Detoxifying government debt, part 4. Labour’s inheritance

 

The Labour party has for a long time been fearful about high government borrowing to fund additional public investment. It didn’t start with 2010 austerity. Gordon Brown, probably the best Chancellor the UK has had over the last 50 years, used PFI mainly as a way of getting public investment done without additional public sector borrowing. It didn’t make economic sense at the time, as public borrowing is normally a far cheaper way of financing investment, but it happened because increasing government debt to finance worthwhile public investment was seen as toxic.

In parts 1-3 of this series we have outlined how none of this perceived toxicity stands up to economic scrutiny. It makes no sense to say that the country cannot afford to borrow to invest more, because government debt is also an asset for those who hold it (part 1). How much government borrowing costs depends on expectations of future short term interest rates, not on how much it is borrowing (part 2). The Eurozone crisis of 2010-2 has no relevance to the UK because we have a central bank that will in practice act as a buyer of last resort for government debt, just as it did after the Global Financial Crisis, at the start of the pandemic and in the latter stages of the Truss debacle.

Those who say that the Truss crisis shows that Labour needs to tread cautiously in raising borrowing to invest have to address why Truss provoked a crisis, but all the many other occasions that UK borrowing has risen didn’t. In part 3 we showed why the key mistake that Truss made was to leave open how she intended to cut public spending, at a time when further cuts to spending were politically incredible. But this raised borrowing costs not because markets thought the UK would default, but because it made future central bank decisions about interest rates much more difficult to forecast. [1] That is why increasing borrowing for worthwhile public investment rather than tax cuts is completely different.

But just as an economic analysis shows that Labour has nothing to fear from increased government borrowing to pay for additional investment, it also shows why this perceived toxicity persists. People, including political journalists in the media who have little knowledge of macroeconomics, look for simple analogies, and so think that government borrowing is like personal borrowing. The idea of arbitrage, and that the Truss crisis stemmed from uncertainty about central bank decisions, is seen as too complex, so it is much simpler to just say that Truss tried to borrow too much.

However ignorance is only one half of the story. The other is that this perceived toxicity suits the political agenda of those that dominate media discourse. Hardly anyone asks why it’s seen as good for the private sector to borrow to invest, but problematic for the public sector to do so, because those questions are not posed by journalists working for the right wing media. City economists are viewed as experts when, on average, they clearly have a right wing bias, as well as an incentive to mystify rather than explain. It is not an exaggeration to say that government debt is viewed as toxic because it suits the media to give that impression.

It is very hard for an opposition party to fight against a media narrative. Been there, tried that. On the other hand a newly elected government, particularly in the early honeymoon period, has immensely more power to set the agenda and terms of reference. To some extent whether they use that power depends on whether they see that it will be to their political advantage to use up their political capital in this way. The rest of this post is why it is essential for Labour to do just that, and detoxify borrowing to invest.

The case for substantially more public investment is overwhelming. As John Burn-Murdoch shows here, investment in the NHS collapsed shortly after 2010, and has stayed at a level well below that in peer countries ever since. NHS capital budgets are currently being cut further still. That is almost fifteen years of chronic under-investment that needs to be reversed. As well as basics like new buildings and beds, we also need to invest in resources for more preventative care and preparation for the next pandemic. The NHS is not unusual in this respect, and you can tell similar stories about under-investment in education, where capital spending for the three-year average up to 2023–24 is due to be about 26% lower in real terms than the three-year average in the late 2000s up to 2008–09. You can tell similar stories about the justice system, flood prevention, social housing and so on. The public sector as a whole has been starved of investment over the last fourteen years by design, and our economy has seriously suffered as a result.

In addition, an essential part of improving UK productivity growth and reducing regional inequality involves better transport links outside London. It is ridiculous that we seem almost alone in Europe in being unable to link our major cities with high speed rail, and thereby help relieve chronic congestion in the existing rail network. There seems like there is almost universal agreement among economists that the UK needs more public investment to end its current stagnation, and public investment can often provide a spur to investment more generally. UK public investment is about half the average for advanced OECD countries. On top of all this is the need to invest to mitigate the biggest existential crisis facing humanity, which is climate change.

However politicians often find it difficult to do the right thing if they think it will cause them electoral harm. So I also want to look at the case for immediate and large increases in public investment, financed through higher borrowing, on the very narrow grounds of Labour’s electoral interest.

In other circumstances, it might be tempting for a new Labour Chancellor to try and emulate Gordon Brown’s first few years as Chancellor, by sticking closely to existing (and falling) public investment plans as a signal of prudence and being an ‘Iron Chancellor’. To do that ‘for the markets’ is pointless, as the earlier posts in this series spell out, because interest rates on UK government debt are not determined by the amount a Chancellor borrows or how the markets feel about the Chancellor but by expectations of future central bank decisions. It might impress political commentators, but the electoral cost would be far too high for two reasons.

First, once elected, the public’s expectation that a Labour government will start reversing fourteen years of deliberate neglect will be immense. The example of the left in Germany is used here to suggest what could happen if these expectations are not met because of unwarranted fiscal caution. In 1997 it was just about possible to stick to existing spending plans because public services, although run down, were far from being in the critical state they are in today. Labour inherited a reasonably strong economy, rather than the economy today in which real wages have been stagnant for almost fifteen years.

Second, the whole point of investment is that it takes time before its benefits are perceived, so if a Labour government wants to get credit for additional investment by the time of the 2029 (or 2034) election they need to start increasing it immediately. Delaying that start for a few years in order to gain some media credibility will be pointless if voters don’t see a substantial improvement in public service provision and economic growth.

So Rachel Reeves should ignore claims that greatly increasing public investment will worry the financial markets, because such claims are bogus and because society and the economy desperately needs much higher levels of public investment. She needs to adopt new fiscal rules that are designed to never constrain public investment. Keeping such arbitrary and unjustified constraints in place, and just hoping that forecasts mean these constraints don’t bite, is foolhardy and a waste of the honeymoon period a new Chancellor will almost certainly enjoy.

What may be a more significant problem in substantially raising public investment is lack of real resources. Although the UK is in recession, and GDP per head has been steadily falling through last year, this is not a typical recession which involves lack of aggregate demand, but one caused by sharp cuts to real incomes following higher energy and food prices, as well as labour shortages caused in part by an increasingly sick workforce following Conservative mismanagement of the NHS and Covid pandemic. The labour market is not as tight as it was a year ago, but unemployment remains at levels that are lower than at any time in the last five decades.

This may change by the time the election comes around, but if it does not, then the Chancellor and the Treasury may be in the unusual position of having to prioritise between public investment projects by looking at where the investment comes from and pressure in particular labour markets. Periods of higher investment are often associated with shortages of labour in the construction industry, although the immigration system can be adapted to relieve those pressures, but the CT scanners the NHS desperately needs are likely to come from abroad so their construction puts no pressure on the UK economy. [2]

Labour will inherit an economy and a public sector in a worse state than at any time since WWII. The task they will have to turn things around is immense. It is therefore vital that Labour focus on these real problems, rather than imaginary worries that the media might throw at them. Probably the most effective way to start repairing the damage of the last 14 years is to substantially increase public investment, and the political longevity of the next Labour government may depend on how effectively they do that.

[1] An interesting question is why Hunt's last two fiscal events, which involved tax cuts 'financed' by totally unrealistic cuts to public spending, didn't have a similar effect in raising interest rates. One simple answer is context. Truss's fiscal event was at a time of high inflation and rising short term interest rates, whereas now the main question is how quickly interest rates might fall. Another is that the unrealistic spending cuts proposed by Hunt are sufficiently In the future that their impact on the Bank's decisions will be modest, while under Truss we had no idea when cuts to spending might be attempted.

[2] Chris Dillow uses the lack of spare capacity in the economy to make the case for Labour to keep a tight fiscal stance, but he also argues against the kind of increase in both spending and taxes that I propose here. I cannot do justice to his arguments in a footnote, but he doesn't tackle a key part to my argument, which is that the next government is going to have to break their current pledges of no tax increases at some point over the next five years anyway, and it would be politically better to do so sooner rather than later.