Opponents of increased public spending have a stranglehold on Britain’s political and public discourse. There was a brief hiatus after the financial crisis, when it was accepted that the government needed to intervene in the economy to bolster demand, but since then the deficit hawks have largely held sway unchallenged. They argue that any increase in government spending will simply push up inflation and increase already unsustainable levels of public debt and/or that a smaller state will inevitably lead to faster economic growth.
The combination of these two beliefs is doing permanent damage to Britain’s economy by unnecessarily holding back demand and further eroding the quality of the public goods—infrastructure, affordable housing, skills—upon which economic growth increasingly depends. They reflect political ideology rather than economics: the sustainable level of demand in an economy is not determined exogenously; government policy helps determine it.
Pessimism about the growth potential of the UK economy rests on a belief that the collapse in productivity growth—productivity is barely higher than a decade ago—is all down to a weakening of technological growth (compounded by population ageing). The government cannot stimulate the economy because there is no surplus capacity; boosting spending will simply push up inflation and wages, hitting profitability and hence investment and jobs. The collapse in in productivity growth has little to do with weak demand and under-utilised resources.
This reflects circular reasoning and is self-defeating. First, productivity growth has slowed in other countries, but by nowhere near as much as in the UK. And, if anything, the pace of technological change is accelerating rather than slowing. The problem is that British firms (and to a lesser extent those in other developed countries) are not investing in those technologies. Productivity growth does not simply reflect technological change but a combination of technological change and capital intensity.
Britain’s awful productivity performance is no surprise: it has easily the lowest level of business investment among the G7 economies. A major reason for that is that demand in the economy is too weak to justify firms taking on the cost of investment. Were demand stronger, firms would be able to justify that investment in new technologies and processes, and that would boost productivity.
“By failing to boost spending and with it private investment, the government is reinforcing weak growth”
In short, investment and productivity go hand in hand. Put another way, demand creates its own supply. The British government could boost spending without simply pushing up inflation and debt, even when, as now, the rate of unemployment is low. Real wages are again falling and consumer confidence and spending weakening—hardly a sign of an economy running at capacity and at risk of soaring inflation. And, in any case, if wage settlements were to accelerate this would give firms a further incentive to modernise and raise productivity.
Second, the belief that the government cannot borrow more to stimulate the economy is self-defeating. The argument is that growth prospects are now so poor that the economy will not be big enough to sustain the additional debt. But by failing to boost spending and with it private investment, the government is reinforcing the weak growth trajectory. And by doing so, it is increasing the economy’s vulnerability to the next downturn.
Moreover, there is no evidence that the UK government is anywhere close to the limit of what it can borrow without investors taking fright. Indeed, it is instructive that so many deficit hawks are so sanguine about high levels of private indebtedness in the economy. It is the overall levels of leverage which matters. And high levels of public debt are arguably less destabilising than high levels of private debt.
Third, the belief that government spending is wasteful and that the smaller the state the faster economic growth will be, reflects political ideology, not economics. There is no correlation between the size of the state and economic performance—some big state countries have poor economic growth records and some very good ones. Moreover, not all private sector economic activity is value-creating; some is little more than value-extraction.
Economic growth is more dependent than ever on public goods that the private sector will not provide—good quality education, healthcare, housing, childcare, and good market regulation. Countries that invest in these are doing well and are better placed to cope with the technological transformations coming down the line.
Of course, there are times when the government should pursue tight fiscal policies, such as when private sector investment is booming and the country does not face debilitating supply-side constraints in the form of weak infrastructure, a housing crisis and poor childcare. But Britain is a million miles away from this scenario.
Supply-side pessimism and small state ideology are bringing about precisely the scenario the government wants to avoid. Britain needs a demand boost to help address the myriad of supply-side constraints holding back its economy and to give firms the confidence to invest. This is especially so with current Brexit uncertainties. The Bank of England needs to do its bit and resist pressure to raise interest rates. But, more importantly, the government need to end its damaging obsession with the budget deficit and get spending.