An era of low interest rates both encourages greater infrastructure spending and increases the amount that government spending will need to do in the next recession.
Sajid Javid and John McDonnell have announced big shifts in their party’s fiscal rules, unlocking billions of pounds worth of extra potential spending, and taking to account – although neither politician said this explicitly – the increased importance of government spending in weathering future recessions.
In the past, one of the major tools available to the United Kingdom and to advanced economies during a downturn has been to cut interest rates – in the most recent British recessions, basic rate was cut by three and five percentage points almost overnight – and on average, interest rates have been dropped by five points during a recession. The Bank of England’s base rate at the moment is 0.75 per cent and the consensus among economists is that interest rates will continue to remain very low simply because too many households and businesses could not weather a return to historic norms.
So at the next recession, government spending is going to have to take more of the slack. As a result, both parties have tweaked their fiscal rules. For John McDonnell, the changes are evolution rather than revolution, with the fundamentals of his fiscal rule still in place: Labour would run a day-to-day surplus, but wouldn’t count “investment spending” against that: so new funding for power plants, railways, and other infrastructure wouldn’t count towards the target. So far, the same policy as put forward in 2017.
But the important tweak is that McDonnell is no longer aiming to reduce the United Kingdom’s debt by the end of the parliament – instead, Labour’s target will be to increase “public sector net worth”. This has two important consequences: the first is that it treats investment spending differently, by scoring it against the value of the asset it creates, the second is that it further clarifies how Labour will cost its ambitious programme of nationalisation (though, as I explained last time, its previous rule allowed it to do that too). It also disincentivises the use of schemes like the private finance initiative, which allowed successive governments to “hide” public spending off the books, by counting them among the government’s liabilities.
As far as the United Kingdom’s debt pile goes, in practice it means that Labour is aiming to keep debt flat or falling as a share of GDP, though in a less stringent way than the Conservatives. What about Sajid Javid’s new fiscal rule?
Well, the important shift here is that the Conservatives are no longer aiming to reduce the size of the UK’s debt pile either, but simply to keep it flat or falling as long as British interest rates remain low. (That is to say, for the foreseeable future.) Like McDonnell, Javid plans to run a day-to-day surplus, but will count infrastructure against his target: and will cap extra infrastructure spending at three per cent of GDP.
As with McDonnell’s changes, this unlocks billions worth of potential extra spending. There’s no particular economic reason to cap infrastructure spending in this way – it’s solely about servicing the attack line on Labour’s greater profligacy, while allowing Javid to keep Johnson’s various promises to cut taxes and increase public spending.
But there’s a big hostage to fortune in Javid’s rule – unlike McDonnell it has nothing to say about what it would do in a recessional economy. That lack of clarity allows Javid to attack McDonnell – whose rule includes the provision for far greater spending in a downturn – but it means that his fiscal rule is less futureproof.
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