Austerity’s second dimension: why fiscal sustainability requires more than cuts

20^th December 2014

How should public borrowing evolve over the years to come? Ensuring the sustainability of public spending is essential to intergenerational fairness, since otherwise today’s young people will pay for the advantages enjoyed by current generations while receiving none of these opportunities themselves. Considerable resources will moreover be required to address the challenges an aging population poses to the NHS and pensions in particular, and the UK must prove itself willing to seriously contemplate the proper size and function of the state.

But sustainability depends on more than the size of our debt. Just as important is the structure of the debt the state incurs, i.e. the balance of public spending between consumption and investment. Rather than seeking to achieve a balanced budget at a time when this may in fact damage the economy given the number of external factors already holding it back, we should instead be seeking to ensure that the debt we do take on is productive, and serves the national interest in the long-run – a theme which the austerity debate has largely overlooked. Diverting more public expenditure towards investment is the method by which this can be achieved.

Investment represents consumption foregone today in order to increase consumption possibilities tomorrow. It is therefore entirely appropriate to take on debt for investment purposes, so that future generations help to fund spending which will benefit them. Indeed, without the use of debt, much investment would never be financeable. Such debt is therefore actually in the interests of the next generation.

But debt of course has costs associated, in the form of interest payments. The more debt we take on, the more we pay in interest, crowding out consumption possibilities both now and in the future. Therefore, unless borrowed money is used in a way which will increase resources in the future, tomorrow’s generation risk seeing all the costs of debt and none of the potential benefits. This is why debt should, in the medium-run, be used to finance investment rather than consumption – a lesson no less true for government than households.

However, as this analysis by the BBC indicates, social security has expanded and investment fallen as a proportion of public spending since the 1950s. Current government borrowing therefore finances spending on welfare payments, pensions et cetera; and while such spending is certainly defensible, it does not represent expenditure calculated to deliver increased future resources – that is to say, it represents consumption, rather than investment. David Kingman of the Intergenerational Foundation (IF) has written about the lack of investment in the UK economy as a whole; and while the private sector must do its part to reverse this pattern, the problem is especially pressing with regard to government spending. Indeed, even New Labour’s considerable infrastructure investment has in fact failed to serve the interests of future generations, owing to the unreasonably high levels of debt incurred via the PFI financing scheme, as noted in a previous IF report.

While not offering a complete solution, three steps could usefully be taken to turn the national debt to the greater advantage of the next generation. The first would be a re-examination of the benefits and subsidies offered to older people, especially to those still in employment. IF has drawn particular attention to the light taxation of and transport subsidies provided to pensionable-age workers. Addressing the first in particular would allow older people to make a greater contribution towards public social security expenditure, of which they are major beneficiaries, freeing up resources to be used for investment or to pay down the national debt.

The second would be the creation of a sovereign wealth fund, of the sort recently announced for the North of England in the Autumn Statement. North Sea oil and gas revenues could perhaps be used to set up such a fund for the UK as a whole as a condition of the continued use of the Barnett Formula, the provisions of which are generous to Scotland. Money in this fund would be used exclusively for investment purposes, to generate resources for future generations.

Finally, expanding the borrowing and/or taxation powers of local authorities, or allowing these to retain more of the tax revenue generated locally (as advocated in a recent ResPublica report) would permit more efficient investment. Local authorities could use their regional knowledge to direct investment to schemes likely to generate prosperity for their area. Localism is key not only to our constitutional but also our economic future; the Coalition’s acceptance of the Heseltine review’s recommendation that Local Enterprise Partnerships receive executive power over the spending of centrally-allocated resources acknowledges this. Examples of gainful local investment include the Leeds city region transport fund, expected to create 23,000 jobs for the region by 2026.

In short then, unless more resources are dedicated to investment, we risk a vicious circle where economic stagnation and rising interest payments require us to borrow ever more to finance current spending commitments. It is common knowledge that the UK government has a debt problem; however, it is not only the level of debt which constitutes that problem, but also the purpose to which the borrowed money is put. The ‘austerity’ debate must acknowledge both parts of this question, for the sake of today’s young people.