Fiscal responsibility through sustainable, resilient and inclusive growth

Dimitri Zenghelis, University of Cambridge

Artwork: Dr Cécile Girardin

Managing public finances well reduces vulnerability to future debt crises, especially if interest rates rise or growth disappoints. The unprecedented government response to the global pandemic and the need for public investment to boost productive capacity has raised concerns about fiscal space as public debt relative to output reaches historic highs. It has also rekindled fears of the return of inflation, in an environment of record broad money supply growth and surplus liquidity.

Yet despite all this, the risks from higher public debt still do not outweigh the benefits. There are growing opportunities associated with a public sector drive to a zero-carbon, climate-resilient economy. The markets agree.

The ‘smoking gun’ is rock bottom neutral real interest rates. If public borrowing had shaped capital market conditions, then rates would have risen as profligate governments bid for limited funds. In fact, they remain at near-record lows.

Of course, governments should not borrow all the time. Over the medium term, governments should balance their current budgets. But this is a crucial moment to invest in recovery and growth led by sustainable infrastructure. Aiming to balance budgets prematurely now is to make the same mistake made after the crisis of 2008. Austerity programmes cost European countries a decade of lower growth relative to the US, which adopted a far more relaxed stance. A similar knee-jerk reaction to the latest economic shock is likely to prove equally self-defeating.

The collective drive towards fiscal austerity in large economies throttled productivity–enhancing government investment, leaving a glut of global desired saving. Inadequate public investment has been a factor holding back private investment and preventing sustained and resilient productivity growth in key economies. As monetary policy took all the slack, pumping liquidity to stimulate an underinvested economy, interest rates collapsed and asset prices rose. The limited benefits predominantly accrued to the wealthiest in society who own property or have invested in the stock market (often indirectly through insurance and pensions schemes).

I argued in a recent paper with Professor Lord Nicholas Stern that what matters is not the level of public debt to GDP, but its quality in terms of generating sustainable investment and growth. It is the latter that secures prosperity and provides the foundations for public debt sustainability.

The only route to growth without inflation is through investment in the economy’s productive capacity. This means investing in assets that offer the greatest potential in the carbon constrained markets of the future and which will not be stranded and devalued. It means locking into future-proofed physical/produced capital and also investment in human capital, to secure the skills and jobs necessary for the 21st century economy by retooling and re-skilling workers to enable those affected by change to participate in the new economy.

This requires coordination of macroeconomic, structural, industrial, innovation, skills, labour market, energy and energy policies. A clear and coherent policy landscape is necessary for building robust, resilient and sustainable assets.

Market participants recognise that outdated infrastructure, skills and ideas are becoming a liability. This is affecting asset prices today, even as fossil fuels continue to play an active role in the economy. This is why the Financial Stability Board’s Task Force for Climate Related Disclosure is calling for mandatory disclosure and stress testing of assets.

Countries should commit to invest in R&D and deployment of new technologies and related networks to draw in private finance and induce productivity enhancing innovation. Public investment and infrastructure banks, operating with clear sustainability mandates, will play a crucial role in reducing, sharing and managing policy risk and thereby encouraging private investment. This must be complemented by clear strategic planning for investment in zero-carbon and resilient infrastructure networks, backed by regulation that can enable the private sector to scale up investment.

Once private investors and entrepreneurs can see that strong, sustainable economic growth is in prospect, they can be expected to drive innovation in new technologies and competitive business networks. Countries that act early will grow the knowledge clusters that allow economies to thrive in the marketplace of the 21st century.

There is plenty of time to worry about public debt vulnerability, if and when underlying inflation revives and desired private net investment bids up interest rates. But by then, policy will have done its job and steered the economy out of a cyclical and secular slump driven by deficient net investment.

The latest IMF Fiscal Monitor for October 2020 suggests that an additional £1 in public borrowing to invest in “job-rich, highly productive, and greener activities” would generate an extra £2.7 of additional output.

The latest drive to boost investment marks an important opportunity to ‘crowd in’ resilient sustainable and inclusive growth. Policymakers should not miss it.

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