Now austerity is over, let's commit to investment—and build a national bank to do it

Investment can benefit society and help stabilise the economy. A separate capital budget, distanced from political interference, is the best way forward

August 08, 2017
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Deficit fetishism has finally been defeated. As I recently wrote in these pages, this year’s Queen’s speech finally put “strengthening the economy” ahead of “the public finances.”

This is progress. But there is still no agreement on what should replace austerity. If the doctrine that a country can cut its way back to prosperity is dead, the hunt for new answers should start with the most obvious alternative—enriching ourselves by investing in valuable things.

The state must reaffirm its own role here. In the Keynesian post-war age, it was accepted that the state had an important—and probably increasing—part to play in capital formation. Yet since the 1970s, things have gone the other way. In the UK, public investment as a share of total investment fell from 42 per cent from 1960-75, to 20 per cent from 1975-2013.

This is the fruit of Thatcherism, an ideology which assumed state investment programmes were bound to be wasteful and inefficient, and that the private sector—the presumed source of all innovation—would already have ploughed money into any projects that were was truly worthwhile. Some of these charges had a basis in the loss-making record of the nationalised industries. But even if there were some real flaws in the older models of state investment, these were contrasted with an unjustifiably idealised model of private investment.

The crash of 2008 and the long slump that followed exposed the fallacy of “the market knows best.” It is time to redress the argument.

Investment can foster stability

The first big reason to reenergize public investment is that it can foster a more stable economy. Private investment is inherently volatile, depending, as it does, on what Keynes famously called “animal spirits.” Having a large, stable state investor is a useful counterweight to this.

The fall in the state’s investment share since the 1970s has rendered total investment more volatile and crises more likely. The cuts in public investment were the most egregious mistake of George Osborne’s austerity policy. Politically, they were easy to make because the projects involved had often not started. Economically, they were a disaster. The immediate drag on the recovery was only the start of it.

Even in normal times, when recession and recovery are not the issue, there are two grounds for favouring a beefed-up role for state investment. The first was given by Adam Smith: the state has a duty to provide “public institutions and public works” which “though they may be in the highest degree advantageous to a great society” could never repay the expense “to any individual or small number of individuals.”

The private sector would not, Smith thought, invest when the payoff period was too long, or too many inputs were required, with transport being one case in point. When the private sector is induced or cajoled into making such investments, as in the case of the Channel Tunnel Company, the results are liable to be disastrous: it took 20 years and several taxpayer-financed debt ‘restructurings’ before that Company started making a profit.

Second, there is the state’s role in innovation. Mariana Mazzucato (and others) have shown that the state has always played a crucial role in fostering new technologies. Take one striking example: all the technologies that make the iPhone a smart phone were state-funded, including the internet, GPS, touchscreen display and the voice-activated Siri personal assistant. Why should this be so? The state’s ability to command ‘patient capital’ means that the state can invest in projects with too long a gestation period to attract private capital.

How to understand public spending

But until recently, most academic economics has been silent on the investment role of the state. It restricted itself, instead, to asking which goods and services needed to be funded by taxation rather than private purchase, on account of one or other 'market failure.'

Similarly, in presenting public accounts, governments have often failed to distinguish investment from current spending. Public finance theory on the matter is clear enough: hospitals and schools count as capital spending, nurses and teachers’ salaries as current spending. But in practice the two things have got blurred. The so-called fiscal stance was assessed in terms of a single number, 'Public Sector Net Borrowing'—all expenditure, less receipts. As Joseph Stiglitz writes: “No private firm could get away with simply reporting cash flows.”

Gordon Brown's 'golden rule' did, it is true, try to distinguish capital from current spending, but he also had other fiscal targets which ignored the difference, and in his rhetoric he would sometimes deliberately blur it, describing all expenditure on, say, the NHS as if it were investment.

Ultimately, there was still too much scope for a Chancellor to borrow money for current spending which should have been covered by taxation. That is always tempting because both types of spending are relevant to the management of aggregate demand and the social purposes of the budget. It was to guard against the abuse of public spending for what was seen as political purposes, that economists and ideologists of the right demanded a return to the Victorian fiscal constitution, the rigid doctrine of the balanced annual budget. But this is throwing the baby out with the bathwater.

A measured approach

A more sensible fiscal constitution would allow the governments to borrow for investment, while stopping it from relabelling anything it liked as “investment.”

The main planks might be something like this: the government should aim for an annually balanced current budget, including a provision for paying off some debt, in a normal year. (A normal year could be defined as 5 per cent unemployment and 2 per cent growth.)

If people want more spending on public services, taxes will need to go up. But the capital budget should be presented entirely separately. There should be no attempt to aggregate the two budgets into a single figure—because this then could become the markets' perception of the sustainability of the public finances. The capital budget should be a gauge of what public spending is adding to the net worth of the public sector. To put it in simple terms: the separation of the two accounts would enable good deficits to be distinguished from bad deficits.

This is not to say that all public investment should be done directly by the state. To reflect this, the capital budget should be further divided into two parts: investment expected to justify itself commercially, and investment which is expected to yield only a ‘social’ rate of return. The first should be out-sourced to an independent investment bank, and the second should be directly handled by the government.

A national investment bank with £250bn to spend over 10 years—sufficient time for this sort of programme to prove its worth and sustainability—is something the Labour party has usefully proposed. But it has been frustratingly vague about the rationale, and some other important details.

The advantage of out-sourcing part of the capital investment programme would be to distance it from political interference. The Bank's mandate would require it to invest in a range of projects on commercial terms. The government specifies the range: the Bank chooses which projects within the range merit investing in. This is how the two relevant comparators—the European Investment Bank and Germany's Kreditanstalt für Wiederaufbau—were set up.

The bank could be empowered to borrow a multiple of its publicly-subscribed capital to invest in not only green projects whose payoff might be decades hence, but in anything that satisfied its commercial judgment, and particularly in viable projects that could help rebalance the economy away from finance and the south towards manufacturing and the north, including transport infrastructure, social housing and smaller businesses.

Being state-owned, this bank would be able to raise funds more cheaply than other banks, making it possible for it to support projects that don’t make sense at the rates they charge. But its bonds would still carry a modest premium over Treasury gilts, meeting the need of pension funds for better risk-free returns.

The quid society

Other investment projects which require a taxpayer subsidy should be the direct responsibility of central and local government. Although they lack a calculable rate of return they may still be, as Smith says, “in the highest degree advantageous to a great society.”

Governments can, uniquely, reap returns on investments through an increase in national income; as national income rises, so does the tax yield. This mechanism makes it viable for the state, unlike private businesses, to invest in hospitals, schools, universities, and R&D on the basis that this will expand the economy.

A reinvigorated investment role for the state is the best alternative to austerity. If it had focused on investment, the government could—and should—have avoided the decline in aggregate demand which flowed from the disorganised fiscal politics in 2010. Guided by appropriate accounting, governments should not have too much trouble in meeting their budgetary targets and keeping to a constant debt-GDP path. Only then will we be able to escape from deficit fetishism.