Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham.
There are three myths that are increasingly pervasive in public debate, not least within the Conservative Party.
The first is that government debt does not matter. We can carry on accumulating it and not worry about it because interest rates are low. More than one Conservative has repeated Ronald Reagan’s comment that the government deficit is big enough to look after itself.
Unfortunately, deficits add up, they need to be taken seriously, and the government debt needs to be small enough for the next generation to be able to look after it.
Secondly, because the economy is in such a state of shock, it is argued that the Government must carry on spending to help keep the economy going post-lockdown.
Thirdly, we are told that we cannot and should not have a period of austerity as things return to normal.
Let’s start with the debt problem. As well as pointing out that interest rates are low, the supporters of higher debt also mention that we had high debt after wars and it all turned out okay. Strictly speaking, this is true. Previous debt peaks occurred after the Napoleonic Wars, the First World War, and the Second World War. I suspect that debt will peak following coronavirus at about 130 per cent of a decreased national income which is obviously lower than after those wars.
But our ability to manage debt does not depend only on interest rates. It depends on the following four factors:
- Real economic growth (higher better)
- Interest rates on debt (lower better)
- Primary fiscal surpluses after debt interest (higher better)
- Inflation (higher better)
We should add “all other things equal” after each of these. In the post=1945 period, real economic growth was pretty high and inflation was very high. The currency lost 98 per cent of its value in the 50 years from 1945.
But we cannot assume we can repeat this trick because, in most situations, the benefits of inflation are cancelled out by higher interest costs.If t hey are not immediately then, in future years, investors demand higher interest payments on debt and might do so for decades to come.
We should remind ourselves of the 25 years of high and fluctuating interest rates from 1972 until 1997. There was a reason why we did not want to repeat that episode: inflation itself was bad enough; eradicating it was even worse.
After the Napoleonic Wars debt fell because there was quite high economic growth but also a large fiscal surplus. However, it is easier to generate a fiscal surplus when the government is spending five per cent of GDP on non-debt interest as it was then, rather than 40 per cent of GDP as it is now.
Indeed, the prospects of a prolonged fiscal surplus are close to nil. The projections are clear and bleak. The last Office for Budget Responsibility (OBR) Fiscal Sustainability Report suggested that, if nothing else were to change, debt would explode to 275 per cent of national income in the next 50 years because of the demographic crisis. And this was before the coronavirus outbreak.
We cannot allow the debt to look after itself. Economic growth will not whittle it away: on unchanged policies, the national debt is destined to explode because of the impact of demography on both tax receipts and government spending.
And this takes us to government spending. Many are arguing that, post-Covid, we should let go of the reins. However, the economy has been hit by a supply shock and not a demand shock. In so far as people are spending less it is because they are earning less or they are prevented from spending.
We should not try to deal with a supply shock by increasing demand. We should deal with it, as West Germany dealt with the problems after the Second World War, by liberating the supply side of the economy, so that the economy adjusts to new patterns of demand as rapidly as possible. Whatever decisions are taken about public spending should be taken on the usual political-economic grounds and definitely not on macro-economic grounds.
Austerity now seems to be a forbidden word, even in the Conservative Party. It is argued by almost everybody that we cannot have another period of austerity. However, if national income falls (as it has) and remains below trend (as it will for some time), we have to have one of the following: private sector austerity (that is tax increases compounding falls in private sector incomes); public sector austerity to match falls in private sector incomes (spending cuts); or austerity for the next generations (more debt). There aren’t any other options.
And the problem is that government spending is on an upward ratchet every time we have a crisis. From the beginning of the First World War until 1924, government spending rose by 18 percentage points of national income. From 1937 to 1950, it rose by another 13 percentage points (after having been squeezed down a little in the inter-war period). After the financial crash it rose by seven percentage points to over 50 per cent and, even after all the years of so-called austerity, we have not got spending back down to where we were before the crash.
We cannot keep doing this. And we certainly cannot allow another spike this time and not rein spending back in.
Not reducing spending following this crisis will mean that we would be accepting two things. Firstly, we would be accepting that private consumption and investment have to take all the strain of the crisis. Secondly, we would be accepting that, if there is to be a long-term hit to national income and real wages due to the crisis, there should be no implications for welfare payments, pensions, or public sector salaries, and that the amount we spend on healthcare and education should automatically rise as a percentage of a reduced national income. To my mind these are untenable propositions.
Unfortunately, the crisis we face will lead to decisions having to be made which will be more difficult than those taken in 2010. We are that much further into the process of ageing so every penny raised in tax goes provides less in terms of welfare or services. But we cannot just wake up, have another drink, and assume the hangover will go away.