The latest fiscal pledges from Sajid Javid and John McDonnell are similar in some respects, but very different in others. In short, both the Conservatives and Labour are planning to ramp up government spending, especially on investment, and have proposed new fiscal rules which should allow them to do so. However, Labour’s plans are much bolder – verging, in my view, on reckless.
(Labour’s plans are based on blueprints from the Resolution Foundation, which has also provided a good summary of both sets of proposals here.)
The similarities first. Both Labour and the Conservatives would aim to balance the current budget, i.e. the gap between tax revenues and day-to-day government spending, which excludes public investment. The Tories would target the balance three years ahead (and presumably in future years), whereas Labour would set a rolling target five years ahead. Either approach, though, would allow more borrowing than under the previous rules, provided it is for investment.
Treating investment separately does makes some sense, because capital spending generally has a more positive impact than current spending on long-term economic performance. Interest rates are also currently low and the rest of the economy is sluggish, so this is potentially a good time for the government to borrow more.
Both Labour and the Conservatives would also introduce a new rule in the form of a ceiling for debt interest payments as a percentage of tax receipts. If this ceiling is breached, the government would be supposed to respond by adjusting borrowing. Actually, I’ll believe that when I see it: fiscal rules are traditionally abandoned at the first sign of trouble. But here is where the differences start: Labour’s ceiling is much higher, at 10%, compared to 6% for the Tories, and more than twice the current figure.
This reflects Labour’s plan to borrow a lot more ‘to invest’. The Tories will limit investment spending to 3% of GDP. As it happens, I’d rather that rule had been expressed as a limit on borrowing for investment, not investment itself. The government could then invest more than 3% provided the excess is offset by a surplus on the current balance. But that ship appears to have sailed.
That said, the Tory target still allows for a large increase in investment. Public sector net investment has been running at around 2% of GDP, so that would allow an additional 1% of GDP for capital spending – perhaps £22bn in the first year, and more than £100bn in total over five years. That should be more than enough to make a significant difference to the quality of infrastructure.
What’s more, assuming ‘normal’ economic growth (say 1.5% real and 2% inflation), Javid’s 3% rule should also still be tight enough to stabilise debt as a share of GDP, if not fall slightly. That’s important. The UK has had higher levels of debt as a share of GDP in the (distant) past, but we are already pushing our luck, particularly given the increasing financial burden of an ageing population.
Indeed, the Financial Times has reported that ‘Number 10 advisors’ (guess who?) are angry that Javid’s new rules would still keep a relatively tight lid on borrowing. I don’t know if this report is true, but, like many others, I would actually welcome the retention of at least some fiscal discipline.
In contrast, Labour has pledged to invest an additional £400bn (on top of its many other commitments): £250bn over ten years and an additional £150bn in the first five years, averaging out at £55bn in each of those first five years. This would be roughly double what the Tories are proposing.
Labour’s rules would allow for this by shifting the focus to ‘public sector net worth’. The new target here is to ensure that the state’s assets grow faster than its liabilities. This approach is explained in more detail by the Resolution Foundation in their earlier paper, ‘Totally (net) worth it’.
In principle, this means that any amount of increased borrowing could be acceptable as long as it is matched by the creation or purchase of an offsetting asset (including non-financial assets). This is partly a nod towards Labour’s plans to spend large sums on bringing privatised utilities back into public ownership. And unusually, it’s not completely economically illiterate.
Nonetheless, this approach is hugely risky. Borrowing is still borrowing, whatever it’s for, and someone has to be willing to buy and hold the new government debt. Interest rates will not remain low for ever, especially if the Bank of England judges that a substantial fiscal stimulus reduces the need to keep monetary policy as loose as it is now, and if other countries are also turning on the spending taps (in the same way as the impact of austerity in the early 2010s in the UK was compounded by the fact that so many other countries were also tightening fiscal policy).
Risk premia are also likely to rise. Investors are already worried by Labour’s broader economic agenda – including higher taxes, increased state control or wages and prices, and attacks on property rights. The world’s biggest bond fund, PIMCO, has already fired a warning shot. And while credit rating agencies are not as influential as they used to be, Moody’s has raised concerns too.
Finally, valuing assets is difficult, and any numbers are intrinsically less certain than the costs of the debt that finances them. There’s no guarantee that any new public sector assets would justify their valuation, or keep their value, especially (I suggest) under Labour management.
Indeed, the track record of all governments here is not encouraging, especially for large-scale infrastructure projects. There are only so many good investment opportunities at any one time. The greater the spend over a relatively short period, the bigger the risk that borrowing is ploughed into less worthwhile projects. Even the Resolution Foundation is warning that the huge scale of Labour plans would be especially challenging.
In the interests of balance, what are others saying? The anti-Brexit campaigner and sometime macroeconomist Simon Wren-Lewis has argued that Labour’s spending plans are actually more credible, partly because Labour is also proposing large tax increases to help pay for them, and partly because a Labour government is likely to mean a softer Brexit, or no Brexit at all. Needless to say, I disagree, partly because I believe that Labour’s tax raising plans would actually be counterproductive and undermine the economy, and partly because I’m much more sanguine about the impact of Brexit.
At face value, Labour’s rules also allow more room to respond to temporary economic shocks. In part this is because a rolling five-year target is more flexible than a single-year target three years ahead. Labour also appears to have adopted the idea of a ‘knock out’ (suggested in an earlier paper by Jonathan Portes and Simon Wren-Lewis) when the requirement to balance the current budget would be suspended when interest rates are at the ‘zero lower bound’. In these circumstances, conventional monetary policy can be less effective and fiscal policy may have to be more active.
I can see some more merit in this. Indeed, there’s a healthy debate to be had among economists about whether the fiscal tightening in the early 2010s went too far, especially when demand was still weak, interest rates were already low, and many other countries were cutting back too. Most would agree that fiscal policy should have a more positive (counter-cyclical) role to play during the next recession. But any government, Labour or Tory, is likely to bend their rules in the face of significant economic shocks, so I’m not convinced that including explicit escape clauses from the outset would make much difference in practice.
However, I do agree with Wren-Lewis about the disadvantages of formal targets for debt. This is because as long as deficits are brought under control, debt will gradually follow. If there is a debt target as well, a much quicker adjustment may be required. Essentially the same criticism applies to Labour’s target for public sector net wealth.
Overall, then, I do think that it’s right for the next government to borrow a little more. However, if you had expected me to conclude that the Tories’ plans look more responsible than Labour’s, you were correct.
This is an expanded version of a piece which first appeared on CapX