Sunak’s belt-tightening flies in face of IMF call to arms

Should governments be throwing caution to the wind and spending big to combat Covid-19?

“Economics is really simple,” boldly declared one Question Time audience member a few years back. 

“I’ve got £10 in my pocket. If I buy three pints in Cambridge, I’m probably borrowing money. If I carry on doing that, then I’m going to run out of money and go bust.”

Unfortunately economics is not that simple. Running the country like the family budget could in fact be damaging for an economy and even its debt pile, an argument known as the “household fallacy”.

With borrowing costs ultra-low and economic recoveries sputtering, the International Monetary Fund this week urged governments to keep on borrowing to stop the “household fallacy” damaging recoveries.

IMF chief Kristalina Georgieva warned cutting lifelines too soon risked turning the “long ascent” of recovery into a “precipitous fall”.

Rishi Sunak does not appear to have received the memo, however. That same day, he harked back to the austerity era by promising to balance the books to protect Britain’s fiscal credibility as speculation over tax hikes swirls.

“If instead we argue there is no limit on what we can spend, that we can simply borrow our way out of any hole, what is the point in us?” he countered. 

Spend or scrimp: is Sunak or Georgieva right?

The instinct to tighten the belt in times of crisis and when deficits widen is understandable but in many cases it can hinder rather than help.

Counter-intuitive action

While counter-intuitive to the layman, in some circumstances more borrowing does not necessarily mean higher debt in the longer term. 

National debt is measured as a percentage of GDP and has risen above 100pc for the first time since the 1960s in the UK. Cutting support for the economy too soon risks pulling down or holding back the growth of the GDP part of the debt equation.

If interest rates stay at benign levels and officials choose projects wisely, borrowing for investment could “pay off”, the IMF argues.

“It puts recovery at huge risk and this in turn might deteriorate public balances further down the road if the recovery isn't sustained strongly,” explains Hande Kucuk, deputy director at the National Institute of Economic and Social Research.

“If the economy doesn't recover to a desired level with high unemployment rates, large business closures and the impact on financial stability through non-performing loans, government has to kick in again anyway.

“The timing of the withdrawal of fiscal support is very important so that’s the main difference from a household budget perspective.”

Spending big today can also help induce private demand and boost lacklustre confidence. If Sunak holds back support during a second wave, business confidence will likely shatter.

In addition, while governments enjoy lower borrowing costs than households, they are disadvantaged in another way. When an individual household cuts its expenses it has no effect on its income, but the same is not true for a country.

Speculation over imminent tax hikes to pay off the Covid bill have swirled in recent months but many economists doubt Sunak is about to pull the rug from under the economy, especially as a second wave strikes.

Paul Johnson, director of the Institute for Fiscal Studies, says Sunak’s speech was “a political message” intended to outline his preference for fiscal responsibility.

“He’s clearly not going to balance the books or anything like it in the next goodness knows how long, so I mean it’s just economically nonsense of course at the moment but in the long run, yes of course you can't keep on borrowing more and more."

The limits of debt

Debt does have its limits but no economist knows where that exact limit is. 

Conditions on financial markets are crucial. Countries need to keep credibility with investors or risk entering a Greek-style crisis where debt becomes unsustainable. 

Currently the UK Government can borrow cheaply from investors with the help of Bank of England’s low interest rates and its bond-buying programme. With the UK having one of the highest deficits in the world this year, Treasury officials may nonetheless be feeling nervous. 

“You can probably run it [the high deficit] for another six months and you might have to run it for a further six months if you've got a plan to get the numbers down,” explains Douglas McWilliams, deputy chairman of the Centre for Economics and Business Research.

“Once you've lost the confidence, it's a lot harder to get it back. It’s like breaking a plate... Until they lose confidence you can actually get away with quite a lot.”

He says officials should be thinking about getting the deficit down over 10 years and national debt over 50.

How high debt ratios can go before markets turn remains a mystery.

A paper by economists Kenneth Rogoff and Carmen Reinhart argued in the aftermath of the financial crisis that 90pc of GDP was the ceiling debt could hit before damaging growth.

The controversial paper was used to justify austerity measures after the crisis.

Debt ratios in many developed countries are well beyond breaking those levels but even Reinhart, now World Bank chief economist, is urging countries to keep on borrowing to fight the economic fallout of the pandemic.

“First you worry about fighting the war, then you figure out how to pay for it,” she said in an interview with the FT on Thursday.

Many economies were already coping with huge amounts of debt without spooking markets even prior to Covid-19. Japan’s debt load had surged to more than 200pc of GDP.

Conditions can change

There are reasons for governments not to throw caution to the wind, however. Demographics are worsening and borrowing conditions may quickly change, particularly if central banks have to act to rein in inflation.

“The challenge for Sunak’s next budget really is to say we will absolutely not go for big reductions in the deficit in the next year or two… but we are aiming for stabilising debt,” says Johnson.

Economists believe in a way both Sunak and Georgieva are right. Spend now to keep up the recovery but set out a credible plan to stabilise debt levels later.

The Question Time audience member buying pints in Cambridge was quickly slapped down by a panelist – Yanis Varoufakis, the Greek finance minister during the height of the debt crisis. He argues spending cuts worsened Greece’s plight by curtailing a recovery, but the country also needed to restore its credibility.

Varoufakis will know better than most the balancing act between spending and debt that Sunak faces.