Tightening fiscal policy soon would be fiscal folly - Capital Economics
UK Economics

Tightening fiscal policy soon would be fiscal folly

UK Economics Focus
Written by Ruth Gregory

At some point, there may need to be a fiscal squeeze to pay for any lasting increase in spending caused by the COVID-19 crisis and increases in age-related spending. But the biggest danger is that fiscal policy is tightened too much too soon to fill a perceived hole in the public finances that never materialises. That could be self-defeating as it would lead to a slower economic recovery, cause long-term scarring and could mean that any eventual fiscal consolidation would have to be greater.

  • At some point, there may need to be a fiscal squeeze to pay for any lasting increase in spending caused by the COVID-19 crisis and increases in age-related spending. But the biggest danger is that fiscal policy is tightened too much too soon to fill a perceived hole in the public finances that never materialises. That could be self-defeating as it would lead to a slower economic recovery, cause long-term scarring and could mean that any eventual fiscal consolidation would have to be greater.
  • The COVID-19 crisis has so far left in its wake a budget deficit and level of public debt that has not been surpassed in peacetime. We expect the budget deficit to reach £415bn (20.2% of GDP) in 2020/21. And it seems likely that public sector debt will rise from 86% of GDP in 2019/20 to 106% of GDP in 2020/21 and stay there for a number of years. This has led to warnings about the need for a period of belt-tightening, perhaps by between £20bn (1.0% of GDP) and £50bn (2.4% of GDP) a year, to repair the fiscal damage caused by the crisis.
  • However, the budget deficit is only a problem if the COVID-19 crisis results in a permanent and significant increase in the deficit, such that the debt to GDP ratio spirals ever higher. This could result from either substantially lower tax receipts or substantially higher spending. But it is by no means inevitable that the crisis will put a big permanent hole in the supply capacity of the economy and thus cause a permanent reduction in tax receipts. And with interest rates exceptionally low, the government has time to let decent economic growth heal the deterioration in the public finances.
  • Admittedly, the government may find it hard not to substantially increase spending. Rising income inequality caused by the crisis could prompt lasting increases in health spending and support for the less-well off. The government has committed to significantly increasing spending on green infrastructure and the regional “levelling up” agenda. But so long as the economy is operating below capacity, then it is justified in raising spending.
  • So rather than move towards a fiscal consolidation, the overriding priority for the government over the next few years should be to focus on keeping an appropriate degree of fiscal support in place to compensate for the weakness in private sector demand. The speed at which policy support should be withdrawn can be calibrated against the time taken for GDP to reach its pre-virus trend, or the time taken for the unemployment rate to drop back to its “natural rate” (i.e. the level of unemployment that is consistent with low and stable rates of wage and price inflation). Our forecasts suggest that the government should wait until the second half of 2021 to taper its support. And only after 2023 should it be withdrawn fully.
  • But once that spare capacity in the economy is used up, keeping the fiscal stimulus in place too long or significantly raising spending would generate inflation. That could prompt the Bank of England to raise interest rates and/or unwind Quantitative Easing (QE), meaning that the fiscal position becomes untenable.
  • Faced with the prospect of an unsustainable debt burden, the government could respond by tightening fiscal policy via tax rises or spending cuts, to prevent the debt ratio from rising. But the government will also have a strong incentive to ensure that interest rates stay low. So it is not hard to imagine the government changing the monetary policy framework to permit higher inflation without higher interest rates.
  • Overall, it’s sensible to let economic growth improve the fiscal situation now while inflation and interest rates are so low. If that changes, then at some point in the future the government may opt to allow more inflation so that higher interest rates don’t undermine its fiscal plans.

Tightening fiscal policy soon would be fiscal folly

There is no denying that the scale of the fiscal response to the COVID-19 crisis has been vast. The UK’s direct fiscal response is currently equivalent to a staggering £280bn, or 13.6% of GDP. To put this in context, the fiscal support provided in the wake of the Global Financial Crisis (GFC) was equivalent to about 2% of GDP. And the last time the UK had to borrow as much was after the Second World War.

This raises a series of questions. What should the Chancellor, Rishi Sunak, do next? Are tax rises and/or spending cuts inevitable? And what does this mean for fiscal policy in the future? In this Focus, we take a closer look at these questions.

How bad is it?

Before the COVID-19 crisis, we had forecast that the budget deficit in 2020/21 would be £68bn (3.3% of GDP). We now expect the deficit to soar to about £415bn (20.2% of GDP). That would far exceed the peak of £158bn (10.1% of GDP) in 2009/10 after the GFC and would be the highest budget deficit since the Second World War.

This deterioration is due to two factors. First, the cost of the government’s direct policy support. This accounts for 80% (£280bn, 13.6% of GDP) of the total £345bn rise in our forecast for public borrowing since February, with the lion’s share devoted to spending on public services and employment support. (See Table 1.)

Table 1: Sources of Fiscal Support in 2020/21

£bn

% of GDP

Public services

127.1

6.2

Employment support

73.6

3.6

Support for businesses

34.4

1.7

Loans and guarantees

31.0

1.5

Welfare spending

8.3

0.4

Other tax support

5.7

0.3

Total

280.1

13.6

Source: OBR

Second, the indirect economic effects of the downturn, which have increased welfare payments and reduced tax revenues. This accounts for about 20% of the rise in the borrowing forecast (£67bn, 3.3% of GDP) since the start of the pandemic. Table 2 shows the upward pressure on the budget deficit from these two sources.

Table 2: Budget Deficit, 2020/21

£bn

% of GDP

Budget Deficit (CE, pre-pandemic)

68

3.3

Direct measures

+280

+13.6

Economic effects

+67

+3.3

Budget Deficit (CE, Dec. 2020)

=415

=20.2

Sources: OBR, Capital Economics

Meanwhile, it seems likely that public debt will rise from 86% of GDP in 2019/20 to 106% of GDP in 2020/21, its highest since the 1960s, and stay there for the next few years. (See Chart 1.)

Chart 1: Government Net Debt (As a % of GDP)

Sources: Bank of England, Capital Economics

Should we worry about the higher budget deficit?

The debate so far has been framed in terms of “how to pay” for the fiscal costs of the crisis. But it’s not at all clear which metric the government should be focusing on (the deficit, debt to GDP ratio, debt interest costs), nor what “paying for” the fiscal damage actually means.

Here we distinguish between the budget position (the flow) and the public debt position (the stock). Both matter but for different reasons.

When it comes to the budget position, this will only become a problem if the virus results in a permanent and significant increase in the deficit such that the debt to GDP ratio spirals ever higher. This could result from either substantially lower tax receipts or substantially higher spending.

But the pandemic will only cause a permanent reduction in tax receipts if it causes a permanent reduction in economic activity. If the crisis means that the economy is permanently smaller in the long run, then most of the increase in the budget deficit is “structural” and there is less room for it to be eroded over time by the economic recovery. But if the size of the economy returns to the pre-virus trend, then most of the deficit is cyclical and it will narrow automatically as the economy grows.

Many have assumed that there will be a permanent hole in the economy, just like after the GFC. In fact, based on the OBR’s central forecast, in which GDP is 3% lower in the medium term than it would have been had COVID-19 not existed, the government may have to tighten fiscal policy by between £20bn (1.0% of GDP) and £50bn (2.4% of GDP) a year to put the public finances on a surer footing.

But it is by no means inevitable that the crisis will put a big permanent hole in the supply capacity of the economy. History shows big permanent losses tend to occur mainly after financial crises and after large parts of the capital stock have been destroyed by war or natural disasters. (See here.)

So it’s possible that, unlike after the GFC, the pandemic does not result in a substantial deterioration in the structural budget position. We think that the economy will be around 1% smaller in 2024/25 compared to if the pandemic had never happened and that the economy will get back to its pre-virus trend later in the decade. That would allow the deficit to return to £55bn (2.1% of GDP) by 2024/25, broadly in line with its pre-virus level. (See Chart 2.) So provided spending does not rise significantly further (we will come back to this later), then there is little need for any sort of fiscal consolidation to return the deficit to the sort of levels seen before the crisis.

Chart 2: Public Sector Net Borrowing (As a % of GDP)

Sources: OBR, Capital Economics

The debt burden could fall on its own

As a stock rather than a flow, the amount of public sector debt outstanding gives a more comprehensive picture of the underlying health of the fiscal position.

Crucially the evolution of the debt to GDP ratio depends on three factors. First the budget position which we have already discussed. If the budget deficit comes down as we expect, then that means the debt to GDP ratio will not spiral out of control.

The other two things to consider are the rate of (nominal) GDP growth and the level of interest rates. If interest rates (r) remain lower than the rate of nominal GDP growth (g), then debt will rise at a slower rate than GDP and, over time, the debt to GDP ratio will shrink naturally. (See Box 1.)

Box 1: The maths of debt ratios

The government debt to GDP ratio can be explained by the following formula:

Dt/GDPt = PDt/GDPt + (Dt-1/GDPt-1 * 1+rt /1+gt) + et

Where: D = government debt in £

GDP = nominal GDP

PD = primary budget deficit

r = nominal interest rate on stock of debt

g = nominal GDP growth

e = residual, anything else that effects the debt ratio, such as asset purchases or sales.

All else equal, a larger primary budget deficit (i.e. the deficit excluding interest payments) will increase the debt ratio. The part in brackets means that if the nominal interest rate that the government pays on its debt is lower than the growth rate of nominal GDP (and assuming a balanced primary budget position) the debt ratio will fall.

To some extent, this was what happened after the Second World War when the debt ratio was worked down from 259% to 81% using a combination of decent GDP growth and lower interest rates, as well as fiscal restraint. (See Table 3.)

Table 3: Post-WWII Government Debt Reduction

Post-Second World War

Period

1946-1966

Reduction in Debt (% of GDP)

178ppts, from 259% to 81%

Annual Averages:

Long-term Gov’t Bond Yields (%)

4.7

Consumer Price Inflation (%)

4.3

Real GDP Growth (%)

2.8

Nominal GDP Growth (%)

6.9

Source: Bank of England Millennium of Macroeconomic Data

Chart 3 shows a stylised example, assuming an initial rise in the debt ratio from 86% in 2019/20 to 106% in 2020/21 and, going forward a balanced primary budget (i.e. excluding debt servicing costs). As the grey line in Chart 3 shows, if nominal GDP growth (g) exceeds the effective interest rate paid on government debt (r) by 3 percentage points (ppts) (or r-g = -3) and the primary budget (excluding debt servicing costs) is kept in balance, then the debt to GDP ratio could be reduced to its pre-pandemic level of 86% over the next 9 years.

Even if the debt dynamics become less favourable, for example if interest rates are 1 percentage point below nominal GDP growth (the black line), then the debt ratio would still shrink gradually over time. In theory, this removes the need for higher taxes and/or lower government spending in the future to pay for the initial rise in debt.

Chart 3: Stylised Example of Government Debt as a % of GDP (Assuming Primary Budget is Balanced)

Source: Capital Economics

And in practice, with inflation likely to remain below its 2% target for the next 2 to 3 years, we think that r will stay below g by at least 3ppts in 2021 and 2022. In these conditions, it is unlikely that the debt ratio will spiral out of control.

What’s more, the bond markets have been unconcerned by the level of public sector debt in recent years, meaning that the government’s borrowing costs have remained extremely low. In fact, UK debt interest spending has fallen to record lows of about 1.3% of GDP. (See Chart 4.)

As for the government’s ability to actually raise the finance it needs, the near-failure of a gilt auction in March prompted understandable worries that the markets may have lost their appetite for UK sovereign debt. And gilt issuance looks set to remain elevated over the next few years. Starting from 2021/22, over the next four years, our central government net cash requirement (CGNCR) forecasts suggest that the government may have to issue a total of £390bn of gilts. (See Chart 5.)

Chart 4: Central Government Debt Interest (% of GDP)

Source: OBR

Chart 5: Net Gilt Issuance and Central Gov’t Net Cash Requirement (CGNCR) (£bn)

Sources: OBR, Capital Economics

But the Bank of England is still hoovering up huge amounts of government debt as part of its quantitative easing (QE) policy and expects to make a further £150bn of gilt purchases during 2021. So the environment will remain conducive to further issuance of government debt. This all suggests that over the next few years, the government has time to let decent economic growth reduce the deficit and, at the very least, prevent the debt ratio from rising.

A shift to a bigger state

However, this all hinges on the government running a balanced primary budget (i.e. excluding debt servicing costs). In practice, the government may find it hard to do so.

After all, government spending has already become a steadily bigger part of the UK economy since the early 1950s. (See Chart 6.) And rising income inequality caused by the COVID-19 crisis could prompt the government to increase health spending and support for the less well-off. (See here.)

Chart 6: Public Sector Spending (As a % of GDP)

Source: OBR

The pandemic may well have worsened inequality, with the job losses disproportionally falling on low-wage sectors like leisure, health and retail, which have been most affected by ongoing physical distancing requirements. The rebound in global stock markets and the unexpected strength in the housing market will also further widen the wealth gap by boosting the price of assets, a greater share of which are held by the wealthy.

And even before the crisis, the government had committed to significantly increase spending on green infrastructure and “levelling up” the regions. There are bigger longer-term questions over the sustainability of the public finances too, due to the additional spending pressures caused by the ageing population, issues that are not unique to the UK.

However, if interest rates remain lower than GDP growth, then the government will still in theory be able to run a bit of a primary deficit, whilst still ensuring that debt as a share of GDP is at least stable. Taking our longer-term assumptions that nominal GDP settles at about 3.7% and interest rates at 2.0%, the government would still have scope to run a primary deficit of about 1.5% of GDP whilst still stabilising the debt to GDP ratio. (See Chart 7.)

Chart 7: Government Primary Balance (As a % of GDP)

Sources: IMF, OBR, Capital Economics

And in this early stage of the economic recovery with the economy still operating well below capacity, the government is justified in running significant primary deficits. Indeed, it is the government’s job to compensate for the weakness in demand in the private sector.

Immediate risk is a premature fiscal tightening

In fact, we think that the most immediate risk is that political motivations or the OBR’s downbeat forecasts lure the government into withdrawing its fiscal support too quickly. And in this regard, the noises coming out of the Treasury seem to suggest that the UK government is keener than most other countries to enter into a period of belt-tightening.

This might be driven by a political desire to prove that the Conservative Party is better at managing the public finances than the Labour Party. Or it may reflect a desire to lengthen the time between unpopular tax rises and the next general election in 2024. Indeed, few Chancellors have dared to announce major tax increases or spending cuts just ahead of an election, even if they don’t actually kick in for several years. Since 1987, tax cuts of £2.4bn on average have been announced in the year prior to an election. (See Chart 8.) So the Chancellor may prefer to raise taxes sooner rather than later to leave room to implement tax cuts before the next election.

Chart 8: Tax Changes (£bn)

Source: IFS

But we think that the government should keep an appropriate degree of fiscal support in place while the recovery is weak and that for the time being calls to tighten fiscal policy should be resisted. If not, tighter fiscal policy could be self-defeating since it would lead to a slower economic recovery, cause greater long-term scarring and perhaps mean that any eventual fiscal consolidation would have to be greater.

Admittedly, some economists argued after the GFC that a fiscal tightening wouldn’t be that damaging since it could foster confidence and offset some of the adverse impact on aggregate demand. But the lesson from 2008 is that tighter fiscal policy can have a major contractionary effect on the economy. Indeed, based on the Office for Budget Responsibility’s (OBR) fiscal multipliers, it is estimated that the government’s fiscal tightening may have subtracted 1ppt from GDP growth in 2010 and a further 1.1ppt in 2011. (See Chart 9.)

Chart 9: Impact of Discretionary Fiscal Policy on GDP (ppts)

Sources: IFS, OBR

And when interest rates are low and monetary policy is constrained, then the fiscal multipliers are arguably higher, as monetary policy cannot easily offset the negative effects of tax changes. So if anything, the drag on GDP growth in the years following the GFC might have been even bigger.

Admittedly, the fiscal consolidation after the GFC was all about spending. And this time the government has said it won’t embrace spending cuts. Granted, it has already reined in some spending, saving £10bn a year from unprotected departments’ non-COVID budgets and £4bn per annum from reducing the overseas aid budget from 0.7% of GDP to 0.5% of GDP. But the implication is that the bulk of any fiscal squeeze this time will be achieved via higher taxes, rather than spending cuts. And whatever you think about multipliers, they tend to be higher for spending than for taxes. For example, the OBR assumes that a discretionary fiscal tightening of 1.0% of GDP would initially reduce output by 1.0% if it was done via cuts to investment, 0.6% in the case of cuts to day-to-day spending on public services and welfare spending, but 0.35% if achieved via increases in VAT and 0.3% for rises in income tax and National Insurance Contributions.

But the experience in recent years in Japan suggests that tax rises can also be self-defeating. GDP fell by 1.9% q/q in Q2 2014 following the rise in the sales tax from 5% to 8%. And the hike in Japan’s sales tax from 8% to 10% in 2019 caused a 0% GDP growth rate in Q3 2019 to turn into a 1.8% q/q fall in Q4. (See Chart 10.) We estimate that in total both tax hikes knocked about 1.5ppts off GDP growth. And with interest rates very low, the Japanese experience provides an example of the impact of a fiscal tightening when monetary policy is constrained.

Chart 10: Japan Real GDP (tr Yen)

Sources: Refinitiv, Capital Economics

So it doesn’t make sense to announce a fiscal consolidation, when the fundamental state of the economy is still so poor and the tax base has not fully recovered. Instead, the tapering and withdrawing of policy support should be calibrated to match the recovery in private sector demand.

The speed at which policy support should be withdrawn can be calibrated against the time taken for GDP to reach its pre-virus trend, or the time taken for the unemployment rate to drop back to its “natural rate” (that is the level of unemployment that is consistent with low and stable rates of wage and price inflation).

Chart 11: ILO Unemployment Rate (%)

Sources: Refinitiv, Capital Economics

Based on this, our forecasts suggest that the government should wait until the second half of 2021 when the unemployment rate starts to fall back to taper its support. And only after 2023 should support be withdrawn fully. (See Charts 11 & 12.)

Chart 12: Real GDP (Q4 2019 = 100)

Sources: Refinitiv, Capital Economics

Retrenchment not out of the question eventually

But this is not a licence for fiscal largesse indefinitely. As the economy recovers and spare capacity is used up, a fiscal stimulus that remains in place too long or a situation in which the government continues to increase spending significantly would generate inflation. That could prompt the Bank of England to raise interest rates and/or unwind QE, meaning that the fiscal position becomes untenable.

Indeed, it only takes relatively small changes in interest rates to change the debt dynamics substantially. If interest rates were 1ppt below nominal GDP growth, the debt ratio would shrink after two decades to 90%. Yet if interest rates exceed nominal GDP growth by 1ppt, the debt ratio would rise steadily to almost 130%. (See Chart 13.) So if interest rates were to rise significantly, then things could get trickier for the government further ahead.

Chart 13: Stylised Example of Government Debt As a % of GDP (Assuming Primary Budget is Balanced)

Source: Capital Economics

Admittedly, the government could let the debt ratio continue to rise. But that might test the government’s credibility in the markets. And if financial markets were to get nervous, that would lead to a rise in government bond yields, prompting their concerns about debt sustainability to become self-fulfilling.

At that point, the government has two choices. One, respond by tightening fiscal policy via tax rises or spending cuts, so that the debt ratio does not climb indefinitely. Or two, ensure that interest rates are kept low so that the debt ratio can at least be stabilised. (See here.) The latter could be achieved in a number of different ways but could involve the government raising the Bank of England’s 2% inflation target or introducing a more flexible interpretation of the current target. So essentially the government would need to choose whether to sacrifice low inflation to keep interest rates low so it could use fiscal policy to achieve its political ambitions. While it is easy to think that the current policy framework is set in stone, the UK has been through a number of monetary regimes. And the US Fed’s recent shift towards “average inflation targeting” (enabling an overshoot of the inflation target) could prove to be the thin end of the wedge. So the legacy of this crisis could be an end of the focus on low inflation to allow looser fiscal policy.

Conclusion

Overall, the government was right to spend big in response to the crisis. And over the next 2-3 years, continued fiscal support will be required to nurse the economy back to health. A rush to tighten fiscal policy would not only cause the economic recovery to stall, but it could also cause permanent economic scarring that would ultimately require a greater fiscal consolidation.

But this is not a licence for never-ending fiscal largesse. Once slack in the economy is used up, higher spending risks generating inflation and prompting interest rates to rise, rendering the fiscal position untenable. In these circumstances, it is not hard to imagine a future where the government changes the monetary regime to allow higher inflation without higher interest rates, allowing it to continue with its fiscal plans.


Ruth Gregory, Senior UK Economist, +44(0) 7747 466 451, ruth.gregory@capitaleconomics.com