InvestmentsMar 19 2020

Chancellor unleashes spending spree to battle downturn

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Chancellor unleashes spending spree to battle downturn

Even without the ravaging uncertainty of the Coronavirus, the challenge laid down to chancellor Rishi Sunak was vast.

The government decided to frame fiscal policy within two priorities.

The first was that the day to day government budget would be balanced within three years, the second that billions would be spent on infrastructure and other spending in the North of England, and that a target rate of growth would be above 2 per cent in normal times.

Mr Sunak’s response was to announce a package which increased the total of government spending by £76bn over the next four years, with just £7bn a year of extra tax revenue to pay for it.

The gap is being filled by increasing government borrowing.

Coronavirus impact

The interest rate at which the UK government can borrow has also tumbled as part of the ramifications of the wider crisis, making it easier to fund the borrowing. Right now (March 16) the UK government can borrow for 10 years at an interest rate of 0.37 per cent.

We fully expect a weaker growth outlook this year. Depending on the scale of shock this year, this could also see growth weaker next year.--David Page

The economics think tank, the Institute for Fiscal Studies (IFS) said the government’s strategy contains serious risks, because if there is a larger shock to the economy than is forecast, such as the Coronavirus crisis having a longer-term impact than is presently expected, or the UK’s exit from the EU transition agreement proves more problematic than the government’s current base case scenario that the UK exits with a deal, then taxes would need to rise, or spending be cut.

Borrowing could also rise in that scenario, but the unknown question would be whether the interest rate at which the government borrows would rise significantly in that scenario. 

Paul Johnson, director of the IFS said: “If it turns out that the short term disruption caused by Coronavirus is just that – short term – then all is well.

"Any significant longer term effect, though, and a smaller economy will mean the tax and spending plans set out [in the Budget] will lead to an even bigger deficit than currently planned in the first few years of this decade.”

He noted that many of the spending pledges in the budget related to the first two years of this parliament, and at the end of that time, if growth has not picked up by then, either spending would have to be cut, borrowing increased further or taxes raised.

The second risk highlighted by the IFS is that while the massive investment programme outlined by the government is that while it might be expected to generate additional economic growth, this won’t happen if the extra money is spent unwisely. 

Growth outlook

David Page, head of Macro research at Axa Investment Managers said the increase in public spending announced by Mr Sunak is the largest since the early 2000s.

He said that even without the Coronavirus outbreak, the expectation of the Office for Budget Responsibility (OBR) had been that UK GDP growth this year would be 1.1 per cent, instead of its previous 1.4 per cent, an estimate Mr Page said he found “optimistic”.

He added: “We fully expect a weaker growth outlook this year. Depending on the scale of shock this year, this could also see growth weaker next year.

"We also forecast growth to be slower than the OBR’s longer-term outlook, sharing the BoE’s more cautious outlook for productivity growth in the wake of several years of weak investment spending. A weaker growth outlook will likely weigh on the public finances relative to the forecasts for borrowing and spending in the budget.”  

Anthony Willis, investment manager at BMO, said the likelihood is that the UK will enter recession in the coming months as a result of the Coronavirus, with the result that more spending is likely to be needed when the chancellor does his second budget of the year in November.

Mr Willis said the dramatic collapse in the oil price in recent weeks is part of a long-term trend, and this is likely to mean inflation globally remains very low.

Lower inflation makes it easier for governments to borrow, as the income paid on the debt has greater purchasing power, while the extra demand generated in the economy, while inflationary, wouldn’t push inflation to dangerous levels. 

Recession fears

On the same day the chancellor unveiled his budget, the Bank of England cut the base rate to 0.25 per cent, from the previous 0.75 per cent.  It has now been cut to a further 0.1 per cent.

In normal circumstances a lower oil price would be welcomed as providing a boost to activity by reducing inflation and increasing real incomes and consumer spending.--Keith Wade

This is designed to make it easier for banks to lend money into the economy, to stimulate demand for credit from businesses.

Keith Wade, chief economist at Schroders, says the risk is commercial banks may not want to lend at a time of such severe economic uncertainty, and in that situation, the interest rate cut would have no impact. 

Mr Wade adds he expects many other countries and economic regions to follow the UK’s lead and increase government spending, but that ultimately, there may be nothing these measures can do to prevent a recession while the Coronavirus remains a threat.  

The challenge faced by policy makers is that Coronavirus is both a demand shock and a supply shock to the economy.

It reduced the level of spending individuals and companies can do (demand shock) and it restricts the supply of goods and services in the market (supply shock). 

Most recessions are ultimately caused by one or other of those shocks, both happening at the same time and is often called “stagflation”.

This means stagnant growth and high inflation. The one difference between previous periods of stagflation and the current situation is that the oil price, a major determinant of inflation, has fallen sharply.

Mr Wade says that in normal circumstances a sharp drop in the oil price would lead to increased consumer spending, and boost growth, but not this time. 

He adds: “In normal circumstances a lower oil price would be welcomed as providing a boost to activity by reducing inflation and increasing real incomes and consumer spending.

"However, in the current environment it is likely that consumers will save most of the windfall gain, partly out of concern about the future and partly as a result of restrictions on movement.”

He said for this reason it is difficult to see the oil price fall “coming to the rescue” of the economy in the way it would normally be expected to do.

david.thorpe@ft.com