The r-g gap is not an exogenous constant. Over the past 150 years it has been on average negative – but it follows a cycle over time, and can turn materially positive, as it did during the 1970s, 80s and 90s. Indeed, the gap has narrowed substantially through 2022 to date.
In an uncertain world where there is a growing risk that the global economy will flip from a period where r is less than g, to one where r is greater than g, investors will want to be confident that governments can credibly, and quickly, transform the sizeable primary budget deficits of today into primary budget surpluses that are sufficient to keep government debt-to-GDP ratios stable.
At today’s high levels of government debt to GDP, that would require a dramatic turnaround, to primary budget surpluses of a magnitude that have never been sustained for more than a few years.
A grave miscalculation?
So what happened in the UK’s fiscal event of September 23?
Boris Johnson’s government had departed from the old economic orthodoxy, that high levels of government debt are bad, in the exceptional circumstances of the pandemic.
Rather than returning towards the old orthodoxy Liz Truss’s government moved further away from it. It appears to have miscalculated and gone too far.
Primary deficits, and high levels of government debt, may demand less urgent attention than was once the case, but that does not mean that they can be ignored. In assessing the validity of a government’s fiscal plans, wise investors will take a probabilistic approach.
Recognising that the balance between r and g can easily turn from positive to negative, they will want reassurance that a government that is allowing deficits to increase has the capacity to move quickly back to surplus should the need arise.
The new Conservative administration has not given that assurance. Instead, having announced a £72.4bn increase in the UK Debt Management Office’s net financing requirement, equivalent to around 3 per cent of GDP, it is refusing to provide any explanation until a period of eight weeks has passed.
It has simply asserted that tax cuts for the wealthy will boost long-term growth and become self-financing. We know of no empirical evidence for that, and nor it appears do investors.
If the aim is to use fiscal policy to raise long-term growth, the money would be far better spent on research and development, either directly or indirectly through incentives offered to the private sector.
Moreover, despite the Office for Budgetary Responsibility being ready to publish its own independent assessment of the outlook for the public finances incorporating the new measures, the Conservative administration told it to wait.