Rather than experiment with another round of austerity, Rachel Reeves should commit to investing in our economy.
After months of speculation, Labour has finally caved to pressure and ditched its flagship £28bn green investment pledge, and thrown plans to insulate 19m homes by 2030 into doubt. £28bn is the amount that we identified at NEF needed to lower emissions and create an economy that improves lives, through things like wind and solar power, public transport, and home insulations. In fact, we found that insulating 19m homes by 2030 would lower household energy bills by hundreds of pounds a year.
But, like George Osborne before her, if Rachel Reeves becomes chancellor, she will argue that economic failures of the previous government make it too difficult to borrow to invest in the UK’s future. In a bid to be seen as “economically responsible” by sticking to its arbitrary borrowing and debt rules, a Labour government is threatening to doom the UK to years of stagnant or even falling living conditions, along with an inability to meet the future challenges of the climate crisis and an ageing population.
A major component of this government’s and Labour’s debt and borrowing rules, also referred to as “fiscal rules”, is for government debt-to-GDP to be falling in five years’ time. For over a decade, our government has been preoccupied with bringing down public debt through spending cuts. But years of austerity did very little to bring down the UK’s debt – to-GDP ratio (figure 1). Inadequate government spending and investment reduce demand, slow growth, and can cause long-term damage to people and the economy. It is widely acknowledged that the UK is currently living with the consequences of 15 years of underinvestment, which include stagnant productivity and crumbling public services. Rather than re-experiment with austerity, Labour could instead try to reduce the debt-to-GDP ratio by growing the economy. Borrowing to invest can achieve this, especially when we borrow to invest in the low-carbon economy of the future. Green investments are particularly good at boosting growth, incomes and jobs.
Figure 1: Over a decade of austerity has failed to bring down the UK’s debt-to-GDP ratio
Despite both major parties’ fixations on the debt-to-GDP ratio (currently around 86%, excluding Bank of England debt), this isn’t a meaningful measure of how much room a government has to safely borrow (known as “fiscal space”). For example, Japanese debt-to-GDP has risen to over 250% in recent years, while interest rates have stayed low and affordable. Meanwhile, Ukraine defaulted on its debt in 1998 when debt levels were only 41.8% of GDP. Fiscal space is determined by a more complex set of macroeconomic dynamics than simple ratios between parts of the government’s balance sheet and the nation’s GDP.
This is why the UK has had nine sets of fiscal rules since 1997. Our fiscal rules are not immovable laws of nature – they are invented and decided by our politicians. Chancellors simply change their fiscal rules when they become too difficult to meet – they are a political tennis ball, not a tool of effective policy. Even Jim O’Neill, the former chairman of Goldman Sachs Asset Management, and the Treasury’s commercial secretary under then-chancellor George Osborne, has since urged this government to “drop such petty and arbitrary fiscal rules that magically claim the deficit in five years’ time will be lower.” While Rachel Reeves appointed O’Neill as an advisor, she doesn’t appear to have taken this advice to heart.
So if fiscal rules are arbitrary restrictions which don’t ensure the health of our economy, how should we decide how much the government should be borrowing and spending? At NEF, we have suggested that this government replace the fiscal rules with new “fiscal referees”, an independent advisory committee in the Office for Budget Responsibility (OBR). These referees would be appointed by parliament and guided by a set of macroeconomic fiscal principles that take into account the complexity of fiscal space – things like resource constraints, the private sector balance sheet position and public sector net worth. While ultimate decisions over tax and spend would remain with the chancellor, they would estimate a target range for optimal government spending over a rolling forecast period, and given wider macroeconomic dynamics.
However, if a UK government is determined to fixate on an arbitrary debt-to-GDP target, they are a few things they can do to take into account the positive impacts of smart investment. First, they should extend the time-period over which the fiscal rules apply. A government cannot implement vital economic renewal over a five-year period.
Second, they should extend the time horizon of OBR forecasts, so that costs and benefits of tax and spending decisions that occur in more than five years can be considered. Currently it is assumed that tax and spending decision have no impact on the economy after five years, which means we underestimate the benefits of investing in climate policies, education and skills.
Third, the government should ask the OBR to explore what sorts of investments would have stronger positive economic impacts per pound spent (known as “multiplier effects”). The IMF has found evidence that green investments have significantly higher multiplier effects than their carbon-intensive equivalents.
And finally, the government should ask the OBR to take into account evidence that that multiplier effects for certain investments may increase over time, as the original cost of funding through taxation and borrowing wears off and the benefits of the policy are experienced in full. The IMF finds that for infrastructure and green policies, multipliers increase for 20 years.
Every “fiscal rule” is a political choice. It’s time for our politicians to start making the right ones.