Fiscal Framework Should Support Long-term Public Investment

All governments incur debt by borrowing. Government borrowing is an important tool of economic management. And good economic management is only possible when public debt is sustainable.

Conversations about public debt sustainability are typically anchored around the Maastricht criteria of a debt-to-GDP ratio of 60 per cent, or the findings of Rogoff and Reinhart which suggest that debt-to-GDP over 90 per cent stymies economic growth.

However, sustainability is a complex artefact, composed of both past actions and future expectations. These hard and fast guidelines rarely capture the nuanced position each national economy inhabits and often act as a straitjacket to serious thinking about public debt.

Let us be clear. We are not concerned about public debt sustainability for its own sake. We are concerned about public debt sustainability to the extent that it limits the ability of the government to respond promptly to economic shocks and to fund long-term public projects.

The debt-to-GDP ratio is undeniably a useful metric, but it is not the whole story. For example, Argentina defaulted on its national debt in 2001 with a debt-to-GDP ratio of 147 per cent. Meanwhile, the Japanese national debt currently stands at 255 per cent of GDP, with no sign of imminent default. What could explain this discrepancy? The devil is in the detail.

First, a high savings-to-GDP ratio in Japan allows investors to absorb most of the government debt issued. Second, the vast majority of the debt is held domestically in yen; partly due to high levels of intragovernmental debt holdings. Neither of these conditions holds to the same extent in Argentina, which has a history of defaulting on its debt.

While this is a reductive example, it serves to illustrate that the ability of a government to carry public debt varies substantially with wider economic conditions. A single ratio cannot capture the reason why government debt is issued or the structure of that debt.

Turning to the UK’s position, its fiscal framework mandates that the debt-to-GDP ratio should be falling over a five-year horizon and that net government borrowing should not exceed 3 per cent of GDP. With national debt exceeding 90 per cent for almost two decades, this framework seems prudent. But it falls victim to short-term thinking.

The sustainability of debt is not determined within any five-year window. It depends crucially on the belief of whether debt will grow without bounds. This is governed by the credibility of long-run government revenue and spending paths and the attitude of financial markets to the underlying health of the economy.

Markets differentiate between credible and non-credible fiscal paths, as demonstrated by the September 2022 Mini-Budget. If investors have doubts, they will substitute UK bonds for other bonds and borrowing rates will escalate as the market quickly becomes illiquid.

However, the credibility of these paths is also intimately linked to investor appetite for holding UK debt, which in turn depends on productivity growth and the composition of government expenditure. Public investment can put idle resources to use and therefore raise productivity and long-run output. It should not be treated in the same way as discretionary spending and unfunded tax cuts because it can raise the denominator of (and therefore decrease) the debt-to-GDP ratio.

The UK’s current fiscal framework limits the scope for long-term public investment expenditure. Any project that does not generate an increase in output which lowers the debt-to-GDP ratio within a five-year horizon is at odds with the Treasury’s fiscal mandate.

This inability to integrate medium to long-term fiscal objectives into the existing framework should give cause for a rethink. For example, as part of the green transition, the UK is legally obligated to reach net zero by 2050. This target will only be met if supported through well-judged public investment in green infrastructure.

Our fiscal framework should reflect these long-term objectives rather than having a single-minded focus on five-year rolling targets. For example, green infrastructure investment could be discounted from measures within the existing targets. As long as there are idle resources in the economy and well-defined objectives, there is no immediate threat of bond markets turning illiquid, providing the advice of our independent economic institutions are respected.

UK public debt is neither at crisis point nor is the situation desperate. The maturity structure of UK debt is good and both domestic and international demand for UK bonds remains buoyant. In light of this, we should not be overly worried about public debt becoming unsustainable. What we ought to consider is moving towards incorporating medium and long-term objectives into our fiscal framework to better enable us to meet our long-term economic goals.

A version of this article first appeared on Comment Central on 22 December 2023