Rishi Sunak’s message to the UK on Wednesday was stark. The nation’s “economic emergency has only just begun”, the chancellor said before warning that public borrowing and debt were “clearly unsustainable”. Anyone who did not get the message that tax rates would need to rise and that there would be more stealthy austerity was not listening.
But what if Mr Sunak is wrong? What if we no longer need to abide by traditional benchmarks for government finances such as stable public debt as a share of national income, or that tax revenues should at least cover day-to-day public expenditure? Then, not only would the coming budgetary consolidation cause financial pain, but it would undermine economic progress and place too heavy a burden on the public today compared with future generations. That would be a big error.
This is a crucial time for public finance targets across advanced economies. President-elect Joe Biden and his likely Treasury secretary nominee, Janet Yellen, will need to decide US budgetary strategy in the coming weeks to enable a new administration to hit the ground running in January. The EU has suspended its stability and growth pact, pending a review of its rules. As new policies are considered, academic thinking on the matter has been evolving at a pace unseen for 30 years.
There are two constraints any new strategy must meet. The first is that a new framework must allow government spending and tax decisions to be the primary stabiliser of the economic cycle until monetary policy regains its potency. This does not necessarily require interest rates to rise above zero, but will need unemployment to be making good progress back down towards low pre-pandemic levels before fiscal consolidation is considered.
A second is that government budgetary policy must retain the confidence and trust of financial markets. You do not have to look too closely at emerging economies to know how difficult setting policy becomes if investors refuse to offer governments finance at reasonable interest rates.
So long as these two conditions are passed, countries would be well advised to heed Jason Furman, chair of the Council of Economic Advisers under former US president Barack Obama. He reasoned in a recent lecture that any fiscal rules should be a balance between “optimal” theoretical guidelines, “understandable” rules for public consumption and “achievable” rules for policymakers to follow.
With economic theory still unable to tell us much about what is optimal in a practical sense, Mr Furman said that “understandable” and “achievable” fiscal rules for the US would be to keep the real burden of interest payments on government debt below 1 per cent of national income. He noted that would be similar to maintaining public debt below 150 per cent of national income.
Applied to the UK, these rules would suggest no budgetary consolidation was required at all in the years ahead. Real interest rates on government debt are heavily negative at all maturities and the debt burden is forecast to rise from roughly 80 per cent of national income before the pandemic to 105 per cent in the middle of this decade.
The UK might have to take a more cautious stance than Prof Furman recommends for the US, because there is a greater chance that the country could lose the confidence of financial markets. But thinking on budgetary rules is evolving so fast that even though the combination of a rapid rebound and extremely cheap debt service is unlikely, it is wrong to assume that Mr Sunak will, or should, prefer fiscal consolidation over higher public borrowing. Talk in the UK after the spending review has been of tax rises to come. The way this debate is changing, don’t bet your house on it.