The chancellor’s fiscal policy has been a disaster – a growth-first strategy driven by a bond-funded HS2 could be the answer
When George Osborne took over the Treasury, he decided that fiscal policy would be governed not by the state of the real economy but by the state of the public finances, as measured by pre-set fiscal targets, particularly the rate of deficit reduction. Those targets were designed to reassure investors in government debt that the state was solvent and would remain so.
Halfway through the life of this parliament, it is clear that the effects of that policy in terms of output and growth have been disastrous. Britain, like the eurozone, remains stuck in the slow lane. We did not grow at all last year, and we enter 2013 with a realistic prospect of a triple-dip recession. Despite our freedom to devalue and massive open-market operations by the central bank, British output is 3% lower than in 2008. The results of the fiscal targets are correspondingly dismal.
What has gone wrong? The central design failure is that the targets were set on the heroic assumption that the economy would recover despite the tightening of fiscal policy implied by the targets themselves. In a balance sheet recession, when the private sector is cutting spending to reduce its over-indebtedness, that assumption was just wrong. Put simply, we cannot all deleverage at once. To save more, you spend less; and if everyone does that, including the government, the economy shrinks.
Osborne blames the failure of Britain to grow on the eurozone, but that argument is circular, as it is following exactly the same policy as we are. The “headwinds” from the eurozone are his own policy blowing back in his face.
The chancellor can claim that the unemployment figures are slightly lower than they were some months ago. How can this be so when output has not grown and may even have fallen? There is a puzzle here, but it is not a large one. The truth is that more people are producing less. With a more flexible labour market, a fall in output is not necessarily reflected in a fall in employment. It may simply lead to a movement of workers into lower-paid, part-time or intermittent jobs or work training schemes, none of which count towards recorded unemployment. This has certainly been happening. It also explains why the government can claim success in increasing private sector employment faster than the public sector is shedding jobs. But most people would not consider a fall in productivity to be a sign of competitive vigour.
The obvious alternative to blind faith in fiscal targets is action to restore the economic trajectory that underpinned the targets in the first place. Public capital spending is not included in the current deficit target, so the government can restart the investment machine without breaching its own targets on current spending. That is the only way it can have a hope of meeting those targets. Thus we should welcome the government’s announcement that it has approved the second phase of HS2, the high-speed rail line.
However, two questions arise. Why will it take so long? The first phase is scheduled to be completed in 13 years, and the second in 2033. This displays an unbelievable lack of energy. Railways can be built much faster than this.
The second question is: how will it be funded? The government says it will have to “start raising private-sector finance to part-fund the £34bn project“. At least this is an improvement on the thinking behind such financing disasters as the Channel Tunnel and the public private partnership for London’s underground, where the whole investment was supposed to come from the private sector.
But why should the private sector be expected to invest in HS2? Because of the huge ratio of capital costs to operating margins, building a railway is highly unlikely to show a profit for the private investor. Even before the railway age, Adam Smith understood this fact about infrastructure when he gave the state “the duty of erecting and maintaining certain public works … which it can never be for the interest of any individual, or small number of individuals, to erect and maintain; because the profit could never repay the expense to any individual or small number of individuals, though it may frequently do much more than repay it to a great society.”
Historically, railways built by private enterprise alone always go bankrupt and have to be rescued by the taxpayer. This does not mean that they should not have been built, because there are “external” returns to the “great society” which exceed the financial returns to the entrepreneur. Today, due to the spectacularly low cost of its own borrowing and surplus capacity in the construction industry, the government has an exceptional opportunity to borrow the money and start the work expeditiously. How about issuing an HS2 railway bond offering a yield marginally above inflation-linked gilts, and geared specifically to attract pension funds starved of returns?
Will such an investment strategy not cause the public debt to increase? The answer is that debt will undoubtedly go up, but so will the capital stock and the economy itself, while the increased output can be taxed to finance the interest cost of the extra debt.
There are obvious risks. The risk of borrowing more than the chancellor initially planned may spook the bond markets and lead to a rise in borrowing costs. However, it is a much smaller risk than putting one’s faith in pre-set fiscal targets that produce a stalling economy, without any guarantee that this will actually deliver on the fiscal numbers. Which strategy does the chancellor really think is more likely to keep our AAA credit rating?
If the growth-first strategy makes sense for Britain, it should make sense for Europe as well. This country was a pacesetter in adopting fiscal targets as a guide to policy after the financial crisis. Why not be the first mover in showing how to reset policy and help lead Europe out of self-defeating austerity?