Flexibility is no sin when policy is failing: In a democracy, willingness to inflict economic pain is rarely a route to credibility. Investors will refuse to believe that the policies will survive. Once they reach that conclusion, credibility disappears. I learnt this in 1992…. The government could not enhance the credibility of an incredible commitment.
This experience informs my view on the options for the UK’s government. The arguments put forward for continuing with the planned fiscal tightening are that, in its absence, credibility will be lost and interest rates on government bonds explode. I suspect the reverse will ultimately prove to be the case….
Remember that official short-term interest rates are half a per cent, 10-year government bonds yield 2 per cent and index-linked gilts yield zero. Yet, despite these extremely low costs of funds and the benefits of commitment to sustainable public finances, the corporate sector ran a huge financial surplus (excess of retained earnings over investment) of 5.3 per cent of GDP last year. The view that the fiscal retrenchment will now generate a surge in private spending seems improbable. More likely is stagnation, if not worse….
The answer is to convince private decision makers that the economy will grow, which requires policies aimed at demand. The trick is to introduce them without threatening the long-term sustainability of public finances. The best way to do this is to combine the commitment to reducing the share of current public spending in GDP with flexibility on taxation and greater public investment. Both of the latter can credibly be temporary. At current interest rates, even a large medium-term increase in borrowing would almost certainly pay for itself in the greatly enhanced present value of current and future output…