There is a consensus among economists that a precondition for higher growth is higher levels of investment, and that one of the most certain ways of lifting investment levels is for the state to provide a lead.
Whether European growth in the 1950s, Japan’s astounding national income-doubling plan in the 1960s or the dynamic growth of the Asian tigers in the 1970s and 80s, it has been the same story of higher public investment triggering a step change in economic growth. In the US, vast increases in investment spending on defence have induced growth and the tech revolution, given extra economic impetus by President Joe Biden’s infrastructure and R&D spending. It was true of Britain in the 1950s and 1960s too, when public investment averaged more than 3% of GDP.
The process is relatively simple and easy to understand. An increase in public investment does three things. It lifts the capacity of the economy permanently by improving the public infrastructure – everything from hospitals, court buildings and public housing to improved transport, utility provision and R&D. This is especially true after years of public underinvestment – following a war, say, or a prolonged period of austerity. There is a second-round effect of crowding in higher private investment as public sector contractors tool up to meet the public contracts, and then a third – as all firms adjust to the higher level of demand by raising business investment levels – of more crowding in and so-called “multiplier effects”.
For the past 40 years, free-market economists have tried to contest these effects: public investment, they argue, can only “crowd out” virtuous private business investment. Economic dynamism comes solely from the private business sector, which is oppressed and crowded out by the state. So-called “multiplier’’ effects of public investment are downplayed.
After a succession of disasters, of which the Liz Truss budget was the most conspicuous, very few economists subscribe to the crowding out, weak multiplier hypothesis. It might have some validity if the economy is operating at full capacity, but otherwise it is largely dismissed.
But not by the Office for Budget Responsibility (OBR). Extraordinarily, it forecasts that the experience of every capitalist economy since 1945 is not to be repeated in Britain as the government lifts public investment cumulatively by £66bn over the life of this parliament. Yes, there will be a “temporary sugar rush” of higher growth in the short term responding to the front-end loading of the spending, as Richard Hughes, the chair of the OBR dismissively acknowledged. Some slight benefit might survive five years, but we would have to wait 50 years for a little more. Inflation would be higher as public investment crowded out virtuous private activity, so interest rates would fall by less than they otherwise would. It was all rather sad – Rachel Reeves’ landmark budget was beset by risks, had little margin for error and was essentially futile.
The OBR’s job is not easy. It has genuine doubts about the quality of a number of public investment projects and how quickly they can be implemented. But it makes its task harder by sticking to a neo-Thatcherite worldview. Thus, between 2010 and 2016 its belief that public investment is an economic sideshow led it to underestimate the impact of austerity. Then, under intense pressure from Tory ministers, it downplayed the impact of Brexit in its forecasts, despite recognising it was an economic calamity in the side boxes accompanying its reports. Now it is making the same mistake, underestimating the multiplier and crowding-in impacts of higher public investment.
Research by the University of California’s Prof Valerie Ramey, for example, shows that in an economy such as Britain’s, suffering from a prolonged period of public underinvestment, the impact of an injection of public investment on the scale proposed by Reeves would at least double the returns supposed by the OBR. The Institute for Public Policy’s Carsten Jung, using this framework, calculates that the additional growth at the end of this parliament would not be the OBR’s 1.5%, but close to 2%. And an impressive and well-researched paper from the New Economics Foundation – The OBR’s Fiscal Powers Need a Rethink – demonstrates the extreme conservatism of the OBR’s approach to assessing the impact of public investment makes it internationally an outlier. Indeed, even the government’s own wealth fund is operating with the expectation of stronger multiplier effects than the OBR.
Is the OBR right and the rest of the world, the IMF included, wrong? It seems unlikely. Yet the OBR is placed on a pedestal as the objective arbiter of Britain’s public investment plans – its views used to pulverise the government, with the pulverisers never asking if the OBR itself has got it right. Thus the credit agency Moody’s, borrowing the OBR’s gloomy analysis, warns of the challenges and risks, accentuating investors’ wariness about buying UK government debt and holding sterling. Unwarranted pessimism has grievous costs.
Of course, even 2% growth, the most likely outcome, is not good enough. If the government wants better, it needs to make progress in two critical areas. Britain must break the taboo and have a closer trading relationship with the EU. Fooling around with improved veterinary agreements and less time-consuming sanitary checks is to operate in the foothills. We need to find our way back into the EU single market and customs union to regain some of the 10% of output we will have lost.
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Second, it is imperative that more of the £5tn of risk capital managed by our pension funds and insurance companies is invested in British companies, instead of the current minuscule percentages. The best are already giving a lead. The government’s own Pension Protection Fund must become a superfund fast.
There is hope. The chancellor has dared to invest, tax and borrow on the scale necessary. She deserves applause, not brickbats. The government does want to create big, powerful, risk-taking pension funds, if agonisingly slowly. The direction of travel on the EU is clear, even if the moves are hyper-cautious baby steps. I had feared retreat; last week represents advance, despite the OBR. Now the government has to double down and go even faster. Good government can make a difference.