Without the burden of the House of Lords reform bill, the UK government has been able to use the summer to pause, refocus, reshuffle and relaunch. Meanwhile, the economic picture has remained mixed.
There is low growth, stubbornly high unemployment, struggling banks and small businesses and no end in sight to the imbalances driving the eurozone crisis. But on the positive side, industrial output, retail sales and exports have all been better than expected, inflation is falling and there are signs of recovery on the high street.
What to do? The first thing is to remember that this is a “balance sheet” recession: that is, a fundamental shift in economic value, created by collapsing asset prices amid huge volumes of individual and household debt. The result is assets that are worth less than the loans taken out to pay for them and a difficult process of deleveraging, which reduces both demand and the effectiveness of monetary policy.
But the position is made worse by a second point: the UK’s low sustainable growth rate. The default assumption among the experts – including the Office of Budget Responsibility – remains that the UK will snap back to a long-term rate of about 2.3 per cent. That may happen at some point, but analysis of index-linked gilts and potential output implies that the sustainable growth rate may in fact only be 1-1.5 per cent for several years yet.
That would suggest the UK economy is not doing badly, despite the tough times. More importantly, it also suggests that an attempt by government to lift growth by stimulating consumption or reversing the present fiscal consolidation is likely to be unavailing and will stoke up inflation.
Not only that, it would threaten the UK’s position in the credit markets and reduce resilience against external shocks such as a deterioration of the eurozone. If this is correct, then the recommendations of such luminaries as Larry Summers and Paul Krugman – to say nothing of the Labour party – are profoundly mistaken.
Treading through this economic minefield is no easy task. The key is to balance the maintenance of demand with measures to raise the sustainable growth rate itself. Steady reduction in government spending as a percentage of gross domestic product will have that effect. For example, we must continue to reduce the costs of the private finance initiative through which the National Health Service appears to be treating its contractors more like clients than suppliers.
But there is also significant room for the government to raise capital spending itself. After all, projected public investment levels remain low, the UK can borrow at zero or near-zero real interest rates and there is spare capacity in key sectors and in the labour market, as shown by the blight of youth unemployment.
Given the present obsession with labels, one might call this “Plan A + Capex”: maintaining fiscal consolidation while significantly raising capital investment. The government has made important steps in this direction through the national infrastructure plan. To this one might add the need for a new generation of good public housing.
However, what is needed is not just more private investment but more public investment as well. Even as much as £25bn at current interest rates would carry a maximum real coupon of just £250m a year – or less than two-hundredths of 1 per cent of GDP. By comparison, the real cost of private finance is generally 50-100 per cent more expensive. For every 10 miles of privately financed road, that is, you get 15-20 miles on gilts. And it’s not rocket science to build a road.
How risky would this be? Would the markets be confused by the combination of restraint on consumption spending and increased capital investment and think austerity had ended?
To judge from experience, it would be unwise to rely on the perspicacity of the rating agencies. But given the small sums involved, there is little real cause for concern. And the point could be rammed home by transparently segregating both the newly created assets and liabilities in the national accounts. This would allow the markets to see that debt was financing investment not consumption, as well as show the substantial equity value arising over time.
In economic terms, it is hard to imagine a better investment; all the more so when the social returns and the signal to animal spirits are included. The government has created this option by its strong early measures to consolidate public spending. Now is the time to take some reward through capital investment.
[This article originally appeared in the Financial Times on 19 September 2012]