Why we need a more realistic and strategic approach to government spending

In January 2024, Sir Keir Starmer called for a decade of national renewal. Few people would deny the need. Our economy is weak, real wages have stagnated, almost one in three children are living in poverty, foodbank usage has exploded, our public services are struggling – and many are at risk of failure. Schools and universities are cutting back. Our national infrastructure is crumbling. And we are not doing enough to protect the environment.

There is plenty to do.

And, as this chart shows, our problems go way back: since the 1980s, we have seen slowing economic growth, and on IMF forecasts, this decade is likely to be the worst since the 1920s. Many of the problems we face are directly or indirectly the result of this poor economic performance.

If we want national renewal, we must have economic renewal; and that is where the fiscal rules are supposed to come in. The government set out six missions including Building Strong Foundations and Kickstarting Economic Growth. The fiscal rules are supposed to be the bedrock of this: responsible spending is supposed to help to kickstart growth. Because this is so important, we are told, these fiscal rules are fixed; they are iron-clad; they are non-negotiable.

In last week’s spending review, the Chancellor duly stuck to her revised fiscal rules and injected a considerable amount of extra money into capital investment, but day-to-day Departmental spending was tightly contained.

Most commentary focussed on whether or not this constituted austerity and whether or not her fiscal rules will force her to raise taxes.

We believe that this commentary misses fundamental points:

• Both The Chancellor’s decision-making and the commentary on it implicitly accept the premise that accounting conventions should drive vital national decision-making;
• That premise is false, and the fiscal rules do not merely need adjustment, they need to be replaced with a more dynamic and more strategic decision-making framework;
• Such a framework requires rebuilding national capabilities that have been lost from both public and private sector institutions, if we are to see national renewal.

It is vital that these more fundamental issues are debated and acted upon, while there is time.

Accounting conventions are no basis for national decision-making

When the Chancellor changed her fiscal rules in such a way as to prevent Government finances from being penalised for capital investment, this was widely regarded as a positive development which would free up money to invest in national renewal. And it was.

The problem is that she did not go far enough: only very special types of investment in the future are counted as capital investment. If I build a new public building in such a way as to create a financial asset, that will count as capital investment. But if I spend more on education and equip a new generation with the skills they will need to be successful themselves and to contribute to the economy in future decades, that will not count as capital investment.

And so, in the spending review, £113 billion additional funding was made available for things which count as capital investment, but day-to-day spending has been heavily constrained. Even the NHS, the Department which is being least constrained, is being permitted an increase of only 2.7% per annum. That is well below the long run average increase that the NHS received in the past to keep up with population growth, ageing and increasing rates of ill-health. That increase will do nothing to address the fact that our spend per person on healthcare is now below almost every other G10 country.

And virtually all other departments fared worse than the NHS. This is just one adverse outcome of basing investment allocation on accounting definitions.

Another is to do with inflation. There are currently many areas of the economy with spare capacity, and if we invested wisely in those areas where there is both unmet need and spare capacity, we could expect to see the extra spending result in real improvements. But if we target all the additional investment into areas which draw on a single pool of workers, construction workers, we are far more likely simply to cause inflation in the prices for construction projects.

And the problems with the fiscal rules go deeper than this; they do not need a further tweak, they need to be replaced.

The fiscal rules need to be replaced

The justification for the fiscal rules is that they are supposed to give a solid foundation for economic recovery, for containing the national debt – and they are supposed to give stability, to ensure we avoid the ‘Liz Truss effect’.

In reality, they do none of these things.

This chart summarises the UK’s post war economic history, with and without fiscal rules.

The horizontal axis shows gross debt:GDP. Generally speaking we would be happier to see that declining over time. The vertical axis shows real per capita GDP—the size of the economy adjusted for inflation and population growth. We would want to see that growing over time. So, ideally, we would see the line moving diagonally upwards from the bottom right.

The line is colour-coded to show the period before we had fiscal rules and the period since.

As you can see, in the period before we had fiscal rules (1945-97), the line was moving in the right direction: debt:GDP was falling, and real per capita GDP rose from around £6,000 to around £26,000. Not bad. The first set of fiscal rules also saw reasonable performance up until the global financial crisis.

But every subsequent set of fiscal rules—and we are now on the 10th set—has corresponded with very poor performance.

The rules have not prevented debt:GDP from rising significantly. They have corresponded with almost zero growth. And they have not been immutable.

But perhaps, you might argue, this set is different: perhaps the Chancellor has found the right set of fiscal rules which will do what we need and will not need to be changed. That seems extremely unlikely.

A truly robust set of fiscal rules would need to determine an optimal total spending profile for government under all circumstances. It would have to give the right answer whether the economy was growing strongly or in recession; it would have to give the right answer if we were in the middle of a trade war or if we were about to join a major trading bloc; it would have to apply whether we were at peace or at war; it would have to apply whether the health of the population was good or whether we were in the middle of a pandemic, etc. The chart illustrates the challenge.

Even if the fiscal rules took all these factors into account, it is hard to believe that a simple algorithm could produce an optimal spending profile for the government. And in fact, all the fiscal rules we have had so far – including the current set – have tried to do something even less plausible: they attempt to define budget responsibility based only on economic and financial indicators such as debt and deficit: they ignore wars, pandemics and other external factors.

Even in the days since the Spending review, we have seen a material geo-political development, Israel’s attack on the Iranian nuclear facilities, which could well affect our economy – eg through oil prices. Our fiscal rules are silent on such topics.

The fiscal rules are not fit for purpose as a guide to responsible economic management and they never could be.

The Chancellor’s spending review was perhaps as good as it could have been given the fiscal rules, and it was certainly better than the austerity Budgets of the last 14 years – but it is not good enough to deliver what the country expects and deserves: national renewal.

We need to rebuild institutional capabilities

We wrote last year about how many of our institutions, both public and private sector have become hard-wired for regress. They tend to act in ways which hinder, rather than aid, national renewal. A government which seeks to work within the fiscal rules and the constraints of today’s institutional wiring runs the risk of finding that, rather than being seen as the saviours of a troubled country, they will end rather like Liz Truss’s ill-fated government.

To see how this could happen, consider the following scenario: the government wishes to engineer a green transition involving the large-scale insulation of leaky British houses. They ear-mark a considerable sum for stimulus and trust that this will drive the change they require: a boost for the economy, a reduction in household bills and a reduction in the UK’s carbon emissions. A simple, powerful idea.

But now let us consider the potential impact of the UK’s institutions on this plan. A far more complex picture emerges:

In this scenario:

• HM Treasury shapes the stimulus, ensuring that it is not for government to act on the supply-side – that is to be left to the market;
• The stimulus does drive demand, initially up to the level of capacity – which means that business happily meets that demand – and then beyond it. CEOs will hire already-skilled people for demand they can see, but after 16 years of false dawns, will be reluctant to make a major investment in training and developing new capacity for the future. They raise prices while they wait to be convinced that the demand will be sustained;
• The Home Office does not allow immigration of ‘semi-skilled’ people like construction workers, only those whose salary exceeds the threshold;
• So inflation takes hold, and the BoE raises interest rates;
• The OBR notes the combination of higher stimulus spending and higher interest rates and warns of ‘serious risks’ to the nation’s debt sustainability;
• The media react hysterically, talking of the government ‘bankrupting the country’ and ‘economic Armageddon.’

In this scenario, the government will, at best, suffer a huge loss of public confidence and at worst be forced to abandon its plan for green transition before it has made a significant impact.

Of course, we cannot be certain that such a scenario will materialise, but it would be foolhardy to rely on the fiscal rules to prevent such a possibility.

These points need to be addressed now

If we don’t want to have static fiscal rules because they don’t promote growth, they don’t contain debt and they don’t protect against the Liz Truss effect, what should we do? We still need some way to define a responsible budget.

Well, here is one option: we move from static fiscal rules to dynamic fiscal rules, and we define a responsible Budget as one which provides a responsible answer to three questions:

1. How much growth should we stimulate? Given the poor growth over recent decades, it is clear that it is a long time since we had a government that gave a responsible answer to that question;
2. What public services does a civilised society need? Both our own pre-financial crisis history and comparison with other developed countries shows that we have not recently had a responsible answer to that question either;
3. How much risk-free saving does the private sector require? People like National Savings, which carry no risk, pension funds need risk free investments so that they can be sure that they will be able to pay out in future years – they need the government to borrow.

The diagram illustrates the relationships between these three questions. The tricky bit is not getting the equations to balance—they balance automatically—the tricky bit is making sure that the answers to the three questions are responsible:

• With Question 1, the temptation is to over-stimulate, but if we do that in an inflationary environment and at a time when the Bank of England’s remit forces it to raise interest rates whenever inflation threatens, regardless of the cost to the economy, we risk provoking the Truss effect. To answer this question in the national interest, we need to understand the real resource constraints the country faces and how we might address them. And we need to differentiate between good growth and bad growth. This means challenging much of our thinking, our measures of success, and our institutions;
• With Question 2: if more spending is needed, as the IMF believes it will be, then increased taxes may be required – and very careful design is needed to make sure that those who pay more are those who can best afford to pay; and
• With Question 3: even though previous governments have quietly, through the Bank of England, created £895 billion in new money, no one dares acknowledge that this is a resource that governments can tap.

These are vital debates the country needs our politicians to have right now.

Conclusion

There is no question that the UK is in a difficult situation now: more difficult than in 1997. But it’s not as difficult as in 1946. After the Second World War, our debt: GDP stood at around 250%, roughly half of GDP had been diverted to the war effort – we were making things that nobody wanted any more. We had lost around 1 million people. And our infrastructure was in worse shape than today.

National renewal was a priority then as now. But if Attlee had had today’s fiscal rules, he could not have prevented mass unemployment as the troops were demobilised, and he could not have implemented the Beveridge Plan. He would have had to say, “Nobody would like more than I to implement this excellent plan, but somebody has to be the grown-up in the room and admit that we simply don’t have the money. My first job therefore is to rebuild our government finances, which I shall do by sticking rigorously to my fiscal rules and then—perhaps in a generation—we can look seriously at this idea of a National Health Service and a Welfare State.”

Thankfully, he did not do that, he listened to Keynes who said, “Anything we can actually do, we can afford.” He found the money. And he ushered in the most successful period in the UK’s economic history.

When governments are determined, they can find a way.

Right now, this means:

• We need the government to accept reality – static fiscal rules are not compatible with national renewal;
• We need the government to start working to define the alternative approach which will guide the government more flexibly and responsibly;
• We need to build the institutional capabilities and adjust the remits of our institutions accordingly.

So we have a lot to do, and we need to do it quickly.

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