeves puts her money where her mandate lies in her upcoming budget, she could significantly transform growth prospects and the outlook for the country's finances (if not immediately) at the same time. Tinkering with rules, taxes and spending on a dime will make the mission impossible.

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