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Fiscal Responsibility in Advanced Economies Through Investment for Economic Recovery from the COVID-19 Pandemic

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Fiscal Responsibility in Advanced Economies Through Investment for Economic Recovery from the COVID-19 Pandemic Fiscal responsibility in advanced economies through investment for economic recovery from the COVID-19 pandemic Nicholas Stern and Dimitri Zenghelis Policy insight March 2021 The Centre for Climate Change Economics and Policy (CCCEP) was established in 2008 to advance public and private action on climate change through rigorous, innovative research. The Centre is hosted jointly by the University of Leeds and the London School of Economics and Political Science. It is funded by the UK Economic and Social Research Council. www.cccep.ac.uk The Grantham Research Institute on Climate Change and the Environment was established in 2008 at the London School of Economics and Political Science. The Institute brings together international expertise on economics, as well as finance, geography, the environment, international development and political economy to establish a world-leading centre for policy-relevant research, teaching and training in climate change and the environment. It is funded by the Grantham Foundation for the Protection of the Environment, which also funds the Grantham Institute – Climate Change and the Environment at Imperial College London. www.lse.ac.uk/grantham/ About the authors Nicholas Stern is IG Patel Professor for Economics and Government, and Chair of the Grantham Research Institute on Climate Change and the Environment, London School of Economics and Political Science. Dimitri Zenghelis is Project Leader on the Wealth Economy project at the Bennett Institute for Public Policy, University of Cambridge and a Visiting Senior Fellow to the Grantham Research Institute. Acknowledgements The authors would like to thank Ehtisham Ahmad, Amar Bhattacharya, Alex Bowen, Sam Fankhauser, Russell Jones, John Llewellyn, Annabel Manley, Bob Ward and Julia Wdowin for their invaluable comments on an earlier draft of this paper. Both authors declare funding from the Grantham Foundation for the Protection of the Environment, the London School of Economics and Political Science and the ESRC through the Centre for Climate Change Economics and Policy. The authors declare no conflict of interest in the preparation of this paper. This paper was first published in March 2021 by the Grantham Research Institute on Climate Change and the Environment and the Centre for Climate Change Economics and Policy. © The authors, 2021 Permissions requests should be directed to the Grantham Research Institute. Suggested citation: Stern N and Zenghelis D (2021) Fiscal responsibility in advanced economies through investment for economic recovery from the COVID-19 pandemic. London: Grantham Research Institute on Climate Change and the Environment and Centre for Climate Change Economics and Policy, London School of Economics and Political Science This policy paper is intended to inform decision-makers in the public, private and third sectors. It has been reviewed by internal and external referees before publication. The views expressed in this paper represent those of the authors and do not necessarily represent those of the host institutions or funders. Contents Executive summary 1 High-level recommendations 2 1. Why debt sustainability is essential 3 2. Taking cues from the market 4 3. Low interest rates and debt sustainability? 6 4. Can low rates be relied upon to continue? 7 5. The evidence on fiscal contractions after economic downturns 10 6. From whom should governments borrow? 11 7. Economic growth is the key to debt sustainability 13 8. Public investment for economic recovery 15 9. Medium-term fiscal frameworks 17 10. Priorities 19 References 20 Executive summary When the COVID-19 pandemic battered the economy and health of nations across the world, the first tasks were to tackle the virus, to prevent economic collapse, and to protect jobs and livelihoods. That was ‘rescue’. The task now is ‘recovery’. If that is to be sustained, strong and non-inflationary, it must be driven by private investment. In G7 countries, the bulk of investment is from the private sector, but this has declined substantially as a proportion of GDP, undermining productivity growth over recent decades. The central task for the recovery is to restore and sustain private investment. At the same time, we must recognise that one reason for the decline in both private investment and productivity has likely been the neglect of infrastructure investment. We now have huge opportunities from, indeed the imperative of, the drive to the zero-carbon and climate-resilient economy. • The first test of the soundness of public policy must be whether it fosters strong and sustainable private sector investment and provides the enabling infrastructure required to boost productivity growth. • The second test is fiscal responsibility. Sound management of the public debt of an economy is a prerequisite for both macroeconomic stability and national prosperity. Governments of both developing countries and advanced economies stand to benefit from having in place, and observing, medium-term strategies that anchor public debt and thereby secure investor confidence. Governments around the world, and certainly the G7 economies, are now finding themselves obliged to increase their expenditure sharply. This is in order to support incomes and livelihoods in the context of following health restrictions and the overall sharp economic shock contraction – the ‘rescue’ phase; and, once the impact of the pandemic abates, to restore confidence, ward off the threat of deep recession and re-establish growth – the ‘recovery’ phase. The G7 economies have suffered a historically severe shock as a result of the COVID-19 pandemic, most of them experiencing record annual contractions in 2020. For most G7 countries, this follows decades of slowing productivity growth and a cumulative shortfall of infrastructure spending. It also comes at a time of accelerating innovation in digital technologies, growing inequalities and the immense threat of climate change and other unexpected shocks made apparent by the current pandemic. But there are concerns that further borrowing could lead to unsustainable government debt and an increase in inflation, exposing economic strategies to further risks, especially when interest rates start to rise. We argue that: • The risks associated with higher public debt for advanced economies able to borrow in their own currency are currently substantially outweighed by the potential benefits from public action to drive investment for a sustained recovery. • The markets are signalling that there is no immediate problem in financing increased public borrowing. Despite nudging upwards, partly in response to President Biden’s ambitious US stimulus plan, real interest rates remain generally close to historic lows, all along the yield curve, reflecting the fact that globally the desired level of private sector saving in aggregate is low relative to the desired level of aggregate investment. • These historically low interest rates reflect the market’s hunt for returns and help greatly with the affordability of governments’ rescue and recovery expenditures. Private sector savers in the advanced economies did not see many opportunities for productive investment. Facing few attractive options for where else to put their money, they were willing to buy government debt at ever-diminishing rates of interest. Clearly the challenge is to put in place the incentives for private investment; a commitment to growth and sound and stable signals on the directions of policy, particularly around sustainable low-carbon and climate-resilient investment and innovation. 1 This investment, and the growth it brings, is desirable not only in its own right, but also because it helps to reduce the size of the public debt relative to growing GDP, the surest way to public debt sustainability over the long term. This will be easier for individual countries to pursue, and the resulting recovery will be stronger, if countries act together. Bond market ‘vigilantes’ are as likely to punish governments for lacking a sustainable growth strategy as they are likely to punish them for lacking fiscal restructuring plans. An historic opportunity to ‘crowd in’ private investment Governments must step in with sufficient ambition to provide the enabling environment to foster private investment, by investing in infrastructure, skills and intangible knowledge-generating assets. These investments must support the transition to sustainable and inclusive growth, advancing the fight against global threats, including infectious diseases, biodiversity loss and climate change. And resilience is crucial too as we are seeing around the world, whether it be floods, storms or fires, the need to adapt to the climate change that is occurring and will occur. Inadequate public investment has been a factor holding back private investment and preventing sustained and resilient productivity growth in key economies. The only route to growth without inflation is through investment in the economy’s productive capacity. A premature tightening of public budgets would almost certainly slow the pace of economic recovery. Economic stability comes through growth that is strong and sustained, and not at risk of faltering. It will be easier to pay back the debt while the economy is growing strongly. Once entrepreneurs can see that strong, sustainable economic growth is in prospect, they can be expected not only to start investing again in new capital stock but also to invest in the innovation process to accelerate the formation of the competitive business networks
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