The author is a contributing editor to the Financial Times and chief executive of the Royal Society of Arts
Last month, I discussed the negative feedback loop between stagnant economic growth and expanded safety nets. How can countries break out of this “doom loop”? An important factor is rethinking the fiscal rules that influence government investment decisions.
The idea of fiscal rules that limit government borrowing is a reasonable one. The government should follow the principle of “good ancestors” and provide assets and income for future generations instead of burdening them with debts and taxes. In this way, fiscal rules can help ensure intergenerational equity—they are the everyday equivalent of leaving a house to a child instead of a mortgage.
Fiscal rules are now at serious risk of being breached following a series of pandemic-related surges in government spending. The U.S. faces a cliff edge next month due to debt limits imposed by Congress. In the EU, the calibration of the Stability and Growth Pact’s limits on national debt proved drastic. In the UK, fiscal rules requiring debt ratios to be reduced within five years limit the government’s ability to pursue long-term pro-growth policies.
Are these rules imposing useful fiscal discipline or restricting investment and growth? I believe in the latter. They are usually based on the ratio of the stock of government debt to income. We expect this ratio to change over time. The greater the challenges facing a nation-state, the stronger the case for debt-financed investment in public goods.
Take the UK as an example. Britain’s debt-to-GDP ratio has doubled on average every century since the Industrial Revolution. It is a clear social choice to invest in the new public goods necessary to support economic and social progress—from schools to housing to health. Debt ratios in other countries also tend to rise over time.
We don’t necessarily expect this pattern to repeat itself in the 21st century. But we should also not expect debt ratios to level off or decline. Many advanced economies face challenges no less than those faced by our forefathers. A new set of public goods to meet these needs is equally compelling.
This highlights a second flaw of existing fiscal rules: they are often based on net financial debt. They do not recognize non-financial assets created by public investment, whether tangible (roads, hospitals, schools) or intangible (intellectual property, data, code). Nor do they recognize investment in natural assets such as clean water, air and a thriving biosphere.
Recognizing these assets will allow us to measure the government’s true net worth. Just as companies or households consider their net worth when making investment choices, so should governments. Countries with high net worth have been found to have lower borrowing costs. Bond market vigilantes target poor ancestors, not borrowers. This is why the real cost of borrowing for governments has trended down over the centuries, even as government debt ratios have trended up. Financial markets know that what matters is the value of the home, not the mortgage.
Countries with higher net worth also tend to exhibit greater macroeconomic resilience. This reduces the burden on the country when adverse shocks strike. Our current debt-based fiscal rules lead to less macroeconomic resilience and inflated post-shock safety nets by restricting public investment.
Such has been the story of the past few decades, with public investment in the G7 countries flat or falling despite global real interest rates being close to zero. This is an opportunity to invest in economic and environmental revitalization and to promote growth and macroeconomic resilience. Misguided fiscal rules meant it was wasted, and the doom loop persisted.
Since then, global real yields have risen globally. But with global real interest rates still below 1%, cost/benefit calculations will overwhelmingly support public investment today to support growth and resilience tomorrow. Recent skirmishes in advanced economies over debt limits mean this opportunity is again at risk of being squandered.
Compliance with existing fiscal rules can lead to underinvestment in tomorrow’s economic and environmental health today. As evidence over the past few decades has shown, debt-based fiscal rules weaken growth, weaken macroeconomic resilience, and amplify doom loops. If we stick to it, future generations will rightly think of us as bad ancestors.