This is an extended version of a piece first published in Prospect magazine.
Austerity didn’t cause Covid-19. But the pandemic has thrown into sharp relief the misplaced sense of priorities of those who have set overall economic strategy since 2010. The idea that the best measure of the country’s preparedness for a crisis – health, economic, or indeed any other – is the size of its fiscal deficit or its national debt was always absurd. The Sunday Times informs us of the grim reality of what that meant in practice: “We were the envy of the world … but pandemic planning became a casualty of the austerity years, when there were more pressing needs.”
But while the policy errors of the austerity era are now reasonably clear, what does that mean for economic policy as we move into the next phase of the crisis? One thing is certain – borrowing and debt will be much higher. The Office for Budget Responsibility estimates that our debt-to-GDP ratio will rise to 95 per cent at the end of this financial year. But this assumes a sharp, V-shaped recovery. By contrast, a more realistic assessment from the Resolution Foundation projects increases to well over 100 per cent of GDP on the most optimistic scenario, while on an – admittedly very grim indeed – assumption that the lockdown lasts for a full year, it rises above 160 per cent.
The good news is that in the near term, there is no market constraint on such borrowing. This is perhaps the key learning of the last decade; worrying about levels of debt and the deficit when the private sector isn't investing is just a conceptual error. The reason interest rates are low is that private sector consumption is weak, investment weaker and risk appetite very low. Savings need to go somewhere; in current conditions financial markets both want and need government to spend and borrow.
But, even if the worst does not materialise, there is no question that debt and the deficit will rise at unprecedented speed. And there will be some who insist that, when the crisis passes, the remedy is yet more austerity. But worrying about the size of the debt or deficit misses the point, and risks leading policy astray, just as it did in 2010. Instead, the government needs to focus on two issues in formulating its economic plan.
The first policy dilemma will be demand management. And here the uncertainties are huge. A “normal” recession –a nd in this sense the financial crisis, extraordinary in many ways, was still “normal” – is caused by a fall in demand, and the economic response (monetary, fiscal or both) is to increase demand by reducing interest rates, cutting taxes, or increasing government spending. Here we have the complete opposite – a deliberate reduction in the supply capacity of the economy, imposed for health-related reasons. So there’s no point in worrying too much about demand now.
But when the affected sectors reopen, what will happen? Will we face a “normal” recession, as unemployment remains high, nervous households hold back on spending, and businesses fear to invest? Or will those of us – the majority – whose incomes have held up well, either because we can still do our jobs or we’ve been furloughed, want to spend the money that we’ve saved during the lockdown period? If the latter, we might actually see excess demand – particularly if some of the supply capacity of the economy has disappeared for good – resulting in higher inflation and interest rates.
Right now, we just don’t know. But the good news is that either way, the implications for fiscal policy are clear. If – as seems most likely – consumer and business spending is depressed, then the last thing we should worry about is the deficit. Even in a normal downturn, the right prescription would be – as we learned after 2008-09 – for the government to keep on spending. The case for that is even stronger if the lack of demand is driven, above all, by fear and uncertainty. Meanwhile, such a deficit should be relatively easy to finance, since by definition the fundamental cause of low demand would be high levels of private savings by risk-averse households and businesses. That savings needs to go somewhere, and if it does not finance private investment then, directly or indirectly, it will finance government spending, meaning the government is likely to be able to continue borrowing at very low interest rates.
What if the problem is the reverse – too much spending? Compared to the alternative, this would be good news for the economy. Indeed, a period of excess demand, pulling people back into the labour market, raising wages, and perhaps even boosting productivity, might be exactly what we need. But it would make managing large deficits harder. In particular, interest rates on government debt would rise, perhaps sharply. Fortunately, inflation is good for government finances – revenues rise faster than expenditures, and the real value of outstanding government debt falls. Nevertheless, taxes would have to go up considerably sooner in this scenario.
Getting short-term macroeconomic management right will be important. But even more vital is to minimise the long-term damage done by the crisis. Some simple arithmetic illustrates the point. Suppose that the lockdown does indeed reduce output by 35 per cent for three months, as the OBR assumes. That’s a bit under £200 billion, or 9 per cent of annual GDP, and an increase in net debt of £260 billion. Bad, but what about if – as the Resolution Foundation assumes, under its most optimistic scenario – there’s a permanent hit to GDP of 3 per cent? Even under very conservative assumptions about how to discount the value of future incomes, the damage to the UK’s economic welfare would be at least ten times as great.
Similar arithmetic applies on the fiscal side. At current yields we can finance an extra £300 billion of debt for less than £2 billion a year. Again a 3 per cent permanent hit to GDP would hit the public finances at least ten times as hard. The implication is clear. We should be willing to endure a considerable amount of short-term economic pain, and spend almost any conceivable amount of money, if it avoids long-term damage to the supply side of the economy.
During the crisis itself, that means, as I and others have written, preserving businesses and jobs, even if the businesses are closed and the workers at home. That will be the easy bit. As the restrictions are eased, it would be easy to withdraw support too early – to save money or to try to show that things are getting back to normal. But there’s also a risk of doing so too late, and propping up businesses that simply won’t be viable in the medium term.
This will be particularly difficult in the case of the government’s Job Retention Scheme. At the moment, this pays firms to pay workers to do nothing. This makes perfect sense if the reason the firms don’t need the workers is temporary, health-related restrictions; we don’t want firms that were viable before, and will be viable again, to go bust or to lay off the workers they will need again. Nor do we want to push people into unemployment unnecessarily. But as we emerge from the worst of the lockdown, the calculus will change. If – and we simply don’t know at this point – the impact of the pandemic is to induce not just a temporary halt to some activities, but medium- to long-term structural changes, then paying people not to work will inhibit the economy’s adjustment to those changes. That will be bad for the economy and also, in the longer run, bad for those workers.
But the political economy of this will be very difficult. Suppose, for example, that social distancing measures in restaurants are here to stay (either government-mandated, or demanded by the public), and that large parts of the sector are unviable. It would not just be expensive, but very bad economics to keep those restaurants, and their workers, in a state of suspended animation – instead. the resources, human and physical, they employ will need to be redeployed to growing sectors. But, in human language, that means firms going bust and individuals being made redundant. New forms of support – perhaps most importantly, a return to the active labour market policies that have largely been abandoned over the last few years – will be required.
More broadly, we’ll obviously need to spend more on the NHS, but this would also be the right time to reconsider other policies, such as the punitive and divisive approach to the benefit system that has characterised the last decade. None of this will be easy; and all of it will cost money. Some of us – especially the better off, and people like me and, I’d guess, most of those reading this, whose incomes have held up well during this crisis – will need in due course to pay more tax. But this time we should focus not on short-term fiscal targets but rather on building a genuinely resilient economy – and society.
Jonathan Portes is a Professor of Economics at King's College London and a Senior Fellow at the UK in a Changing Europe.