A Way out of Britain’s Growth Dilemma

Co-authored with Felix Martin

As he prepares for Wednesday’s Budget, George Osborne, chancellor, faces a dilemma. On the one hand the recovery has stalled even before his cuts have started. On the other the simple solution of relaxing austerity plans to stave off a double-dip recession is financially and politically unrealistic. Fortunately, there is a way to square this circle – and it requires no U-turn at all.

Mr Osborne dare not renege on plans to liquidate the deficit, fearing (perhaps with good reason) that any change would unsettle the bond markets. But he must also see that, without support, private demand will not suffice to return Britain to full employment. Here the data are clear. In January, the Office for National Statistics revealed that Britain’s economy shrank in the fourth quarter of 2010. Recently Jonathan Portes, head of the National Institute for Economic and Social Research, warned in these pages that the first quarter of 2011 looks little better.
What is the best way out of the current dilemma? In his June 2010 emergency Budget Mr Osborne proposed a green investment bank – an idea borrowed from the last Labour administration. In November’s spending review, however, the Bank’s funding was postponed and made dependent upon privatisation receipts.
The revival and radical scaling-up of this idea can provide a way forward. The chancellor’s Budget should expand on existing plans, and consult on establishing a new UK National Investment Bank. This should have a mandate to finance not only “green” projects, but also other that can contribute to the rebalancing of the economy – particularly transport infrastructure, social housing, and export-oriented small and medium-sized enterprises.
There are two main arguments for establishing such a venture. The first is the traditional rationale for public development banks. Private capital markets are prey to short-termism and other market failures, and tend to provide less finance than is optimal to projects that generate economic benefits to the wider economy in excess of their private returns. A public development bank can circumvent these shortcomings by taking a longer-term view, and by including these external benefits in its project appraisals.
This role has long been widely acknowledged in continental Europe and east Asia. However, until recently the conventional view in the UK and US was that a government bank would be bound, for one reason or another, to “pick losers”, and thereby pile-up non-performing loans. But surely only those with a vested interest in denigrating the state will have the nerve to make that argument now, after the catastrophic misjudgments of private banks in the run-up to the crisis.
In any case, like all fundamentalist beliefs, it has little empirical backing. Two relevant comparators – the European Investment Bank, and Germany’s Kreditanstalt für Wiederaufbau – show that, in well-regulated financial systems, such banks pay for themselves.
But it is a second argument that should clinch Mr Osborne’s decision now: a national investment bank could play a significant role in short run stabilisation too. A limited fiscal commitment – say, £10bn in subscribed capital, with contributions drawn down over the next four years – would allow the new bank to finance enough spending to more than offset the £87bn of reductions in public investment planned before 2015. In this way it could provide a way to bolster confidence and increase demand, without adding significantly to the deficit.
The difference between the total and government contribution would be funded from the bond markets. This is the magic of leverage, of course: that magic which got such a black name as a cause of the crisis. But a national investment bank is an opportunity to turn that magic to a constructive end.
In fact, an investment bank would kill three birds with one stone. First, through its funding programme, it would create a new class of bonds – long term, but with a yield pick-up over gilts, reflecting the modest credit risk of the Bank – which could include features that fit the needs of the UK pensions industry, as the population ages. Second, by lending for the long term, and in line with economic and environmental priorities, it would help long-term growth. And finally by ramping up its operations now – when the corporate recovery is being hamstrung by shrinking bank lending and fiscal austerity – it can offer a boost to aggregate demand when it is needed most.
The only question likely to be asked of Mr Osborne is why he has to create a new public bank, when the state owns two already. A fair question: but then this bank will also be setting out to prove that banking does not have to be, in Lord Turner’s scathing rebuke, “socially useless”. For that it may be better to start with a clean slate.
Robert Skidelsky is author of Keynes: The Return of the Master, and Felix Martin is an economist at Thames River Capital LLP, a London-based asset manager