“Imagine the reaction. The soaring market interest rates. The widening spreads. The credit rating back under threat.”
That was George Osborne at the World Economic Forum in Davos in 2011 criticising those who, like me, thought that rather than cutting public spending the UK could and should borrow more. I argued in the New Statesman that there was no reason to think that this would lead to higher market interest rates; that we could and should ignore the credit rating agencies; and that the chancellor’s policies would unnecessarily hold back recovery from the financial crisis.
More than a decade later, the economic and political consensus across the spectrum is that I, and colleagues such as Simon Wren-Lewis, were right, with Liz Truss taking the lead in criticising the abysmal economic record of the government in which she served for a decade. But is the market reaction to the Prime Minister’s catastrophic Budget retrospective vindication of the Osborne argument? That is, that fiscal responsibility may be painful, but the alternative – a loss of market confidence and soaring interest rates – is worse.
This argument rests on a fundamental misperception – that those of us who argued for more expansionary fiscal policy in the early 2010s thought that the markets were getting it wrong. Quite the contrary – that was, implicitly, the Osborne view. In fact, as Martin Wolf argued then, the markets were saying “borrow and spend, please”. Consistent with standard Keynesian theory, with demand and investment weak and interest rates at zero, extra borrowing had essentially no impact on long-term government bond (gilt) rates.
And, as we also said, it was what happened in the markets that mattered, not what City analysts said. Ratings agencies did indeed downgrade the UK. And precisely as predicted, this made absolutely no difference, as gilt rates fell even further.
Nor is there any truth to the odd claim that austerity gave the UK “fiscal space” to finance the crisis measures taken during the Covid-19 pandemic. We entered the pandemic with debt far higher than at the time of the 2008 financial crisis but our fiscal response, and hence our budget deficit, was much larger. If you believed the arguments of the proponents of austerity, this should have been impossible, or at least very dangerous; but again, with extraordinarily high private saving, there was no problem financing very large deficits at very low interest rates.
But, when the facts change, so do the markets. With high inflation and short-term interest rates rising both here and abroad, more government borrowing translates into expectations of faster rate rises and hence higher gilt rates. This isn’t because, as Osborne argued, too much borrowing raises the fear that the UK government will default on its debt – that risk remains, as it was in 2010, essentially zero – but because the Bank of England is going to have to raise interest rates further, faster and for longer.
[See also: Will there be an early general election?]
The result has been that in the last few days, we’ve seen a traditional left-wing narrative – that “the markets” are a bunch of speculators who will connive to frustrate the economic ambitions of even a modestly left-wing government – supplemented with an even more bizarre right-wing libertarian one. Here, the markets are a bunch of woke Remainers in thrall to Treasury orthodoxy (no, me neither).
The truth is more prosaic. While there is plenty wrong with the functioning of the UK financial system, large and liquid bond markets are by and large simply a price mechanism. There’s no point complaining about them.
Far from vindicating the Osborne-Cameron approach, the last few weeks merely emphasise what a tragic error it was. We didn’t borrow enough when it would, at minimal cost, have enabled the economy to grow faster, avoiding the hollowing out of the welfare state and the erosion of public services that made us so vulnerable to Covid-19 and its after-effects.
Does that mean that Jeremy Hunt’s approach now that he is Chancellor – reversing some of Truss’s tax cuts but also cutting spending, very much as Osborne would have done – is indeed the right prescription? It certainly matches reality better than either Kwasi Kwarteng’s plans last month or Osborne in 2010-12. But in itself it is a long way from what we need, and what any government serious about addressing the UK’s long-term economic problems needs to do.
First, we have to face the unpleasant reality that extra borrowing will now, as we have seen, have a real cost. Any serious economic strategy has to recognise that. Given the state of public services – not just the NHS but education and justice – and growing poverty and destitution, that means higher taxes.
Second, the government has to restore credibility. The fundamental problem with the Truss Budget was not the presentation but the policies. Sacking the Treasury’s permanent secretary, Tom Scholar, and refusing to publish forecasts produced by the Office for Budget Responsibility made things considerably worse – particularly after a very long period during which Conservative politicians have deliberately undermined many of the key institutions and norms of the British state. The creation of the OBR was one thing that Osborne got right – strengthening its role and making it responsible to parliament would be an excellent start here.
Finally, commit to the proper reform and restructuring of the dysfunctional UK tax system so as to both raise revenue and make it more growth-friendly. It’s been obvious for some time that the UK needs structurally higher taxes if it is going to finance high-quality public services in the face of demographic pressures, but the politics has always encouraged marginal tinkering rather than wholesale reform. There are plenty of good ideas and blueprints available, from proposals to tax capital gains and inheritance as income to pensions and property tax. What has been lacking is political will; that needs to change.