Built to last
This paper, part of the Economy 2030 Inquiry, tackles the key question of how to futureproof the UK’s macroeconomic policy framework. Looking beyond the immediate policy challenge of high inflation, it focuses on whether the current framework – largely set during the calmer economic times of the 1990s – is still fit for purpose.
Since the financial crisis, public sector net debt has nearly trebled as a proportion of GDP – an unprecedented peace-time rise. A major driver has been the use of fiscal policy during a series of large economic shocks. Fiscal policy has a key role to play in downturns, but the scale of the interventions has important implications for the sustainability of the public finances. We argue that putting the public finances on a sustainable path requires a reset of both monetary policy and fiscal policy. We must reduce our chances of interest rates hitting their lower bound once again, thereby relieving the pressure on fiscal policy in downturns. And we must have the right fiscal policy tools in place to deploy targeted support that gets us more bang for our buck.
These reforms would reduce the extent to which public sector debt ‘ratchets up’ each time the UK enters a downturn, but debt would still rise. A realistic budget surplus of 1 per cent, rather than 3 per cent in the absence of any policy reforms, would be sufficient to put debt on a gently downward path in the long run.
- Since the financial crisis, public sector net debt has nearly trebled, rising from just 36 per cent of GDP to around 100 per cent, an unprecedented peace-time rise. A key driver has been the role played by fiscal policy in supporting the economy a series of major economic shocks.
- If fiscal policy continues to support the economy each time the UK goes through a downturn, governments will need to run a budget surplus in good times to ensure a stable level of debt in the long run. Based on the average size of fiscal support in post-war recessions, this would require a primary surplus of 3 per cent in three out of every four years, something that has only been done in three out of the past 50 years.
- If we return to a world of low average interest rates, the Bank of England’s headline policy rate is estimated to hit the zero lower bound once a decade. Raising the inflation target from 2 per cent to 3 per cent, and paving the way for negative rates of up to -1 per cent, could reduce our chances of hitting the lower bound to once a century.
- Better-targeted fiscal support would have saved £35 billion through the pandemic and cost of living crisis, saving the Government around £1 in every £5 spent on support during that period.
- Our analysis suggests that avoiding the lower bound, slightly reducing the average size and frequency of fiscal interventions through better-targeted fiscal policies and improved risk management, would mean that a 1 per cent surplus, rather than 3 per cent, would be sufficient to put debt on a gently downward path in the long-run. This would still be challenging, but would be much more in line with the experience towards the end of the 20th century, when we ran a surplus of 1 per cent or more in three out of every five years.
- Regulators should pave the way for the Bank of England to follow other central banks by cutting rates into negative territory. This would involve exploring ways to mitigate the adverse effects of negative rates on banks, building on the engagement undertaken by the Bank and the Prudential Regulatory Authority in late 2020.
- Once inflation has fallen back to 2 per cent, the Government should review the UK monetary framework, ideally in concert with other advanced economies. The review should consider the right level for the inflation target in light of evidence that emerges on the level of interest rates after the current turbulence.
- The Government should achieve a higher sustained level of public investment, implemented through multi-year settlements for departments’ capital budgets and long-term plans for major projects, which would allow investment to be accelerated during downturns.
- Existing unemployment benefit policy should be made more powerful in a downturn, for instance through a system of unemployment insurance that would replace two-thirds of lost earnings for the first three months of unemployment.
- The Government should build a flexible mechanism for delivering targeted fiscal support. At its core, this requires better data sharing between different parts of central government – and between central, devolved and local governments – to put in place both a database which can help target support and mechanisms through which to pay it.
- More should be done to identify and mitigate future risks, addressing failings of risk management in central government.
- Governments should run a primary surplus in good times to ensure that fiscal support in bad times does not put public sector debt on an unsustainable path. Our analysis suggests that, with better monetary and fiscal policy, a primary surplus of 1 per cent could be sufficient.
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