In the early dawn of this column’s existence, I wrote about an argument US economic historian Brad DeLong made for why we should expect government spending to be higher in the 21st century than in the 20th. DeLong’s 2015 thesis was that the structural changes in advanced economies meant more of their resources would have to go to things that are state responsibilities (health because of ageing, education because of the knowledge economy), or have significant “externality” or spillover effects that markets don’t handle efficiently (information, climate change).
Those responsibilities have only become more pressing. Since 2020 we can add to them defence spending and the need for economic resilience — even at the price of some duplication or inefficiency — in the face of security threats or large disruptions of supply chains. The thesis that the state footprint in the economy will be permanently greater has held up well. But it is not at all clear that the political and economic policymaking system has taken this fully in.
Take a moment to contemplate the likely scale of change we are talking about. Just the physical investment required to decarbonise the economy is enormous. Nobody seriously disputes the order of magnitude called for by the International Energy Agency: about $3tn in additional annual clean energy investments globally, nearly 3 per cent of the world’s gross domestic product. Not all of this has to be done through government budgets, of course. Indeed most will and should consist of private investment. But governments are responsible for making that happen. If they can crowd in six euros of new private investment for every euro they put in in incentives or investment of their own, they would still need to raise public spending by 0.5 per cent of GDP.
To appreciate how big a change that is, consider that it would amount to a doubling (or more) of many countries’ recent net public investment rates, and that Joe Biden’s Inflation Reduction Act targets a mere 0.15 per cent of GDP worth of spending. And that is only decarbonisation. If you count on your fingers all the other new imperatives of greater public spending, you may quickly run out of hands.
There is an “irresistible force meets immovable object” phenomenon here. For the logic of a bigger state footprint in the economy runs into the question of where the money will come from. Wherever you look, the political pressure to contain rather than expand public budgets is strong: from the battle to reform EU fiscal rules to US debt ceiling stand-offs. And policymakers everywhere have begun to look over their shoulders at what bond markets will tolerate, now that interest rates have taken off from their long rest around zero.
This clash could be resolved in one of two ways. One is that the immovable object wins: political inertia will prove too strong and the policy needs for more spending will be jettisoned regardless of their merit. But the opposite possibility — that the irresistible force prevails — is more intriguing. Then we have barely seen the beginning of an imminent radical shift in state spending, and soon enough, the amounts governments have put on the table in the Inflation Reduction Act or the EU’s Recovery and Resilience Facility could look miserly rather than profligate.
A straw in the wind here is the British Labour party, likely to form the next UK government. It has promised to spend £28bn per year on green investments, or about 1.1 per cent of GDP. Relative to economic size, that is more than seven times more than the IRA, and nearly twice as big as the RRF. We should mentally prepare ourselves for a world where fiscal commitments of that size are the rule and not the exception.
That means thinking about how to pay for it, and how to manage the political ructions paying for it will cause. For the arithmetic is merciless: borrow more, spend less on something else, or increase tax revenues.
What is the room for tax increases? That is going to vary a lot from one country to the next. In the US, the combined levels of government take in 33 per cent of GDP in revenue, which leaves a lot of room for tax increases. Not so much in France, which already takes in 20 percentage points more.
There are creative ways of funding higher spending: witness Denmark’s choice to eliminate a public holiday to fund more defence. Still, high-tax countries will have to look at cutting other expenditures. One might think this contradicts the starting point that governments have to spend and invest more. But actual government spending on investment and services are only part of their budgets. A big source of variation in the budget-to-GDP ratio reflects different levels of transfers, redistribution of cash between different groups of citizens. Countries with high levels of transfers should consider more targeted or less generous transfer payments to leave room for more outright spending.
Since either taxing someone more or giving them less is politically painful, the temptation will be to borrow more and fund increased spending through deficits. The challenge there is, of course, fiscal sustainability. The best time to have done massive deficit-funded investments was in the decade when interests were around zero. Those who then opposed more spending when debt service costs were tiny should be careful about using high interest costs as an argument for fiscal restraint today. But we are where we are and getting the investments we need will be harder with interest rates higher.
That does not mean all new spending ought to be tax-funded. While that makes sense for permanent spending (such as health), big physical investment projects (such as for decarbonising our energy systems) should have their costs smoothed out over many decades. So we should expect a mix of tax- and deficit-funding at the scale of the new spending necessary.
If this is where we are headed, there are some chunky implications for the craft of fiscal policymaking and for the statecraft of fiscal politics.
First, the reward for smarter tax and spending structures will be greater. Governments that clean up old tax and expenditure structures, to make taxation more efficient and spending more growth-friendly, may avoid some of the political pain involved in shifting the economies’ resources towards new demands.
Second, political conflicts over budgets and over debt and deficit management will get worse. That is because the stakes are bigger when larger resources have to be reallocated.
Third, inflation surprises will no longer be all bad news — at least not for governments. They can create windfalls for public budgets since they amount to an unexpected tax and reduce real debt burdens — and frustration for households or businesses for the same reason.
And fourth, tensions between fiscal and monetary policymakers will increase. The former benefit from higher inflation and lower interest rates; the latter are expected to lower inflation by raising rates. These tensions are already simmering. As governments commit to their implicit new spending objectives in earnest, expect them to come to a head — and expect the pressures to grow for a new arrangement for the fiscal-monetary division of labour.
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Source: Economy - ft.com
