The resignation of Sajid Javid and elevation of Rishi Sunak to Chancellor (Treasury Minister for non UK readers) has raised the prospect of more expansive fiscal policy (at least in the UK press). If the sole goal of Boris Johnson is to be re-elected in 5 years this is not such a bad idea. The new Tory voters stolen from Labour are partial to state spending. Traditional Tory voters are normally less keen but circumstances may make them more welcoming, especially as taxes need not go up. Propitiously, an expansive fiscal policy may be just what the economic doctor ordered for the UK at present.
Fiscal policy has two aspects. The macro aspect focuses on how much government spending exceeds revenues. The excess is normally funded by borrowing, though it need not be. The central bank could just print money and hand it to the state to pay bills. We will assume it is funded by borrowing. The micro aspect focuses on how total state spending is distributed. The two are not strictly independent but it is a useful separation and one commonly made by economists. We will continue with this separation.
UK macro fiscal policy has hitherto attempted to match current expenditure to revenue and restrict borrowing to state investment. The implication of recent press reports is that borrowing to finance current expenditure might also be allowed. The distinction between current public expenditure and state investment is often blurred so the focus here will be on how much the outstanding stock of UK net debt will be allowed to grow. This is normally measured as a % of GDP. The accepted wisdom is that to allow the net Debt to GDP ratio to rise above X will bring forth the four horseman of the apocalypse. X varies across countries and it is clear to anyone but dogmatic economists that the appropriate level of X can vary over time and geography. The evidence is that in the UK it has room to increase quite a bit without triggering any events from Revelations.
The key economic variable (according to me) is potential output. How fast can the economy be run without triggering accelerating inflation. In a closed economy one need only look at monetary policy and, of course, inflation. Monetary policy has been loose for 10 years and still inflation keeps dropping below target. This is prima facie evidence that there is potential for output to grow faster. If macro policy is expansive it will bring forth employment of resources hitherto not employed and without accelerating inflation. Note that as GDP will grow faster as well as debt X may not change and could indeed go down. The UK is, of course, an open economy and the current account is also a constraint. UK fiscal expansion will also stimulate other economies in so far as the extra spending ends up being spent on imports. This means that some of the growth in UK debt will have to be bought by overseas investors (aka Johnny Foreigner) in order to generate the necessary foreign currency to enable the extra imports. At present there is good reason to believe such purchases of UK debt will forthcoming. Indeed many will be trampled in the rush.
Real yields on UK debt are negative. They are very negative. They have been negative for some time. Real yields are around -1.5%. There are more people wanting to hold bonds than there are bonds available. In part this reflects the fact that the Bank of England keeps buying them. If the BoE observes an expansionary fiscal policy it may cut back purchases. It should cut back purchases. The real yield may rise but in the present environment that will most likely be met by a wave of grateful buyers. Both domestic and foreign bond investors are desperate for positive real yields. They will settle for less negative. Put differently, the UK government will have no trouble selling debt in the immediate future. Pension plans and insurance companies alone will take whatever they offer. Moreover, yields will not need to rise much to bring forth the necessary demand even if the BoE stops buying.
The risk to this strategy is that the government will not take corrective action when required. If Boris Johnson runs an expansionary fiscal policy long enough then inflation will start to accelerate. UK debt yields will rise and foreign demand for UK debt may tail-off putting downward pressure on sterling, which will in turn exacerbate inflation. At this point he should stop and go into reverse. The risk is he does not because it is electorally inconvenient. It is fear of political expediency that has driven the fiscal prudence movement not economic theory. Governments cannot be trusted to do what is in the best interest of the country because they always believe they are in the best interest of the country. The history of the 1960s and 1970s (and in Germany, Weimar) is often cited as a warning as to the temptation of fiscal expansion. But of course the context was quite different.
The fiscal expansions of the 1960s and 1970s were accompanied by a peculiarly unionised labour force. The peculiarity was pay relativities. The unions established their own hierarchy of pay. If one union achieved a pay rise based on productivity agreements (hence affordable) all unions wanted an adjustment based on ‘relativities’ whether productivity improved or not. The process was underwritten by the state which had a commitment to ‘full employment’ and which expanded fiscal policy in pursuit of this commitment. The Bank of England could not counter the policy because it was not independent. It was an arm of the Treasury. As many of the industries were then nationalised, the state simply paid up whether it made productivity sense or not. The result was inevitably accelerating inflation, very high nominal yields, sectoral decline, and balance of payments crises. This situation does not apply today (though perhaps it could have reared its ugly head if Corbyn was pm).
The present government would be expanding fiscal policy into a flexible labour market. The only caveat I would offer is their own immigration policy. The aim is to get net migration down which may reduce the working population. This could create pockets of excess labour demand (skill shortages) and force up wages or simply make expansion in certain sectors impossible. This could be inflationary. It is ironic that many of those that complain of immigrants taking their jobs in fact only have jobs because immigrants complete the labour supply and make the industry viable. The migration policy needs to be flexible with an expansionary fiscal policy. In the long run labour shortages may bring forth the productivity improvements that have eluded this country for so long. However, Boris Johnson is only interested in the next election date. One way around labour shortages is of course to get foreign firms to build infrastructure and bring their own (temporary) labour force. Hence getting the Chinese to build nuclear power stations and railway lines in exchange for UK debt.
The micro aspect of fiscal policy is more difficult to gauge. There will be a bias towards spending ‘up north’, and no doubt keeping tax rates stable if not reduced. Allowances may be where all the innovation takes place. Generally it cannot be too harsh a micro fiscal environment because Boris Johnson has a much broader voter base than previous Tory pm’s. The usual binary trade-offs no longer apply. The next 5 years looks like being a benign fiscally stimulated environment which suggests that, barring accidents, Boris Johnson will win another term. The constitutional changes this may bring are worrying but domestic economic policy, for once, is not so concerning.
From an investment strategy point of view it is as well to focus on those stocks that stand to benefit from a fiscally stimulated environment. Some stocks may be obvious. Others are not. At times like this services such as https://www.quant-insight.com or QI can be very helpful enabling a screening of stocks that would be expected to benefit from the environment described above.
- I am shareholder (less than 1%) of the holding company that owns QI