Will the coronavirus lockdown lead to another round of fiscal austerity? Former chancellor George Osborne has warned that it could. “We’ll be going back into a period of retrenchment and trying to bring public-sector debt down,” he told the CBI recently.
There’s no question that government borrowing will increase sharply; The Office for Budget Responsibility (OBR) forecasts net borrowing this fiscal year of £273bn, which would push the ratio of government debt to gross domestic product (GDP) up to 94.6 per cent, its highest since 1959. Although these numbers are subject to a massive margin of error, nobody doubts the direction the public finances are heading in.
What they do doubt, however, is whether austerity is necessary.
Certainly, history suggests that high debt need not be a problem. The UK came out of the second world war with government debt equal to almost 250 per cent of GDP. Not only did this not lead to any financial crisis, but we saw the strongest sustained economic growth in our history over the following 30 years.
In fact, there are five good reasons not to embark upon fiscal austerity next year.
One is that we cannot be certain how strong the economy will be. Yes, there’s likely to be a surge in demand when the lockdown is lifted. But will this carry through? With unemployment likely to stay high, it might not. This argues for at least delaying any decision to tighten significantly.
Secondly, there’s the question of where to cut. One reason why Chancellor Rishi Sunak eased back on austerity before the coronavirus crisis was that public services were already fully stretched. That won’t change.
Thirdly, there’s the fact that conventional monetary policy can do little more to support the economy in the face of either fiscal tightening or any future demand shock. Unless you are willing to consider unconventional measures such as subsidies to banks to encourage lending or direct transfers from the Bank of England into our bank accounts, this means there’s a case for fiscal policy to at least not depress demand.
Fourthly, with real interest rates negative in real terms, we don’t need spending cuts to reduce the ratio of debt to GDP. We can do so even while running a modest deficit. If we assume that trend GDP growth is around 2 per cent, then simple maths tells us that with real interest rates at -2 per cent we can reduce the debt-GDP ratio over time with any primary deficit (that is, borrowing before interest costs) less than 3.7 per cent of GDP. Last year, there was actually a small surplus on the primary balance.
Finally, of course, recent history tells us that austerity doesn’t always reduce debt. In June 2010, the OBR forecast that the debt-GDP ratio would be 67.4 per cent in 2015-16. In fact, it turned out to be 79.9 per cent. One reason for this overshoot was that austerity is to some extent counterproductive. Holding down public spending depresses economic activity (relative to what it would otherwise be) and so reduces tax revenue. Which poses the question: if austerity didn’t reduce government debt then, why should it do so in the 2020s?
This leaves another possibility. As Maynard Keynes said in 1933: “Look after the unemployment, and the Budget will look after itself.” This strategy worked after 1945. It might well do so again.
