Scrap HS2 to ease government debt crisis

December 18, 2014

Hyperinflation 206x167The recent announcement that the projected cost of Crossrail 2 has risen to £27 billion should be cause for deep concern within the Treasury. Added to High Speed 2 and High Speed 3, this means the total budget of just three planned or proposed rail schemes could be close to £100 billion – or perhaps even higher, given the overruns so typical of big government projects.

Economic conditions amplify the financial risks. The deficit remains stubbornly high, while robust medium-term growth cannot be guaranteed given the ongoing crisis in the euro zone and the fragile condition of the banking sector. This implies that a large proportion of future transport investment may be funded by government borrowing, adding a not insignificant amount to a national debt that has already reached £1.5 trillion.

There are clear echoes of Japan in the 1990s: a heavily-indebted government viewing transport investment as a way to stimulate growth after a deep recession.

To be fair, there is some merit in this argument. Improved transport links tend to raise productivity and boost growth by lowering the costs of trade. Greater specialisation and economies of scale are facilitated. Workers find it easier to access jobs that make good use of their skills and talents.

But transport spending also has major downsides. The additional tax burden needed to fund schemes directly, or repay debt incurred, suppresses economic activity. Incentives for work and entrepreneurship are diminished, while resources are misallocated due to the distorting effects of taxation. The overall cost to the economy is substantially higher than the direct tax bill.

The negative effects may be particularly severe if transport spending pushes levels of government borrowing into dangerous territory, such that market confidence is undermined. This risks a ‘debt spiral’, with a larger and larger share of tax revenues used to pay back investors in government bonds.

Heavily indebted governments should therefore exercise particular caution on transport investment. They must ensure that the economic benefits outweigh the full costs, taking proper account of the downside risks of budget overruns and the impact on public debt.

This didn’t happen in Japan. Vast sums were wasted on poor value schemes with low benefits – including the notorious ‘bridges to nowhere’. Government borrowing was pushed up, while taxpayers were also forced to pay ongoing maintenance and operating costs.

Unfortunately, a similar pattern is now emerging in the UK, as an ‘infrastructure craze’ grips our politicians. Rather than focusing on high-return, low-risk projects, the government is favouring low-return, high-risk schemes such as HS2. Once the negative effects on the wider economy of the additional taxation and borrowing are factored in, there is a significant chance that the costs of these projects will exceed their benefits.

The dangers are further exacerbated by rapidly changing technology. Developments such as advanced video-conferencing and driverless cars have the potential to completely transform transport markets by 2030. New technologies, for example in rail signalling or road pricing, also mean congestion and capacity problems can now be tackled at a tiny fraction of the cost of building brand new infrastructure.

Fortunately, there is still time for the UK to change course. One of the new government’s first priorities next year will be to instil confidence in its deficit reduction plan. Scrapping poor value transport projects would achieve this at minimal political cost.

City AM, December 2014

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Do we need to make further spending cuts?

March 4, 2013

George Osborne is taking a reckless gamble by extending his fiscal target out to 2017/18. Government borrowing will now remain at dangerously high levels for a prolonged period. Worse still, the deficit reduction plan could easily be derailed by lower-than-forecast growth. The Chancellor is relying on robust growth in the medium term to boost tax revenues and enable him to meet his targets without the need for radical spending cuts. This outcome cannot, however, be guaranteed. Recent history shows that OBR forecasts are extremely unreliable. Borrowing in 2013/14 is already likely to be almost double the figure originally expected. If stronger growth fails to materialise, the UK could quickly lose the confidence of the bond markets and face a debt spiral. Given the risks, a wiser Chancellor would have taken a much more conservative approach. Deeper cuts would have made Britain much more resilient to future growth shocks.

6 December 2012, City AM

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The Chancellor is still gambling on strong medium-term growth

March 4, 2013

At the time of the last Autumn statement, the Office for Budget Responsibility (OBR) was predicting growth of 0.7 per cent in 2012, followed by 2.1 per cent in 2013, 2.7 per cent in 2014 and a robust 3.0 per cent in 2015. Yet again, these forecasts have been downgraded, to -0.1 in 2012, 1.2 per cent in 2013, 2.0 per cent in 2014 and 2.3 per cent in 2015. Forecasts of strong growth of almost 3 per cent have now been put back to 2016 and 2017.

Despite the unreliable nature of such forecasts, the Chancellor is still gambling that strong medium-term growth and the consequent increases in tax revenues will allow him to meet borrowing targets without making radical spending cuts. So far this strategy has not been successful. As a result of lower-than-expected growth over the last two years, government borrowing in 2012/13 on a like-for-like basis will be around 50 per cent higher than projected in the original deficit reduction plan. Borrowing in 2013/14 is now forecast to be almost double the figure expected back in 2010. At around 7 per cent of GDP, it will remain at a similar or higher level than in several countries currently experiencing debt crises, such as Italy, Spain and Portugal.

In addition, there are good reasons to believe that the long-term ‘trend’ rate of growth in the UK has declined over the last decade or so. This reflects a large rise in public spending – to a peak of 50 per cent of GDP – as well as an expanded regulatory burden on businesses. Moreover, various government stimulus policies since 2008 have hindered recovery by preventing necessary adjustments, such as the liquidation of boom-time malinvestments and the reallocation of resources to more productive activities. Going forward, significant increases in energy and transport costs, resulting from the government’s environmental policies, are likely to have a negative effect on economic output. And, as the Chancellor mentioned in his statement, the ongoing euro zone crisis adds further uncertainty to the medium-term growth outlook.

In this context, the Treasury is taking a major risk in basing its deficit reduction plans on growth forecasts that are likely to be inaccurate. Given that government borrowing remains at dangerously high levels, and that the confidence of the bond markets could quickly be eroded if outcomes disappoint, there is a strong case for taking much more radical action to reduce public spending. The real terms reductions in working-age benefits are a good start, but the Chancellor could also have acted to cut age-related benefits, as well as abandoning the coalition’s deeply unpopular plan to increase foreign aid. Significant medium-term savings could be achieved by cancelling major projects such as Trident and High Speed 2. The IEA’s recent publication, Sharper Axes, Lower Taxes, provides a long list of potential savings.

5 December 2012, IEA Blog

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Do we need to make further spending cuts?

March 4, 2013

The government has behaved recklessly. Assuming a strong recovery with high growth and rising tax revenues, it gambled that relatively modest spending cuts would be enough to fulfil the deficit reduction plan. The latest borrowing figures betray the magnitude of this miscalculation. It seems likely that the deficit will remain dangerously high, and there is a very real risk of the UK losing credibility in the bond markets.

Given the gravity of the situation, a combination of more substantial spending cuts and radical deregulation is the only realistic option for the Chancellor. The former would reduce the deficit directly while the latter would translate rapidly into higher growth. By contrast, a stimulus programme would only increase the risks facing the economy. Additional borrowing would put the deficit further into the danger zone and an even larger state would suffocate private-sector activity.

23 August, City AM

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Cut more, regulate less

March 4, 2013

Relying on growth was always going to be a risky strategy. Yet a healthy recovery, with robust GDP increases of 2%-plus, formed the core of the government’s deficit reduction plan. In this context, the combination of prolonged recession and yesterday’s higher-than-expected borrowing figures is a cause for deep concern. Indeed, there are several reasons to believe that the outlook for the UK economy is bleak and that growth will not be sufficient to play the key role in deficit reduction assumed by the government.

Firstly, the stimulus policies adopted after the onset of recession have hampered the necessary market adjustment process by which resources ‘malinvested’ during the artificial boom are reallocated. In other words, stimulus measures have cushioned the decline in the short term but at the expense of recovery in the longer term. Secondly, the expansion of the state under New Labour will have reduced the long-term growth rate of the economy by crowding out wealth-creating private sector activity. Finally, there are a number of more specific negative factors, including an ageing population (contributing to slowing labour force growth); regulatory pressure on the banking sector; the euro crisis; and the potentially disastrous impact of various green policies on business costs.

Since the government can no longer rely on growth (and the extra tax revenues that flow from it) to bring the deficit down and stimulus measures would be counterproductive, spending cuts are the only realistic policy option. And the likely scale of the tax shortfall resulting from the double-dip recession means that these cuts will have to be very substantial indeed. Many of these cuts can, however, be combined with reform to produce long-term economic benefits, as set out in the recent IEA study, Sharper Axes, Lower Taxes. In particular, spending reductions should be combined with deregulation. Reducing unnecessary burdens on business feeds directly into higher productivity. Strict planning controls, green energy policies and restrictive employment legislation are key restraints on business growth and should be urgent priorities for liberalisation.

22 August 2012, IEA Blog

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Darling must cut UK’s huge welfare bill

February 17, 2013

Alistair Darling is staring into the abyss. Unless he makes severe cuts to government spending there is a real risk he will plunge the UK into another economic crisis.

Without a credible commitment to bring public expenditure down to sustainable levels, the bond investors funding Britain’s near £200 billion annual borrowing may demand a risk premium in the form of higher interest rates. A big rise in rates would in turn increase the cost of the government’s debt repayments, threatening a debt spiral which could jeopardise economic recovery.

Growth is already threatened by the well-known crowding out effect of public borrowing, which diverts resources from the productive parts of the economy. This may mean official growth forecasts are too optimistic, making cuts in spending even more necessary.

In the context of these grim economic realities, Darling cannot make savings of sufficient scale without tackling the major areas of government spending – health, education and, most importantly, welfare. Including state pensions, welfare benefits cost about £170 billion per year, around one in four pounds the government spends. This emphasises the magnitude of the problem. Even a highly contentious 10% across-the-board cut would save just £17 billion – worthwhile, but a fraction of what is needed.

Yet many welfare benefits are more about favouring particular groups of voters than providing a safety net to cover basic needs. For example, a whole host of payments have been introduced that favour the over-60s, including pension credits, winter fuel payments and free travel. These special benefits add up to at least £12 billion per year and often go to relatively well off households. They also reduce incentives to work and save.

A combination of phasing out special payments for the over-60s and reducing benefit rates by a relatively small percentage across the board would help ensure welfare played a proportionate role in rescuing the public finances. A failure to address Britain’s huge welfare bill in today’s PBR will augur very badly for the country’s economic future.

9 December 2009, IEA Blog

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US will pay a high price for Obama’s spending spree

February 17, 2013

There is talk of recovery, but little reason for optimism. Government action may have cushioned the initial impact of the recession, but the long-term economic consequences of borrow and spend policies have yet to be felt.

The problems are perhaps most severe in America. President Obama’s spending spree – in the name of economic recovery – means that this year about half the money the Federal Government spends will be borrowed.

Not satisfied with the worst debt levels since World War II, the President is embarking on a whole host of expensive programmes to subsidise healthcare, boost education and protect the environment. At a cost of $787bn, his Recovery and Reinvestment Act is the largest stimulus package in history. Much of this money will be used to fund social programmes and environmental schemes that will require further outlays to keep them going.

This follows eight years of Keynesianism under George W Bush, who increased public spending, strengthened the government’s role in the economy and allowed debt levels to spiral. He did little to tackle the growth of America’s welfare state. And as the baby-boom generation hits retirement age, there is now a big question mark over the future funding of existing healthcare and pension schemes.

As a result of Bush and Obama’s profligacy, the US budget deficit is likely to reach an unprecedented $1.6 trillion for 2009, and there appears to be no realistic strategy to bring it under control.

Such high levels of government borrowing will have a devastating effect on the prospects for sustainable recovery. They will damage the productive part of the US economy by crowding out investment in the private sector. And before long they will lead to higher taxes and interest rates, as the government is forced bring its debt levels under control. This prospect will inevitably undermine economic confidence and deter the business investment that drives growth.

A recent IEA study suggests that in this regard there are strong parallels with the policy mistakes made during the Great Depression. In the 1930s, another Democrat President, Franklin D Roosevelt, launched the “New Deal” in response to economic crisis. He increased government spending, ran huge deficits and launched an interventionist industrial policy which had eerie similarities to that of fascist Italy. Dramatic tax rises were also implemented, with the top rate of income tax eventually reaching 90 per cent.

Contrary to conventional wisdom, these measures delayed recovery by several years by deterring private-sector investment and stifling entrepreneurship. As a result, the US had probably the deepest and longest-lasting depression of all the major countries in the 1930s. Even as late as 1939, unemployment was close to 20 per cent and real incomes were little higher than they had been at the start of World War I.

Yet it would appear that today’s US policymakers have failed to draw the correct lessons from the failure of Roosevelt’s New Deal. Instead of moderating the burden of government on businesses by deregulating and keeping taxes low, they have focused on increased spending and state intervention as the solution to a faltering economy.

As a consequence, America is likely to lose its economic dynamism and will become more like the anaemic, state-dominated countries of continental Europe that have barely grown over the last 20 years.

In the worst-case scenario, the US could follow a similar path to Argentina, which less than a century ago was one of the richest countries in the world. Like Obama, when faced with economic crisis, its politicians turned to socialism, protecting and subsidising favoured industries.

The President’s policies will certainly increase the share of the US population that is directly dependent on government largesse. This risks nurturing the kind of destructive special interest politics that brought misery to Britain during the 1970s and helped to consign South America to decades of relative economic decline.

It also increases the chance of monetary instability. Historically, large budget deficits have often preceded periods of high inflation. When powerful groups depend on public spending, politicians typically find it easier to print money to pay off debts, rather than implementing deeply unpopular cuts.

Such a scenario would not just be a nightmare for the US. The UK, as a major trading partner, would also suffer badly.
Many hope that next year’s elections will bring some much needed restraint to US economic policy by reducing the Democrats’ majority. Recent history suggests, however, that, as in the UK, there is little difference between the major parties – Republicans have been similarly devoted to borrow and spend. If this proves to be the case and the US fails to change course, recovery is likely to be slow and America may lose its position as the world’s economic superpower.

21 October 2009, Yorkshire Post

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UK debt crisis: politicians must wake up and smell the coffee

February 17, 2013

Britain now faces its worst ever peacetime fiscal crisis, yet our politicians seem incapable of grasping the seriousness of the situation.

Indeed, when Andrew Lansley suggested recently that a 10% cut in public spending would be required under a Conservative government, he was widely lambasted.

In reality a 10% reduction is unlikely to be enough, while Lansley’s proposal to ring-fence expenditure on health, schools and overseas aid will almost certainly be unaffordable. Indeed, this proposal to ring-fence such expenditure means that a 10% cut in other expenditure will not cut borrowing below the current projections at all!

Next year around one in every four pounds spent by the government will have to be borrowed. This is clearly unsustainable and needs to be addressed urgently to avoid jeopardising economic recovery.

All government borrowing crowds out private sector investment and thus government borrowing stunts the much-needed growth of the productive sector. There is also a real danger that debt will have to be issued at much higher interest rates, thus raising the cost of funding and increasing government spending further.

Increasing taxes to address the crisis would not be a wise decision. The tax burden is already at historically high levels and raising it further would discourage economic activity and would be unlikely to raise much extra revenue.
 
A substantial cut in public spending is therefore the only practical option, going far beyond what has been mentioned so far by Conservative Party spokesmen. And to achieve savings of sufficient magnitude it will be necessary to address the major areas of government expenditure: welfare benefits, pensions, health and education. It is difficult to understand why areas such as foreign aid are sacrosanct, given the well-known damage to the development of the poorest countries that arises from the over-provision of aid.

Unfortunately, the “vote motive” means that politicians are reluctant to be honest about the scale of the debt crisis facing the UK. Future generations do not vote and many of those who will bear the burden have not yet been born. The short-term outlook and self-interested behaviour of politicians, combined with an unwillingness to take the necessary action, are likely to have severe long-term economic consequences.

22 June 2009, IEA Blog

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Cutting government spending should be the main priority

February 17, 2013

Gordon Brown may be advocating a further fiscal stimulus as a means to promote economic recovery at today’s G20 meeting, but, certainly in Britain’s case, implementing such a policy would be reckless in the extreme.  

The Bank of England is pursuing a policy of quantitative easing by buying assets (both corporate bonds and gilts) from non-bank financial institutions. The sellers receive bank deposits in exchange for their assets, thereby increasing the amount of money in the economy. In this way the Bank hopes to offset the deflationary pressures created by the collapse in bank lending.

At some point in the future, bank lending will recover and the velocity of money will increase. The Bank will then wish to reverse the quantitative easing process in order to mop up excess liquidity and avoid high inflation. It can do so by selling the bonds it holds back to non-bank financial institutions, thereby reducing their bank deposits.

But selling these assets will be far more difficult if the market for gilts is already saturated as a result of very high levels of government borrowing. The government is likely to have to raise in excess of £150 billion a year in the medium term. A key question is whether it will be possible for the Bank to sell its assets on top of this, without bond yields rising significantly. If investors are not reassured that quantitative easing is being reversed quickly enough then they may also demand higher yields in the form of an inflation risk premium.

Given high levels of debt, such a rise in bond yields will, of course, damage the prospects of economic recovery – perhaps causing a double-dip recession – and put further strains on the banking sector. It could also prove difficult for the government to service its own repayments. This is the reality of the government massively increasing its borrowing. One way or another, life must be made more difficult for the private sector – in the medium term if not sooner. Indeed, all these pressures may lead to the government inflating away its debts – thus justifying the market’s fears of higher inflation.

Given these horrific risks, the government needs to act quickly. It needs to reassure the markets by slashing its borrowing. This means large spending cuts in the forthcoming Budget. Fiscal policy is set to run against the grain of monetary policy if government spending is not reined in.

2 April 2009, IEA Blog

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