1 May 2020

Despite the gloom, there are reasons for fiscal optimism


The coronavirus pandemic is of course primarily a social crisis, but the fiscal costs are also important. A sharp and sustained deterioration in the public finances could have major implications for future government spending and taxation. Fortunately, there are also some good reasons to be sanguine.

Let’s begin with the bad news. A slump in economic activity is inevitable and even desirable; we actually want most people to stop doing what they would normally be doing, in order to save lives. However, this will also lead to a surge in government borrowing, reflecting both the direct costs of the fiscal measures being taken to protect businesses, jobs and incomes, and the knock-on effects of a steep fall in GDP on welfare spending and tax revenues.

The headline figures are scary. Given all the uncertainties, it makes sense to talk in terms of ‘plausible scenarios’ rather than ‘forecasts’, and any hard numbers are more than usually dependent on the assumptions made. But the big picture is clear.

For example, the OBR’s ‘coronavirus reference scenario’ assumes that, after a 35% slump in the second quarter, the level of GDP returns to its starting point as soon as the end of this year. On the basis, GDP would fall by 13 per cent in 2020 as whole, then rebound by 18% in 2021. The unemployment rate would jump from 4% of the labour force to 10%, before falling back slowly as the economy recovers.

Other ‘plausible scenarios’ are available. In particular, the National Institute of Economic and Social Research (NIESR) has pencilled in a decline of ‘only’ 7% this year. Unemployment therefore does not rise quite as far as in the OBR’s scenario, peaking at around 3 million (8.5%). However, NIESR assumes that the economy will take longer to recover, so that GDP does not regain its pre-crisis level until the end of 2021.

The upshot is the similarities between the OBR and NIESR analyses are more important than the differences. Both assume a big hit to GDP, followed by a fairly rapid recovery. And while they each have a large rise in unemployment, both assume that government measures (especially the Job Retention Scheme) are effective at limiting job losses.

Either way, there will be a surge in government borrowing and debt. On the OBR numbers, public sector net borrowing (PSNB) would be £218 billion higher this year than the March Budget forecast. This would take the annual deficit to £273 billion, or 14% of GDP, even higher than the peak of 10% reached in 2009-10 after the global financial crisis.

There is a similar jump in the level of public net sector debt, to about £2,200 billion this year, or 95% of GDP. At the bottom of the downturn the debt to GDP ratio will be well over 100%. That compares to the recent peak of 83% in 2016-17.

So, what are the reasons for optimism? First, both deficits and debt have still been much higher in wartime, which is arguably the more appropriate benchmark. The OBR’s databank shows that the deficit rose as high as 27% of GDP in 1941-42, while debt hit 259% in 1946-47. Both these numbers improved rapidly as the economy recovered following the war, and government spending returned to more normal levels.

Second, what is happening now is a one-off jump in annual borrowing (if all goes well) and a step increase in the level of debt, rather than a permanent deterioration in the public finances. The deficit should naturally drop back as the economy recovers next year and the emergency fiscal measures can be wound down.

In the meantime, total debt will be higher in cash terms, but the debt to GDP ratio is a better guide to the burden on taxpayers. Provided annual borrowing as a share of GDP is kept below the growth rate of nominal GDP (about 4% in a normal year), this burden will start falling again. Indeed, the downward trend should resume as soon as next year.

These points are crucial. Together they mean that there should be no need for large tax increases or spending cuts to bring the public finances back under control. We can still argue about whether the ‘austerity’ of the early 2010s went too far, or whether the burden was fairly shared, but it is simply not required now.

For now, the surge in government spending will be financed by increased borrowing. Some of this will come from an extension of the Treasury’s ‘Ways and Means’ facility at the Bank of England, which is, in effect, the government’s overdraft with the central bank. However, the use of this facility is only expected to be temporary (rather than a permanent monetisation of the debt) and the primary source of funding will still be the sale of bonds on the open market.

Thereafter, there is no compelling reason why the government needs to change its fiscal plans significantly. The new(ish) Chancellor, Rishi Sunak, has announced a review of the fiscal rules left by his predecessor. But the OBR projections for 2021 onwards would still be consistent with the broad principles of balancing the budget on day-to-day spending over the economic cycle and borrowing an average of no more than 3% of GDP for public investment.

Debt and hence the cost of servicing that debt will be higher. Nonetheless, low interest rates and the relatively long average maturity of UK government borrowing provides enough wriggle room here too.

Inevitably there are risks – and these are mostly on the downside. One is that the economy takes much longer to recover than expected. For example, on this site yesterday Alan Lockey sketched out a grim future of widespread business failures, mass unemployment, and a lack of ‘animal spirits’.

I think that is too pessimistic, partly because the flexibility of the UK economy and labour markets should help it to bounce back (provided businesses and employers are not saddled with huge additional costs). But obviously the longer the economic disruption continues, the greater the potential scarring.

The crisis is also encouraging calls for additional and permanent increases in public spending in a wide range of areas, over and above those already planned, including the NHS and social care, public sector pay and welfare benefits, as well as a new wave of expensive state interventions in the market economy.

Hopefully, the Chancellor will resist these pressures. But these days, very little is certain.

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Julian Jessop is an independent economist.