Policymakers must bear four points in mind: first, they must promote the essential strengthening of investment and net exports; second, they must realise that this big economic adjustment is a necessary condition for a durable fiscal improvement; third, they must also prevent the fiscal deficit from crowding out the needed rebalancing; and, finally, they cannot assume that today’s huge fiscal deficits can be comfortably financed indefinitely, should the rebalancing of the economy itself fail to occur.
This is going to be a very tricky policy performance.I agree with the diagnosis. But it raises a different question which is not answered: why does not the market solve this problem?
Some would argue that public sector borrowing itself causes the problem - if the government did not run a deficit, the private sector would have nowhere to put its money except into investment. Interest rates would fall until productive investment shows a net positive return.
However, Wolf points out that:
The Panglossian view is that...domestic private spending and the external balance would adjust automatically. But, with real interest rates on index-linked gilts at just 0.6 per cent, short-term interest rates at 0.5 per cent, yields on conventional 10-year gilts at about 4 per cent and weak growth of credit and broad money, this is a fairy story.This is the Keynesian view - that interest rates can't fall any further, so an increased saving rate would drive national income down (the paradox of thrift) until the economy reaches a new equilibrium at a much lower level of GDP.
Scott Sumner would argue that a rising level target for NGDP or prices would combat this. Partly because inflation would make real interest rates negative (meaning capital investment is relatively more attractive than holding cash), and partly because a credible growth target for NGDP would make the expected returns on real investment higher.
But even if this is the right policy, it is not yet accepted by a consensus of central bankers, and seems unlikely to be implemented. Thus, the answer to my question is: the market on its own is stuck in a low-return equilibrium and private actors can't solve the imbalances, or make investment profitable, without help or coordination. Is there a second-best policy which could achieve some of the same four objectives?
The first of the four goals is the most important. Promoting investment is a clear objective of both main political parties. However, while Labour is indicating that it would pursue a strong industrial policy to directly boost private investment, the Conservatives (as far as I can tell) take the Panglossian view described by Wolf.
Though I am tempted by Labour's approach on this issue, I am not convinced that industrial policy alone can create enough investment to make the difference. We are talking about £75 billion a year of new investment, over and above the £210 billion that's already taking place. Where else could it come from?
Government can directly invest some of the money - if the deficit on revenue spending can be reduced, public investment in infrastructure could take up some of the slack. The obvious candidates - railways, roads - will be limited by the amount of skilled labour available, so we need some diversity of investment (this theme will come up again in a posting in the near future - look out for it). If government is going to invest directly, it must find ways to invest significant sums in other areas such as digital infrastructure, software, green energy - or perhaps technologies for long-term care. This should ideally be done with the intention of privatising the assets later, or else run at arms-length by creating a fund which will invest in private projects to build these technologies.
More importantly though, the private sector needs to believe there are specific opportunities for long-term growth in the economy. Policy can have some influence on this.
Some opportunities are demographically obvious - for instance, there will be millions of people retiring in the next few years and many of them will soon need long-term care. Why are more private investors not building care homes? Probably because the nature of the business opportunity is very unclear, due to uncertainty over future government policy. This can be resolved at low cost by simply making a clear policy announcement (neither party manifesto is clear on this, though Labour has a little more detail than the Conservatives - see also page 6:5 in Labour's full manifesto and page 48 of the Conservatives').
Other opportunities are path-dependent - if someone invests in high-bandwidth digital infrastructure, then complementary software and media investment will also become profitable; otherwise, they won't. This is a valid argument for public investment in basic infrastructures, to move the economy into a better equilibrium.
Wolf's other three objectives are all about how the public deficit is managed. In short, the deficit needs to be left intact for a year, brought down only as these imbalances can be resolved, but once they are resolved, reduced sharply. If the economy does not make a successful shift towards investment, significant devaluation of the pound, and lots more QE, may be the only option available. Let's hope the private sector has the sense to stop accumulating financial assets before that has to happen, and finds somewhere productive to put its resources.