Julian Jessop, Danisha Kazi and James Smith.

Q92 The Chair: Good afternoon, and welcome to this session of the Economic Affairs Committee. Would you like to introduce yourselves to the committee?

Julian Jessop: Thank you. I am an independent economist. I have over 35 years of experience in the City, the public sector and consultancy. I am a fellow at the free-market institute the Institute of Economic Affairs, but I am speaking here in a personal capacity.

Danisha Kazi: Hello. I am the head of economics at the think tank Positive Money. We focus on reforming the money banking system so that it serves people and the wider economy, and the green economy.

James Smith: I am research director of the Resolution Foundation.

Q93 The Chair: Thank you all very much for coming. I will ask a starter for 10, so that you can set the scene for us. The OBR’s Fiscal Risks and Sustainability report of July 2023 is pretty depressing and worrying reading, one might say. The first sentence says, “The 2020s are turning out to be a very risky era for the public finances". You get the sense that we are potentially entering a doom loop, as some have called it. How worried should we be?

James Smith: We should definitely be worried. Public debt has nearly trebled since the financial crisis, which is an unprecedented peacetime rise. Yes, it has risen in other countries as well, but it has risen in the UK almost more than in any OECD country over that period. We have definitely seen a huge rise in debt.

The key point I would like to get over is that what seems to have happened since then is that we have had a series of crises which we have responded to using fiscal policy, and we have allowed debt to ratchet up over that period without ever having a concerted effort to bring debt down afterwards. If we continue down that path, we will end up on a really high debt path. We can see from other countries that when you lose fiscal space and the power to use your fiscal policy, real hardship awaits.

The Chair: Thank you. Danisha?

Danisha Kazi: I want to add a little more to that understanding of debt sustainability and the challenges we face. There are heightened challenges; we have had a lot of economic shocks, and there is a lot of uncertainty ahead.

One thing we need to look at is private sector debt. A really meaningful thing is to look at private sector debt as a share of the economy as well as public debt; we cannot look at both of them in isolation. As we know, it was explosive levels of private sector debt, along with financial deregulation, that led to the global financial crisis that was the start of increasing public sector debt. We need to look at them both together; they are both really important.

For the sustainability of our public finances, we should also be looking at the nature of private sector debt. The public sector obviously supports the private sector, so we need to see them working together. While there are heightened levels of uncertainty and concern about the future, the private and public sector working together is important.

It is also useful to think about what really matters in debt sustainability. The levels of public debt are not as important as the management and structure of debt, and the debt servicing costs. We need to look at how we manage debt servicing costs, because that is where the affordability is. The levels have been increasing; they have been on an upward trajectory for a while. They have exploded with the recent pandemic and the various shocks to the economy, with inflation, but they were already rising before that. We have had fiscal targets for 10 years, but the levels have been rising; they have sort of doubled in that time. The level of public debt is not so much the issue as how we manage the structure and affordability of it.

The Chair: Excellent. There are topics there that we will come back to, but that was very interesting. Julian?

Julian Jessop: Well, it is a good start. There are several points I agree with there. I am not panicking about the overall level of debt at the moment. I do not think it really matters whether that debt level is 100% of national income or 120%, but I am concerned about the trends. One point James already mentioned is that we seem to have a series of crises every time the debt-GDP ratio ratchets up, but it never subsequently falls. That is on top of a general upward drift over time. That, of course, is even before we get the big hit coming through from the adverse demographics that I know we will touch on later.

These high levels of debt also have all sorts of potential costs. Clearly, we may get into the situation where we need much higher levels of short-term interest rates to finance that debt, or much higher levels of inflation, which have knock-on consequences. High levels of debt are a symptom of other problems in the economy, whether that is a state that has got too big or growth that has been too slow. We should not be panicking about where we are now, but if you look, as you say, at the profile over the next decade or two, it does get increasingly worrying.

Q94 The Chair: Can I just pick you up on that point? We face a number of challenges, as you say: the costs of servicing the debt that Danisha talked about, what I call the demographic issue, decarbonisation, defence—they all begin with D—and digitalisation, which will potentially cause changes, both positive and negative, to our workforce. When you look at those challenges—maybe Danisha can come in on this—perhaps it is all of them, but is there one that we should be focusing on as policymakers, or are they all adding to the doom?

Danisha Kazi: I do not know about doom. They are obviously challenges that we have to face. I think the IFS has also said that we cannot keep kicking the can down the road. We need to address how we will meet these challenges. At Positive Money, we have been calling for much better co-ordination between the Treasury and other key economic institutions, such as the Bank of England, so that we can manage the debt, its structure and servicing costs, so that we can address these challenges. They are all important.

Of course, tackling climate change and the transition to net zero is crucial. Critically, with these challenges—demographics, the climate emergency—dealing with up-front costs now will avert higher costs later. We know that there is a consensus on this.

I think the OBR itself has highlighted that early action towards a net-zero transition would increase debt-to-GDP levels by 20%, but no action would increase it by up to possibly 300%. It highlighted this in 2021. Averting higher costs later will contribute to debt sustainability in the long run, and not put so much pressure on future generations, which is what the fiscal targets are intended to do. It makes a lot of sense.

The Chair: Thank you. Julian, what are your thoughts on risks that we should focus on more than others?

Julian Jessop: If I had to pick just one, it would be the demographic challenges. That feeds into another D—the dependency ratio.

The Chair: Thank you. We will come back to that. James?

James Smith: I would agree that demographics are the biggest of those challenges. If you look at what happens in the OBR’s long-term risk projections, it is pretty clear that, based on current policies, debt looks like it is close to being on an explosive path. People dismiss those as something held under an utterly unrealistic lens, as there would be policy to move that along, but we need to have a conversation about what that policy looks like, and how we actually go about implementing what the framework would look like.

The Chair: When you look at these OBR projections up to 2070, at what point do you think that it just becomes fanciful? Twenty-five years ago, for example, we did not have iPhones or iPads. The full weight of the technological revolution that we now see was still science fiction in many people’s minds. Where should our horizon be before discussing what might happen becomes pretty meaningless?

James Smith: It is clear that you should not take those lines literally, but they do tell you what the public finances look like going forward, based on the population and policies we have. That is what you should take seriously. The are telling you that there needs to be a change in policy or something else to come along. I do not think we should count on there being some sort of technological miracle to wish this problem away.

Q95 Lord Blackwell: The Office for Budget Responsibility told us that it thinks that these issues require action to address them in the next Parliament. Its projections show public expenditure, driven by an ageing population and health et cetera, rising from 40% up to 64% of GDP by 2070. Assuming that taxes do not keep up with that, that leads to an increasing deficit.

They also project that for the next decade it is not much of a problem in terms of public sector borrowing; debt does not start going up until the 2040s. Do you accept that it needs to be addressed in the next Parliament because of lead times, or can we afford to relax and see what happens?

Julian Jessop: First, there is a risk that we continue to kick the can further down the road. As you say, if we look at the short-term projections, or at least the next five to 10 years, debt is likely to fall as a ratio of national income, so it might appear that the problem can be forgotten about for a while.

A lot of the things I think you need to do to fix the longer-term problems will be politically very difficult. For example, you might need to look again at the triple lock on the state pension. It will probably take at least one Parliament to get a consensus on what we do about the state pension, so I do not think it can be left for the Parliament after next. That is a debate that needs to start in the next Parliament.

There are a number of other things that you can start doing now that will help to ease the problems in the future, such as incentivising people to stay in work longer than they currently plan to, and making sure that labour markets are as flexible as possible, so ensuring that labour force participation remains high. The sooner you start to do that, the better, because once people have dropped out of employment, it can be very hard to get them back in again. I think you need to take action on that in the next Parliament.

Lord Blackwell: Do you agree with that, Danisha?

Danisha Kazi: I think what is underlying this issue is that the OBR is asking us to have a long-term view, because the current fiscal framework does not do that. It is very narrowly focused on one thing: to see levels of debt falling as a share of GDP. This very narrow view means that we are not looking at debt sustainability in the longer term. That is really what it is asking us to pay attention to.

The current fiscal targets are self-imposed and arbitrary, as we know. They change a lot. Every time there is a new Government, they change. We know that they lead to lots of dramatic headlines about fiscal illusions—big fiscal black holes or massive headroom—but this is not a very credible or serious way to deal with the public finances, because, as the OBR highlights, we have long-term challenges that we have to face. That is not just the demographic issue, but the transition to net zero, productivity issues in the economy, and crumbling infrastructure. A decade of austerity has left us woefully unprepared for the economic shocks we have had recently. We are quite likely to have more as things proceed, because we do not know whether the path for these key indicators, such as growth and inflation, will be as smooth as we would like to think they might be. We will still have supply chain shocks because of the climate crisis; we know that extreme weather is already affecting supply chains and food and energy prices.

There are lots of things that we can do if we take a longer-term view now to ensure debt sustainability in the long run, not just in the immediate short term of a Parliament of four to five years. The forecasts that we use right now are very uncertain, so we need much more solid grounding in how we manage our debt, as I have mentioned.

James Smith: Both main parties have said that they want debt falling. The Government have said that they would do that at a five-year horizon, and we think Labour would do something similar. That is a fiscal framework that is putting debt on a trajectory to rise to 150% to 200% of GDP, so I think the OBR is right to say that we need to tackle this overall framework question. There is a lot that you can do on policy, but the start of that question is to get serious about what your overall framework looks like.

Lord Blackwell: Am I right in hearing from all of you that that is primarily to do with managing policies on expenditure?

James Smith: I think that is right. You essentially need to run surpluses. You might say, “Oh, debt’s around 100% of GDP. That seems to be manageable. It’s not a problem”. There is no one level of debt that is too much, but the higher your debt is, the greater the risk of losing fiscal space and the ability to use fiscal policy.

One way to read the episode around the mini-Budget is that that high debt, that high risk, played into some of the policy issues there and led to a much more adverse reaction. Would we have had the same sort of reaction if they had announced the unfunded tax cuts when debt was 5% of GDP? It is a much bigger deal, as we are much closer to the limits of sustainability. I think the key thing is taking that seriously.

Lord Blackwell: Are you also all saying that it is not so much that you expect radical action in the next Parliament but that the debate about these major changes will take time?

Julian Jessop: It is partly that. I think the big problem for the next Parliament, whoever wins, is that they will be looking at a set of fiscal forecasts based on an implausible set of public expenditure assumptions. I think a lot of the bandwidth—or the energy, if you like—will be used trying to work out how to square that circle.

I know Richard Hughes testified to the committee about this, describing those numbers as basically a work of fiction. Actually, it is almost a farce rather than fiction. I think a lot of the time will be spent trying to work out how to hit those spending targets or trying to find what else you can do to balance the budget, whether that is through higher taxes, which might be the outcome if it is a Labour Government, or by some sort of radical action on productivity, which I hope both alternative Governments would consider. But it is very hard to get big savings in the short term.

Q96 Lord Blackwell: The other factor in the sustainability equation is interest rates. What is the risk that a Government faced with this problem might try to intervene and manage down interest rates, even drive them negative?

Julian Jessop: It is not just expenditure and interest rates. It is also growth and inflation. There are a lot of things that could happen with both of those.

On interest rates, I guess you are thinking partly of the question of financial repression.

That is a very broad term that means different things to different people. Some soft forms of financial repression we have already had over the last few years and decades, a long period in which real interest rates were relatively low or negative and financial institutions in the private sector were encouraged to buy government debt through prudential regulations, and so on.

When other people talk about financial repression, they often mean something more sinister, more the sort of thing that might happen in an emerging economy where private sector institutions are forced to lend to the Government far more than they would otherwise, where you might have capital controls or exchange controls—those sorts of things.

That is very unlikely in an advanced economy, as I still like to think the UK is. However, there will clearly be more pressure on central banks to keep interest rates lower for longer than they would otherwise have done, because of the need to finance a massive public debt.

Q97 Lord Lamont of Lerwick: I want to go back, if I may, to something that James said at the very beginning. You said that our debt-to-GDP ratio, although lower than other countries’, had risen faster than other countries’, and you put that down to fiscal policy. Would you say that our fiscal response to the successive crises we have had in the last few years has been bigger than in other European countries?

James Smith: I would not say that it is just down to fiscal policy. It is down to how we have been exposed to some of the shocks that we have faced; the financial crisis and the bailout of the banks were much bigger in the UK than elsewhere. I certainly do not think we should be frightened of using fiscal policy when recessions, downturns, hit. That is a big part of stopping real hardship created by recessions.

The problem with the successive impact of having shocks since the financial crisis is that we have had a near tripling of overall government debt, which has put us in a position where it becomes more urgent to create that space.

Lord Lamont of Lerwick: You were not implying that it was a bigger response than elsewhere.

James Smith: There are some instances in which the UK fiscal response has been a little larger than, say, the fiscal response in the US—to give the most obvious prototypical example. It was a little smaller in the US in the financial crisis but much bigger during the Covid-19 pandemic. You could argue that the UK did something that was pretty similar to other countries and was probably about right. The key point is that it is really important to give the space to do that again.

The Chair: Lovely. Thank you.

Q98 Lord Burns: You have all said that the demographic challenge may be the biggest challenge to debt sustainability that we face. It is also possible that most of the advanced countries are facing a similar challenge. Indeed, some countries have a bigger challenge than the one we face.

Could we look in a bit more detail at how we deal with this? You have already mentioned the triple lock on the state pension and incentivising people to stay in work for longer. Could you also look at the time period over which one might try to achieve some of these things, and whether those would be sufficient on their own or whether we will have to go rather further than that? Or is the inevitable implication that it will cost us all more in taxation?

Danisha Kazi: I think there are still some uncertainties about what the nature of the demographic challenge will be. We know that there will be one, but the nature and scale of it could change over time. We cannot forecast too far into the future. We do not know how the health of the population as it gets older will change. We do not know about net migration and how policy may affect that. There are still lots of changes and uncertainties there.

We need to think about reforming the tax system. There is a lot of tension around the fact that we tax income from labour very heavily in this country versus how we tax wealth. An appropriate approach would be to start looking at how we tax wealth and having conversations and public debate about that. The Wealth Tax Commission said in a recent report that the public have a real appetite for us looking at how we can start taxing wealth. The Office of Tax Simplification has said that there is a lot of unfairness between the way we tax income and the way we tax wealth. So that is also really important. Capital gains tax should be brought in line with taxing income. There is also a lot of wealth inequality as well as income inequality. These issues underlie the demographic challenges that we should look at.

Again, I would bring us back to the current fiscal orthodoxy and framework, which is very narrow in the way it understands debt sustainability. Whether it is a demographic issue or other, long-term challenges such as the climate emergency that we will face, we need to look at what we could do now to create more fiscal space and debt sustainability for future generations.

Julian Jessop: Just to inject a sceptical note about people’s enthusiasm for paying more tax, those surveys are often skewed by the fact that the people who respond that they would like bigger taxes on wealth think that somebody else will be paying them. So I am a little sceptical about some of those surveys. I certainly agree with the idea of more neutrality when it comes to taxing income from employment compared to income from capital.

On the challenges to do with the dependency ratio, obviously there are different components of that. One very important part is reducing the cost of looking after people in their old age. There are a number of things that we could be doing now that we are probably not doing enough of that would deliver significant returns in the future. A good example here is dementia care, which will clearly be a massive and growing challenge. We probably underinvest in research there compared to other causes, such as cancer care, so we need to look at the costs of dementia care and how we can manage that better. In particular, we need to make sure that the burden does not fall on unpaid care. To put it crudely, we need to make sure that children are not expected to look after their parents in their entirety with no support from the rest of society. Dementia will be an important part of it.

The other side of the dependency ratio is the lack of people of working age who are working. Again, there are lots of things that we could do there. At the moment, as you know, inactivity rates have shot up, in part because a significant proportion of people are long-term sick. If we could get some of those back into work, that would be good. A surprising number of people of what would normally be considered conventional working age—16 to 64—have already retired; I think it is more than 10%. Good luck to those who have, and I am not criticising them for that, but I suspect that many of them could have remained in work if they had had a wider range of opportunities, more flexible labour markets—and more attractive terms, which might be to do with the tax and benefits system and the wages available to them, or whatever else it might be. Maybe AI can play a big role there too.

We should be looking not only at reducing the costs of looking after the elderly, as we all want to do, but at making sure that there is a bigger tax base available to fund those costs.

James Smith: The big thing here, and Julian has already referred to it, is the conversation about fiscal fictions and the sort of debate that we are currently having about fiscal policy. That debate is taking place where there is an arms race to look competent and to deliver sustainable public finances, but it is done through the lens of a set of spending plans that not only do not engage with the issues that we are talking about but are set entirely on the basis that we will continue to deliver all the things that the public sector currently does but at ever-decreasing cost.

There is a big issue with our fiscal debate in this area. It is much more near-term than the sort of issues that we are talking about here on the demographics. The big thing on the demographics is that demographics are not destiny. A great example here is what has happened to the state pension age, which has been raised successively and has played a role in the UK seeing, over a longer period, higher participation rates in the labour market relative to many other countries—a policy that has been a success. The same grappling of the nettle in other areas such as health, which we have already talked about, and an honest, grown-up conversation about what needs to happen there would be incredibly powerful, but it needs to start happening soon, because it will take time.

Q99 Lord Burns: Would you not agree that, although there are uncertainties, when it comes to demographics, it is one of the things that one has some sight of quite some way into the future? I find it very difficult to see that there is an optimistic outcome that removes the need to think about some of these issues quite quickly.

Julian Jessop: There might be something on birth rates. Birth rates at the moment are relatively low, for various economic and social reasons, and it might be possible to lift the birth rates. Obviously, that is by definition a long-term policy if we are looking at getting people back into work; I am not advocating 12 year-olds being forced into the labour market.

Lord Davies of Brixton: Do you have any examples of a Government who have successfully done that?

Baroness Wolf of Dulwich: I was going to ask the same question.

Lord Razzall: China did it the other way.

Baroness Wolf of Dulwich: Plenty of people have done it the other way.

Julian Jessop: China has done it the other way. Hong Kong and Singapore are the two examples that come to mind. From time to time, they have intervened reasonably successfully, providing fiscal incentives for people not just to have children in the first place but to make sure that they have good childcare and the other things around that. There are some things that you can do at the margin.

Q100 Lord Burns: Can I generalise this into the other questions? Is there anything to be learned from some of the countries that are already a bit further down the road here?

Julian Jessop: Japan is the obvious one that comes to mind. One thing it has done, which we have not really yet done in this country, is fully embrace the potential of AI. It uses that a great deal in the way it looks after older people.

I am sorry to come back to dementia care, but it is a particular interest of mine. Japan has done relatively well in introducing AI into homes to help people to identify that they are having problems with their memory as they get older, and providing more support to older people. That is a very effective intervention, because it tends to tackle problems early. Of course, a lot of these interventions do not require people; they have AI systems that can help people. You need people as well, but how Japan looks after people in older age is a good example of something that we could do here.

Q101 The Chair: You mentioned other policy areas. The policy area that we have not talked about is migration. The migration long-run projection is for net migration of 315,000. Do you think we are looking properly at the mix of our policies here? In other words, is it really acceptable for us to think that it is right and economically wise for us to be relying so much on net migration continuing at that level, with a rising number of inactive citizens who are of working age, and at the same time seeing a shrinking of the working-age population thanks to ageing? It seems an interesting approach that we are taking here.

James Smith: Obviously, one way you can boost your working-age population is through migration. I do not think anyone is having that particular conversation. It is hard to think of an area of policy where the rhetoric is as far removed from the reality of what is happening. There seems to be an incredibly strong will to bring down migration, yet the numbers move in exactly the opposite direction. You referred to the latest population projections. The net migration assumption has increased once again—to be fair, taking us back to levels we were at something like a decade ago.

The bigger thing here is more that, as Julian has alluded to, you can think of policy approaches that allow you to tackle the labour market and health implications, and what it is doing to other public services, but that conversation has to start early, it has to be serious, and it cannot be conducted in a fiscal policy debate that ignores all these things and any other changes to public services.

Q102 Lord Turnbull: I think it was Julian who defined the working age population as 16 to 64. I wonder whether that is a fossil from the days when 65 was the normal retirement, and whether the 65 to, let us say, 75 year-olds should be regarded as potentially part of the workforce. Maybe not all of them, but idea of the norm that we do not work after 65 seems to me to be one of the things that has to go. We have already made the change with the pension age, but we have not made the corresponding adjustment when it comes to the working age.

Julian Jessop: I entirely agree. I know plenty of people who are extremely active in their 70s and are still working, including in my own family, and they are contributing.

A noble Lord: And in this committee.

Baroness Wolf of Dulwich: In the room.

Julian Jessop: I did not like to say. That is really important, and not only because of the contribution they can make to the economy and to society. I also genuinely believe that it is good for people to remain active and engaged and to have all the networks that that creates. It is a win-win for everybody.

The way to do that is to ensure that there is the maximum number of different opportunities available to keep labour markets as flexible as possible. A good example here is zero-hours contracts. I know those have a pretty bad reputation in wider society, but a lot of the people who take zero-hours contracts are students who can fit it around their studies or older people who decide to dip in and out of the labour market as it suits them and for whom zero-hours contracts are absolutely ideal.

We need to keep the labour markets as flexible as possible so that people who generally have the opportunity to do nothing if they want to can none the less see a good range of opportunities, including some that will appeal to them.

The Chair: Excellent. Thank you.

Q103 Lord Londesborough: Can we focus on debt-GDP ratios? I think it is fair to say that the majority of studies have shown a relatively weak correlation between debt-GDP ratios and default on debt, yet research does show some correlation between high debt and slow growth, without a clear consensus as to which is causing which. Does the metric of debt as a percentage of GDP adequately capture sustainability on the national debt, or is this too narrow? Do we need to look at a broader set of measures, and if so, what measures would you suggest?

Julian Jessop: It is a very good question. First, on the correlation between debt levels and default, I would not really expect one anyway, because I do not think that default is the main issue, at least for advanced economies; the UK in particular, could always just print more money to service its local currency debt. So I do not think that default is a significant risk, and most market participants would not look at it in that way.

You are right that various people, particularly Reinhart and Rogoff, tried to look at a relationship between a particular debt level and the risk of growth being slower than it would otherwise have been. Their study was flawed in a number of ways. One was simply that they got the spreadsheet wrong. More fundamentally, they did not think enough about the direction of causation. You may well have a high level of debt relative to the size of the economy if your economy is weak, because your economy is weak, not because the debt itself is causing the weakness of growth. So I am sceptical that there is a particular magic level of debt that you can identify as being a problem level.

Your broader question was whether debt to GDP is the best metric. If I had to choose just one metric, it would be debt to GDP—that is probably the one that captures it the best—but it does not tell you about lots of other things that are going on. There are two things in particular. One is the level of interest on that debt, which is partly related to the maturity of borrowing and whether, for example, it is linked to inflation or not, which is a particular issue in the UK. The other is that it does not tell you anything about what that debt is being invested in. It does not pick up the split between just maintaining very high levels of current spending compared to investment spending. So if a country has a relatively high level of debt to GDP, but that is matched by that money being spent on some very useful things that deliver big benefits in the future, I would qualify simply looking at debt-GDP. But if I could only look at one thing, it would be debt to GDP.

Lord Londesborough: Thank you. Danisha?

Danisha Kazi: The metric we use is a very aggregate figure. It does not really tell us anything about debt sustainability; it tells us that debt levels are high. Recently we have seen growing debt levels and historic lows on interest rates, for example, which have helped us manage our public finances until recently. Economic conditions had changed dramatically with higher inflation and interest rates and weaker medium-term growth. The figure tells us current levels of debt, and maybe it helps us to compare to other countries, but it does not really tell us about the economic landscape and how that is changing and how it helps us to grow the economy. It is also only one aspect of growth, so linking high levels of debt to growth—the causation—is difficult to unpack; there are lots of other factors. As a metric, it is useful to include it alongside other factors and other elements that affect the economy, but it is not useful on its own.

For debt sustainability we need a longer-term view. Importantly, as Julian said, day-to-day spending is one thing, but long-term investment in the economy and in tackling future challenges is very different and would improve our debt sustainability over time. Being able to invest in strategic sectors in the economy and in our long-term public services and infrastructure would all contribute to a healthier economy, so those are also really important to look at.

Lord Londesborough: Thank you. James?

James Smith: I think history tells us that what really matters here is the type of use you have for the measure that you are using. If you are talking about fiscal targets, what gets excluded tends to get exploited. So you want your fiscal rules to incentivise good fiscal behaviour. To pick an example completely at random, if you abandoned a large-scale train-line building project and sold all the land that you had for that, that would reduce your debt, but would that be a good policy?

You want your fiscal targets to incentivise good policy-making that takes long-term welfare into account. We have advocated a net-worth rule that takes government assets into account and so creates incentives to build productive government assets, as well as just focusing on debt.

Q104 Lord Londesborough: It sounds from what you are both saying, James and Julian, that we could take a leaf out of the private sector and adopt a rather more sophisticated balance-sheet approach to looking at debt. Is that a view that you concur with?

James Smith: We have been on the record to say that that would provide better incentives. There are an incredible number of issues to do with how you implement any fiscal rule, and you have to take all of them seriously, but if you want policy to incentivise welfare-enhancing fiscal changes, that is one thing that would be a step in the right direction, in our view.

Julian Jessop: I agree. I have read the excellent paper that was produced a few years ago. It was co-written by Richard Hughes from the OBR, so there is some support there for the idea of a public sector net-worth target. I am slightly surprised by how a lot of the economics commentariat has swung against that more recently, because, in principle at least, taking some account of where the money is being spent sounds like the right to do.

However, I do understand some of the concerns that people have about that approach. There are two in particular. One is that if you invest in an asset like a school, a hospital or a road, obviously it delivers important economic and social benefits, but it does not pay for itself. It is not necessarily something that the markets would look at and say, “This makes it easier for us to justify buying government debt”, because it does not help to finance that debt directly. It does indirectly, but not directly.

The second concern is the difficulty of valuing assets, and some of the longer-term liabilities that would go into this calculation, properly. It is obviously a lot easier to put a value on a short-term financial asset or liability than on something that might go into a public sector net-worth target.

The principle of taking account of those things is very sound. It is worth saying that the Government already do that; it is one of the many other things that the OBR chucks into the mix that it is supposed to be looking at, but I am surprised that more people do not support the idea of giving it a higher profile.

Q105 The Chair: There may be other questions on this, but, on the liabilities front, I think you mentioned in your piece, Julian, how fiscal conservatives might be attracted by what we are discussing, in that it might shed light on longer-term liabilities. Can you talk a bit more about longer-term liabilities that you feel might not be reflected in our current thinking about the debt?

Julian Jessop: I am glad that you have read my piece. I printed it out this morning to remind me of what I said.

A good way of looking at this is that a public sector net-worth target would appeal both to fiscal conservatives and to those who want to spend more, to invest more. From the point of view of the fiscal conservatives, there are different ways in which you can define public sector net worth and count different liabilities, such as pension fund liabilities. There are broader definitions that include both funded and unfunded liabilities, so you might want to take proper account of those.

There are other things that you might look at. There are some things that at the moment might be considered to be off balance sheet. There are ways in which the Government can get round existing fiscal rules by using variations on private finance initiatives. So they do not appear in the headline numbers, but they are things sitting in the background that a serious approach should take account of. From a fiscal conservative point of view, these are also attractive, because you end up counting all your liabilities as well as your assets.

From the point of view of somebody who might be a bit keener on a bigger state and more intervention, the fact that you look at a broader range of assets is also important. You could borrow for a project like HS2 if you thought it was worth while. We would not have so much concern about Labour’s plans to spend £28 billion on green infrastructure if that was matched by the acquisition of an asset that offset the additional liability.

So I can see how this would appeal both to what you might call fiscal conservatives and to those who want to spend.

Q106 Lord Layard: Mr Jessop, you said that sustainability should not be thought of in terms of low default risk, because that is not there. So how would you define sustainability? Would it be in terms of what real interest rate you would have to pay on the debt? How would you define it? That is what our terms of reference are, but it would be helpful to have a definition from all three of you.

Julian Jessop: Of course, at the limit, sustainability just means that the debt-GDP ratio keeps rising and rising. In the end, default might be one option, but you would default because the cost of servicing that debt becomes too high, so you have to spend increasing amounts of money on servicing that debt by paying interest to the holders of that debt. So one form of sustainability is simply that the cost of servicing the debt becomes too high.

Another way of looking at it is that you would be crowding out too much private sector activity, because basically the entire financial system is dominated by government borrowing and the need to keep servicing that. Or you might find that the only way to keep the debt-to-GDP ratio down is to inflate the debt away, which might help the public finances but has all sorts of other costs to the economy if inflation is running consistently at 5% or 10% rather than 2%.

So in one scenario the problem might be that you have to default on your debt, but in the process of getting there there will be other things that will bite you first; as I say, it simply becomes too expensive to service that debt without having huge detrimental effects on the rest of the economy, and in private sector in particular.

Danisha Kazi: Disorderly outcomes like debt default are not really a worry for countries like the UK, because we have control of our currency. A textbook explanation of debt sustainability is that the costs of servicing the debt are equal to or below the growth rate, so we know that the tax base can be credibly dipped into to cover the future costs of servicing that debt. However, the current fiscal framework does not take account of all that; it is based on arbitrary targets. So it is important to think about what we are actually looking at now when it comes to our current fiscal framework for debt sustainability, as well as textbook examples.

Related to that, and we have talked about this, is having a longer-term view of what debt sustainability should be—a broader approach rather than the narrow fiscal targets that we have been given and which change quite a lot; they have changed six times in 10 years. We need to have a real conversation about that.

There are other approaches, such as the balance-sheet approach whereby we separate out day-to-day spending—the golden rule that is a good starting point for thinking about this—from longer-term investments in the economy, which generate income for the economy but also put us in a better position to withstand future shocks. The OBR is pointing right now to the fact that we are facing lots of uncertainty and potentially more economic shocks, so we need a conception of debt sustainability that goes beyond the current fiscal framework.

The Chair: Excellent. James?

James Smith: Debt is sustainable as long as the market can absorb it. That is frustratingly subjective. There is no one measure that will tell you when debt is perfectly sustainable. All the things that have been talked about will be indicators of it. The key point is that you do not want to increase your debt and borrowing to a point where it becomes prohibitively expensive for you to roll over your debt.

The Chair: Great.

Q107 Lord Lamont of Lerwick: Julian, you said that you were very sympathetic to the balance sheet approach, but it seemed to me that your first arguments against it were pretty much knock-down arguments: that it may be beneficial to the economy to invest in health or education, but the benefits are sometimes very difficult to quantify in monetary terms. This, I think, applies to an awful lot of public expenditure.

I have always—dare I confess it—been a bit sceptical of this argument about separating borrowing to invest and borrowing for current purposes. The dividing line is not so clear, and although one perhaps ought to give priority to investment, it is only when you see the benefits that you know the benefits are there. It seems to me quite a dangerous path to go down.

Julian Jessop: I agree. Even a simple division, as you say, between current spending and investment spending is difficult. For example, if you are doing a lot of current spending on healthcare or education, to what extent is that also an investment in the future? The particular problem we have at the moment with NHS waiting lists is an example of something that might be considered current spending but which clearly has important capital or longer-term benefits. It is a good example of where we sort of agree on the principles, but whether it would be an improvement in practice is debatable.

Perhaps the answer is simply to think about what your hierarchy of fiscal targets would be. At the moment, the single most important fiscal target is whether the debt-GDP ratio is lower in year five than it is in year four of a totally arbitrary time horizon based on forecasts that even the OBR would recognise are highly uncertain. Should that really be your top fiscal rule, or should it be something else, with other secondary or tertiary rules to back that up?

Q108 Lord Griffiths of Fforestfach: I would like to ask James a question that is a variant of the one Lord Lamont asked. It is really about the net worth rule. The point about having debt is that you need cash to pay interest on it. If you have a net worth rule and you are investing in education or national parks, you are not actually earning cash in order to pay it back. Therefore, although I can see the intellectual case for saying, “Yes, we have debt, and we’ve created an asset”, the asset frequently is illiquid, whereas the real issue with debt is that you need liquidity, much as if I have a mortgage and an income I need cash as a household to pay back my mortgage. So although I can see the intellectual case for making it, and it is very neat intellectually, in a practical way it does not help me very much.

James Smith: Every private company in the world is valuing its assets and liabilities. This is well within the wit of man to do. It is very odd that we suddenly drop any sort of sophistication in accounting when we are looking at the public finances. I do not worry a lot about that. How much does a tech company value its IP in terms of its apps and so on? That is a much harder conceptual question than, “If I build a bridge, how much is it worth?”

On your specific point about debt, debt does not measure cash either; let us be clear about that. If what you are worried about is how much cash you have to get out the door, you could use the net cash requirement as your fiscal target.

Lord Griffiths of Fforestfach: Is income not a proxy for cash flow?

James Smith: Let us look at the Government’s current target, which is debt excluding the Bank of England. What the Government have to do depends arbitrarily on how quickly the Bank of England is selling assets, and not even which assets it will sell but what the OBR interprets to be which assets it will sell. Any measure you have will have measurement issues, so it is wrong to say that debt itself is an absolutely pristine measure of what you need to issue.

I think you need to think about the purpose for which you are using your fiscal measure, what sort of policy you want and what you want to incentivise. That is the key question here.

Q109 Lord Turnbull: One of the disadvantages of the net worth rule is that it leaves out the biggest asset of the lot, the tax franchise, which companies do not have but Governments do. What really matters is whether that franchise is as good as they like to think it is, or whether it can vanish overnight. Really, the limit of sustainability is when taxpayers begin to revolt and will not back Governments that are charging them those taxes. It could be inflation if it goes on, but it is a political limit that will eventually prevent people going down that route when the tax franchise evaporates.

Julian Jessop: I strongly agree with that. It is interesting; looking at the figures that are published for public sector net wealth at face value, you would be absolutely terrified, because it is a huge negative number, which could lead some people to suggest that the UK is in some sense bankrupt. It clearly is not, because at the moment at least we have the tax base that can continue to service the financial liabilities that we have. One of the risks, of course, is that you continue increasing the tax burden and at some point arrive at a stage where it becomes counterproductive.

The Chair: We will come on to the tax burden in a second. Does anyone have anything specific to add to what Julian has just said?

Danisha Kazi: Recent history is a really good example for us here. We still have a lot of scope for how we manage our debt structure and debt financing costs. We have had the very recent example of higher inflation, and the Bank of England increasing interest rates by significant amounts in the last two years.

However, there were other approaches to how we could have managed this kind of inflation that did not necessarily involve aggressive interest rate hikes. Joined-up working in how we manage the debt structure and economic policy, and what we do with debt servicing costs could take us into a different direction that is much more sophisticated in managing our debt and does not require us to focus very narrowly on whether we can raise taxes, for example, the tax base.

Our approach to inflation could be very different when we know that the sources of inflation were not domestic; they were external sources. That would have really helped us with our debt servicing costs, because we would not have hiked interest rates up so much. That helps us to keep our debt sustainability much more in check.

It is really important for us to have a look at a different way of managing all of this, with joined-up working across our key institutions.

The Chair: Thank you.

Q110 Lord Davies of Brixton: First, I express a level of disappointment at the agreement between our witnesses; I was hoping for a bit more challenging there. I just want to focus on fiscal rules. They have become politically totemic, and parties brandish their idea of what the right fiscal rule is. Danisha has already cast doubt on this, saying that it is whatever they want it to be at that particular point in time. Do you think there is such a thing as an effective fiscal rule? What would yours be, and what would you really see it achieving?

Julian Jessop: Maybe I can be controversial here and say that personally I would junk the lot. I am not convinced that fiscal rules add anything. I know that they are supposed to boost credibility, but I have yet to meet anybody, even in the financial markets, who truly understands the current rules. As others are saying, they change all the time. The only real advantage of them, and this is perhaps why the Treasury likes them, is as a tool for fiscal discipline, because officials or Ministers can say, “We can’t do this, because it would break our fiscal rule”. That is already applying in opposition too; Rachel Reeves, I am sure, is already using that to clamp down on requests from potential spending Ministers.

My temptation, frankly, would be to junk the lot and come up with a set of economic policies and a set of forecasts produced by the OBR—I do not think the OBR is the problem; I think the fiscal rules are—that are presented to the markets and the markets decide whether they like them or not. That would be my preferred approach.

So I probably would not have a set of fiscal rules. If we had to have them, I think there is broad consensus on two things. One is that you need to separate out current and capital spending in some way. The other is that you need rules for debt that look at the longer term and do not create short-term incentives to bad behaviour.

As I say, though, my starting point would be to consider junking the whole lot.

Danisha Kazi: As everyone has said, the fiscal rules are very arbitrary. Even the OBR has said that they are increasingly being gamed by successive Governments, so the current set of fiscal rules are not fit for purpose. If we had to have one, a good starting point would be the golden rule that has been touted, which separates day-to-day spending from investment spending. We need to take seriously the challenges of investment in the future of the economy and our public services, challenges which the OBR has highlighted. They are important long-term issues that we need to deal with. We cannot kick the can down the road any further. The IFS has also said that it is crunch time and we cannot keep pushing these issues down the road.

Rules that do not bake in short-termism are really important. There should be democratic public debate on what those should be, but they should focus on long-term investment in our public services and our economy in order to make us resilient for the next set of economic shocks that are potentially around the corner.

We can take examples from abroad—Germany, for example, does not include its state investment banks in its public debt—and look at what other countries are doing to support investments in their public infrastructure, services and economy. We need to take these things seriously, because all these challenges will increasingly cost much more down the road than they do now. To avert those higher costs and take that more seriously now, we need fiscal rules that are fit for purpose.

James Smith: I will end this agreement. I think that fiscal rules are incredibly important, because they tell you what to expect from the Government’s fiscal policy. Fiscal policy is an economic policy tool. It works to a large degree in expectation. If people expect you to tax more, they will spend less in the near term. These things are not policy levers that we should think of as just somebody pulling them and there is a mechanical reaction at the exact moment when that policy lever is pulled. So fiscal rules tell you what the Government intend to do with their fiscal policy.

We saw, around the time of the mini-Budget, what happens when fiscal anchors, fiscal expectations, get lost. You can see adverse reactions showing up in volatility in financial markets, all that sort of thing. I think we can all agree that we want to avoid that. Having clearly set out fiscal rules helps to avoid that situation. The reputation of fiscal rules has been damaged by having some very poor rules that have been implemented badly in recent years, to be quite honest, but they are very important in setting out what you are trying to achieve.

Lord Davies of Brixton: I think the problem is that it could be argued that, in practice, they are inherently badly applied. It is good to have them in theory, but in practice they just do not work. Do you agree?

The Chair: You are getting some nodding.

Lord Davies of Brixton: Defend them a bit more.

James Smith: I think they are really important and they need to be applied properly.

Lord Davies of Brixton: They are a signal rather than a control mechanism.

Q111 Baroness Wolf of Dulwich: My immediate response when Julian said to get rid of the lot was positive, I have to say, but there are of course real drawbacks.

I have a couple of follow-up questions to this. One is whether fiscal rules are important. You have said that they are, because they allow you to know what the Government are going to do. However, as I am sure everyone in this room knows, the fiscal rules have changed constantly over the last 30 years. If you look at a chart of this, it is quite mind boggling. So, in fact, they do not tell you that.

First, would fiscal rules be much more useful if one had any sense that they were stable and would stay around for a long time? If so, how could you do that without getting into what I would call a German trap?

The second question is to Julian. If you do not have them—they are of course an enormously important tool of control within government: “No, you can’t spend on that. You can only spend on this”, and so on—if you got rid of them all together, what would you use as a substitute, assuming that you think that Treasury should maintain some level of control that is moderately coherent?

They are slightly separate questions, but all three of you may have views on both of them.

Julian Jessop: On the second question, as a former Treasury official—I know there are a number of experienced people on this in this room as well—I do think you need something that the Chancellor or the Chief Secretary can wave around. It could be something as simple as a general pledge in the manifesto that we will keep public spending under control and we will not increase the tax burden—just a general statement of that type.

However, once you start getting into specifics, you get all sorts of unintended consequences. A good example is that whenever somebody writes in a manifesto that we will not raise certain rates of tax—VAT, national insurance or income tax—we know that all that will happen is that they will shift the tax burden somewhere else, such as freezing personal allowances at a time of high inflation.

So the more specific you get, the more dangerous it gets. That is the particular problem that we have at the moment with the fiscal rules. I mentioned the ridiculous obsession between what happens to debt between the fourth and the fifth year of a Parliament. That is clearly a suboptimal outcome.

So I would hope that you could have some sort of general agreement that you will limit some sort of overall envelope for public spending, some overall concept of where the tax burden is going, without being more specific than that.

Danisha Kazi: I do not want to repeat stuff that has already been said, but the current fiscal rules have changed so much that the OBR itself says that they are being gamed. So we need a real conversation about what kind of fiscal rules will help us, or what kind of framework will help us to meet future challenges, and the goals that we want to achieve, such as debt sustainability, not just for current generations but for future ones. That means dealing with the challenges that we are facing—demographic and net-transition challenges, among other things. It is more a framework that lends itself to genuine debt sustainability and well-managed public services that look at the debt structure and the costs of servicing that debt. We might need to look at multiple things rather than just one fiscal rule that gets arbitrarily moved all the time.

We have to be honest about what is happening with these fiscal rules at the moment. They are a sort of throwback from the last 10 years, and it is worth saying that the debt level has been on an upward trajectory, regardless of multiple fiscal rules. We have to be honest about what is in front of us.

James Smith: We should not be surprised that fiscal rules change. The Government are using the fiscal rules to tell you what they intend to do with their fiscal policy, so when you have a lot of changes of government, you will probably have a lot of changes of fiscal rules. I think it is a symptom rather than an underlying cause of some of the fiscal problems that we are talking about, to some degree.

What would be ideal would be setting out a fiscal rule that says, as we have just been hearing about, “I want to build fiscal space in good times, and when bad times come along I’ll stop trying to achieve that and use fiscal policy aggressively to support the economy. Then I’ll come back to building more fiscal space when that’s over”. I do not think it is all that difficult to set out a set of rules that achieve that and give you a sense of what types of good fiscal policy you would have in different situations.

We at the Resolution Foundation have a proposal that tries to achieve exactly that. I can send that to the committee. Trying to give a clear sense of what you are trying to achieve with fiscal policy and how you are going to do it is, I think, signalling what good policy looks like, shaping expectations and providing a fiscal anchor. That is one of the biggest things you can do to reduce some of the risks we are talking about.

The Chair: Thank you very much.

Q112 Lord Griffiths of Fforestfach: My question is to do with the taxation system and debt. You have made it very clear that the current taxation system needs to be reformed, and that there are weaknesses in the system. I must say that, as I read serious commentators—the people who run the think tanks that you represent, yourselves, and so on—I get the feeling that the case for the reform of tax is also a case for the reform of a higher level of tax. I wonder what you think of that.

Secondly, at what point do you think that increasing the rate of tax or tax as a percentage of GDP has a detrimental impact on growth?

Julian Jessop: Again, it is a very good question. As a starting point, trying to measure the burden of tax as a single number is similar to the problems of measuring debt as a proportion of GDP, as we discussed earlier. It is probably the single best metric, but there are lots of problems with it. The tax burden in the UK is at a record high on our own terms, but there are plenty of other countries that have a higher debt burden, so it may not so much be the particular level that you are at but how quickly that changes over time. That is where the UK stands out; it has had a relatively rapid increase in the tax burden over the last 10 years or so.

I also think that the overall level of tax is only one of the metrics you should look at. There are two others. One is the complexity of the tax system—in particular, the marginal rates of tax that really matter, which create the behavioural responses that you may or may not want. So complexity is part of it.

The other part is consistency or certainty. One of the problems we have had over the last few years is the constant chopping and changing. The windfall tax on the excess profits made by energy companies is a good example of that. In principle, you could probably make a decent economic case for that if it were indeed a genuinely one-off tax, but it is constantly being expanded and increased, creating uncertainty.

In short, it is not just about the overall level of tax; it is about how much it is changing over time, the complexity of the tax system, particularly marginal rates, and the uncertainty or inconsistency—the impact you are having on business and household decisions if things are chopping and changing all the time.

Danisha Kazi: On the issue of taxation and growth, the important underlying principle there is that taxation needs to be fair and equitable among different groups in society and among current and future generations, so it leans back to the issue of debt sustainability in that sense. It is not surprising that we have a system that taxes labour and income much more heavily than wealth. I have to come back to this, because this needs to be looked at if we are going to look at a fairer and more equitable tax system.

We need more emphasis on how we can appropriately tax wealth. It is obviously a thorny issue but, in the UK, we do not tax wealth properly. The Office of Tax Simplification highlights this every year; it shows on a graph who takes the biggest burden of tax, and it is income and people in middle age, basically. After that, it tends to fall down, because certain groups have more wealth than others. We need to think about which different groups are taking on that burden. Something fair and equitable is also really important when we think of the tax base.

The evidence on how it affects growth is very ambiguous. You will get lots of different research and studies that offer a positive or a negative view. That sort of stuff needs to be taken with a pinch of salt. At the moment, we know that medium-term growth forecasts are weaker, so we might have to think about different ways of taxing the current population. That might mean looking at wealth, but also corporations. Another recent element is banks; they have had unearned windfalls from higher interest rates. We have talked about windfall taxes on the banks. They have higher rates from products because of interest rates, but also because, since 2009, the Bank of England has paid interest on bank reserves. We can look at these sorts of unearned incomes to make the system fairer.

The Chair: Thanks.

James Smith: I would not say that we automatically need more tax; we need better taxes. I agree with a lot of things that have been said; we have become too reliant on income from workers being taxed as the kind of key source of income. All sorts of taxes, particularly carbon-related tax—fuel duty, for example—need reforming for the new world we are in. Council tax needs reforming. There is a long list of reforms that you could do in the space, but I would push back on the idea that they automatically need to be higher. The conversation that needs to happen, for all the reasons we were talking about earlier, given the pressures on fiscal policy, needs to be: “What do we do less on in terms of spending in order to achieve the same or lower tax burden?” That is not the conversation we are having.

Q113 Lord Blackwell: However you raise tax, whether on capital or income, you are essentially talking about how much of output—GDP—is being spent by the public sector and how much is private consumption. That is both an economic decision in terms of the impact you think that has on incentives and growth, and a political decision in terms of the tax franchise and the acceptability of that.

Rather than focusing on a balance sheet, as we have been, would a simpler fiscal rule be to say that, whatever the judgment, we will keep public expenditure below 40% or 45% of GDP—pick a number that you think is the right judgment—because that provides the discipline that spending and taxes have to stay within reasonable bounds.

Julian Jessop: I at least would be sympathetic to that, as long as you allowed the number to vary over the economic cycle, to recognise that at some point public spending will have to take more of the slack than it would otherwise have done.

My own feeling is that that number could probably be a lot lower than some other people might think. Coming from a free-market perspective, I think there are relatively few things that the state can do that the private sector could not do better. If the Government are spending 40% of national income, that is surely more than enough to do the basic things they need to do. That would include, by the way, a decent welfare safety net and the various public goods like defence, flood protection, the basic elements of health and social care, and so on. But I find it difficult to understand why the Government need to spend more than about 40% of national income—or certainly more than 50%, as is the case in many European countries.

Q114 Baroness Liddell of Coatdyke: I am glad that we are beginning to talk a bit about growth, because I want to put a bit of emphasis on that. How important is it that the productivity puzzle is solved? We are told that productivity growth slowdown is unprecedented in more than two decades. How do you set that right? Last week, Professor El-Erian suggested the appointment of a productivity or growth tsar. Any ideas?

Julian Jessop: The first thing to understand is why productivity has slowed as much as it has. To understand the solution, you need to understand what has caused it. As I am sure you are aware, there are lots of different explanations for the productivity puzzle. Some people think it is a permanent structural shift, and there may be an element of truth in that. I think it is no coincidence that it started around the time of the global financial crisis—which was global, not just specific to the UK. I think it was partly something to do with the fallout of the global financial crisis. That resulted in a number of changes in the economy that were negative for productivity, so I would look to reverse those.

One is that we ended up in a very long period of very low interest rates, which helped to support growth in the short term but has been bad for productivity because it has distorted investment decisions and meant that a lot of so-called zombie companies have been kept going by cheap money, when it would be better to allow them to fail and for those resources to be diverted to more productive uses. There is a whole chunk of things to do with the legacy of the global financial crisis that the normalisation of policy will help to fix.

There are also other particular problems that, by and large, are to do with the state having got too big. There is a particular problem with productivity in the public sector. At least productivity in the private sector has continued to grow at a reasonable clip since the global financial crisis. The main problems have been in the public sector. There are lots of measurement difficulties there. I am not blaming people who work in the public sector for those problems, but we have a problem with public sector productivity that needs looking at separately.

There are a number of contributing factors there. One, ironically perhaps, is the fiscal rules that mean that the public sector is too dependent on the Treasury trying to meet its fiscal rules, which starves it of capital which it sometimes needs. There is a lack of competition in the public sector. More controversially, I think public sector unions are too strong. The culmination of all those things is that they are slow to adopt new technology and so on.

It is essential to fix the productivity problem. Part of it will solve itself, because it is the legacy of the global financial crisis, which is now finally working through the system, with interest rates back to normal, but we also need to look specifically at the public sector productivity problem.

Danisha Kazi: The issue of the productivity puzzle is huge. It is quite a large topic that relates to lots of different parts of the economy, public sector and private sector, and people have varying views on it.

Bringing it back to the specifics of this committee and the fact we are looking at debt sustainability, what can we do within the fiscal framework we set ourselves to address these issues? It really does come back to investment. Where the private sector has not been able to take on innovation—they tend to be risk-averse about making high-level investments in infrastructure or in the wider economy that support improving productivity—the public sector needs to be able to step in and provide that patient capital for innovation. We have lots of examples of where the state has provided the capital to boost the private sector. This also links into the productivity puzzle.

Although there are many pieces to this puzzle, one aspect for this committee is how we borrow to invest in a sustainable way so that we can improve infrastructure and public services. We are facing a period of the worst stagnation in incomes and living standards, which is linked to this productivity issue. We need to invest in our economy to improve these conditions so that we can have that positive impact on productivity.

It is a complex picture, and we cannot just pick up one element of it. The role of public finances is to look at how at we can borrow to invest efficiently to support improvements in productivity.

The Chair: Thank you. James?

James Smith: The short answer to your question is that it would be transformational for the productivity problem to be solved. If you returned yourself to the pre-financial crisis trend for GDP, you would be looking at spending 20% more—so something like £200 billion more spending. All the problems we are discussing suddenly look very different in that context.

This is the economic policy challenge of our time. The Resolution Foundation has just written a 300-page book on how to return to growth. I agree with a lot of the things that have been said by the other panel members. The key distinction I would make is that it is very popular to say that the UK does not invest enough: the public sector does not invest enough, the private sector does not invest enough, we are too volatile, there is no certainty.

I think that is true—we need to invest more—but we need to look harder at what has changed. I completely agree with Julian that the watershed here was the financial crisis. The UK has become a much less dynamic economy in that time. Workers move between jobs less. Firms are born and capital shifts between firms much less frequently than it did before the financial crisis. Thinking about that dynamism problem, and not just thinking about what is going on with investment, is key.

Above all, we really need a Government who take seriously the challenge of growth and bring that through all aspects of policy: grasping the nettle on trade, emphasising where the UK has real strengths—that means in the service sector, not getting nostalgic for past manufacturing. The key thing is thinking about our skills policy, our schools and regulation in a way that is coherent, that takes advantage of and leverages the strengths of the UK economy—not trying to do this in a piecemeal way in one-off initiatives. The big thing we need to drive faster growth is an entire strategy that is coherent.

Q115 Baroness Liddell of Coatdyke: The Economist has already pointed out that the Treasury—apologies to Lord Burns and others in the room who are connected with the Treasury—puts too much value on short-term savings over long-term outcomes. That seems to be a fairly structural problem. Do you agree?

James Smith: I think we are on record as saying that public investment in the UK is among the lowest of OECD countries, and the most volatile. The Treasury has repeatedly pulled the lever of cutting investment when they need to retrench fiscally. If that is the key bit that we are talking about—the long-term thinking and spending on growth; a lot of it is investment—that has been repeatedly cut. If we had continued spending at the OECD average on public investment, we would have something like half a trillion more public sector capital relative to the post-financial crisis period that we talked about, which would be transformational. I think there is some truth to that, and again the way we set up our fiscal policy is the problem.

Q116 Lord Londesborough: I am sort of wearing my private-sector background hat again, because although I absolutely take the point that the watershed for productivity was the financial crisis—the statistics clearly back that up—that was 2008, so we are 16 years on, and it does feel as though we are in an era of productivity at around 0.5%. That is up to 2020. In the last few years it has probably been lower than that. We will know when we have final data.

It raises a concern about whether we have a structural slowdown in productivity. Investment is usually the first issue raised, both on the public and the private side, but I wonder about labour supply, infrastructure and demographics. I would add that in the last 15 years we have had the digital transformation, which our chair touched on earlier. It appears to have made no difference at all to productivity, or possibly presented a downturn, and I do not think we will ever be able to disaggregate that.

How concerned are you about a structural slowdown in productivity, particularly if you look at the OBR’s assessment, where we are assuming a 1% increase in productivity per annum?

Julian Jessop: I am a relative optimist there. I am sure you are familiar with the concepts of the key drivers of secular stagnation being things like a backlash against globalisation or rising inequality, or diminishing gains from information technology. I tend to turn that around. I think that a lot of that is basically a bet against human ingenuity, and that we will be able to get further big gains from AI in particular in future. That has barely been exploited yet, in the public sector in particular, so I am probably more optimistic on that front.

There are some things that will change over time. Take regulation, for example. We are talking here about fiscal policy, but a lot of the things that you can do to boost the economy and improve the state of public finances in the longer term will not cost anything because they are about regulating the economy better. Usually that means deregulation, but not necessarily; it can just mean improving the existing regulations. There is a whole host of things that we could do to boost productivity that will not involve the Government doing more; if anything, they will involve the Government doing less.

Looking at the detail of the productivity performance since the global financial crisis, it is noticeable that some of the biggest slowdowns were in two sectors: financial services and the energy sector. Both have seen quite big increases in regulation for various reasons. Simply reversing that could make a big difference to productivity, and, as I say, that does not cost the Government anything.

Danisha Kazi: There is a structural issue underneath all this discussion about productivity and what has happened since the global financial crisis. It goes back to my earlier point about the way in which an explosion of private sector debt destabilises the economy and needs to be seen together with public debt. We saw private sector debt in the lead-up to the financial crisis peaking at 200% of GDP—that is an important figure—in around 2010, and it is still above 100% of GDP.

So the role of private sector debt and public sector debt needs to be seen in tandem. A highly leveraged private sector will not invest in the way we would hope. That is where the public sector comes in to support the private sector. Since the global financial crisis, we have seen a lot of investment funds being channelled to asset price inflation—obviously to house prices, but also to private assets in general. That money is not being directed into the productive economy. That is an important part of this puzzle. We need to see different measures used by government departments working together to channel investment funds towards the productive economy. That would really support productivity.

The Chair: Thank you. Lord Verjee has a question.

Q117 Lord Verjee: I harp on in this committee about vision. A lot of the time it seems that one of the biggest factors in our lower productivity is our heavy dependence on financial services pre 2008, and we are still recovering from that shock.

How can we change the wealth creation culture in our nation? I just came back from Taiwan, where I met the founder of the Taiwan Semiconductor Manufacturing Company. He is a man who created the industry 20 years ago and now the whole nation is thriving because of this one vision of investing in semiconductors. What can we do to change the culture of our country to think of wealth creation opportunities? Do you have any ideas?

James Smith: I think it is what we were saying earlier. It is having a strategy that focuses on our strengths. Services are the thing that really stands out for the UK. The UK is the world's second largest services exporter, which is absolutely amazing when you consider the size of some of the countries out there.

It is doubling down on those strengths and using trade and industrial policy to build on those strengths to help to rebuild our cities so that they allow services to thrive. That would be biggest thing to unleash that source of growth. It looks incredibly promising globally because of the services we sell. We should be proud of our financial services, but we should think about services beyond that. The services we sell are growing incredibly quickly globally and could be a massive success for the UK.

Danisha Kazi: We have a really good historical example. Since the post-war era, most countries use credit guidance policies to direct capital and funds to where they are needed. You talked about Taiwan. These Asian tiger miracles were based on strong industrial and credit guidance policies. Those are really useful tools that we can implement again.

There is a return of industrial policy. America, for example, is focusing more on those kinds of policies in its Inflation Reduction Act. That can help to unleash investment towards to productive sectors of the economy.

Julian Jessop: I will push back against that, because it sounds dangerously like the Government picking winners, which I think they are very poor at. The Government’s role should be to create the infrastructure, the environment, in which the private sector can decide what our strengths are going to be and let the market test it.

The examples of South Korea and other countries that did well are interesting, but their industrial strategies were more about creating the infrastructure that allowed the private sector to thrive, rather than directing capital into one area and not another. In terms of vision, my concern is that it implies that you—the Government or whoever—have that vision and nobody else does. I am a bit sceptical about that. It is better for the Government to have the vision of creating the most favourable business environment possible and letting the private sector get on with it.

The Chair: Great, thank you very much.

Q118 Lord Lamont of Lerwick: Can I ask the panel to comment on the structure of our national debt and its implications for short-term and long-term funding? By structure I mean things like index-linking the majority of our debt—of the gilts—and how far we are dependent on the kindness of strangers, on foreign ownership, if that is at all relevant.

Julian Jessop: On the structuring of the debt, there is a short-term problem that because of the way the Bank of England has been financing quantitative easing, our debt servicing costs are much more sensitive than they used to be to short-term interest rates. I think that problem will diminish over time as the Bank of England runs down its holdings of bonds and as short-term interest rates fall. I think the biggest short-term challenge in the structure of our debt is that the effective maturity of the debt is a lot shorter than it was previously.

The biggest long-term challenge is probably the other point you mentioned: we have a large proportion of inflation index-linked debt. I do not think that is necessarily a bad thing. It is driven partly by what the private market—the pension funds—wanted, but it does reduce the scope for the Government to erode their debt away by running a higher level of inflation than they would otherwise have done. Perhaps that is a good thing, but perhaps it is a bad thing.

On the kindness of strangers, that is a particular problem for the UK.

Lord Lamont of Lerwick: Is it really a problem?

Julian Jessop: I think it is, because the UK gilt market is small enough for people to run an underweight position on UK government bonds and for it not to be a big issue. Ironically, because there is so much Japanese government debt and US government debt and the pool of debt in the eurozone is so big, to go underweight on those is a bigger issue. So it is relatively easy for foreigners to decide not to invest in the UK.

However, that will not be a problem over the next few years. There has been a shift in sentiment towards the UK over the last year or so. We are no longer seen as such an outlier in economic performance or inflation, so I think the bond market vigilantes will be asleep for a while. There is a risk that at some point in the future the UK will be seen as a market that international investors can afford to ignore.

Danisha Kazi: The UK is quite unusual in having a greater proportion of longer-term maturity debt. A portion of that is the index-linked debt we talked about. There are short-term issues with that, which have been discussed, because of higher inflation and interest rates. Very bluntly, the OBR said that once the Bank of England has unwound its asset APF and as inflation comes down to target this year, those issues will be weeded out. I think the OBR predicts that that will normalise over time.

The Chair: Sorry, what do you mean by “normalise over time”? Paragraph? Paragraph 4.20 of the fiscal report talks about the issuance of debt being at twice the post-financial crisis average between 2023 and 2028. So this issue is not going away any time soon.

Danisha Kazi: Well, no. I think it has forecast that once the Bank of England unwinds its assets and inflation comes down, we will return to a normal level of risk compared to other countries. Right now, it is very heightened in comparison to other G7 countries in terms of our debt servicing costs, but that will return to a normal level.

The Chair: You are talking about the profile here returning to a normal level.

Danisha Kazi: Yes.

The Chair: Julian, do you agree?

Julian Jessop: Yes. Specifically, we have the advantage that we have a relatively long average maturity of government debt, or at least we did before quantitative easing took over and effectively shortened that maturity. Once QE has been unwound, we will be in a position where our debt is at a relatively long maturity compared to other countries’, so that is still a plus that we have in the locker.

Q119 Lord Lamont of Lerwick: That means that we have to reverse what has happened recently with QE. When you talk about unwinding, do you think that will just happen automatically?

Julian Jessop: As you know, they are currently selling back over £100 billion of gilts over the coming year. I assume they will continue at that pace, so they will be gradually unwinding that. That puts some upward pressure on gilt yields in the meantime, but that is being more than offset by the prospect of big cuts in short-term interest rates. If you are going to unwind the debt, then now, when interest rates are expected to fall, is probably not too bad a time to do it.

I agree that it is clearly a risk. There are many people on the more monetarist side—even more monetarist than me—who are worried about the extent of quantitative tightening and the impact that is having on the money supply numbers in the country.

James Smith: We are not well positioned for the shock that we find ourselves in—high inflation and high short-term interest rates—given the structure of our debt, but, as Julian is saying, that will ease over time.

On the kindness of strangers, the fundamental problem is that we do not save enough as a country. That is the flipside of needing to borrow from the rest of the world. We need to take that much more seriously. What types of policies allow people to build up pensions for retirement, and buffers for big and small shocks that they face? Many families are just not prepared for the sort of shocks that might hit, so there is an additional saving problem here that we need to grasp and address.

Lord Davies of Brixton: But that is because budgets are under pressure. You seem to be implying that they ought to be saving more. They cannot afford to save more.

James Smith: I am talking about a longer-term thing, not right now in the heat of a cost of living crisis. Now is not the time to max out your pension if you are struggling with eating and heating. The type of thing I have in mind is putting policies in place that encourage sensible savings, so that the next time something like this comes around there are bigger household buffers.

The Chair: Thank you very much.

Q120 Lord Layard: I want to ask you about our commitment to net zero. Is this in danger of involving us in unexpected extra expenditures, unexpected new taxes? What risks does it pose to sustainability?

Danisha Kazi: This is obviously a very important priority for the Government. We know that the effects of climate change are taking place now, with extreme weather conditions affecting supply chains and energy prices. We know we need to deal with these things up front. The Climate Change Committee has estimated that we need £50 billion a year between 2030 and 2050 to decarbonise the economy. Those are direct costs; they are not all the costs.

It is a huge challenge. It is a massive structural shift in our economy. There is no shying away from that. We have to be honest about that. We also have to be honest about the role the private sector plays in that. The recent Stern review estimated that the public sector should contribute at least £26 billion a year. These are very large sums. The contribution between the public and private sector might need to be discussed. There may be institutional ways in which we can determine what that balance between the public and private sector should be, but up to now the problem has been that relying on the private sector is not taking us to the scale and speed at which we need to make these changes.

I will leave that with a figure that the OBR put forward a couple of years ago: that early action on the transition to net zero would increase our public debt by 20%, but no action at all could increase it to around 300% by the end of the century. Taking on those costs now will avert higher costs much later down the road. How we do it, and the balance between the public and private sector, should be democratically decided and discussed. But there is no kicking the can down the road on this issue any more. It needs to be taken seriously.

Julian Jessop: I agree. It is another huge issue, and there are potential costs on both sides. On the one hand, there is doing too much and wrecking the economy, but on the other hand if you do nothing and the economy gets ruined by climate change or whatever, that carries big costs as well.

A lot of this can be done in ways that are fiscally neutral or potentially even fiscally positive. I am a big fan, as you know, of using market mechanisms to do this. Rather than subsidising activities, which potentially costs the Government a lot of money—you end up wasting a lot of that money as well—use pricing mechanisms like carbon taxes, which in the short term actually boost the public finances, because, before people fully adjust, you are raising more money from activities that have a negative impact on the environment. A reliance on market mechanisms should help to protect the public finances.

Secondly, on the wider impact on the economy, when we talk about net zero, it is not just about reducing the amount of emissions; it is also about extracting those emissions when they have been produced. I would be a big fan of looking more closely at things like carbon capture—things that can achieve your net zero aims without preventing people necessarily from doing all the things they are doing at the moment that boost economic activity, but which in the process create carbon emissions that you need to extract.

James Smith: I would agree with a lot of that. It is clear that we need to spend a lot, particularly in investment, to deliver a path to net zero along the lines of the commitments we have already made. It is not obvious how much of that needs to be spent by the Government. It need not be absolutely ruinous for the Government to set longer-term policies on a track that makes it clear that we are moving to a net zero transition over a clear timetable, with the Government catalysing spending and that transition in areas where they are providing the networks—particularly the electricity network, I suppose—and setting in place the conditions you need for a fast transition. That is what we have heard already.

Where I would add to what has been said is that we have made a lot of the low-hanging fruit changes here in our overall electricity system. The next steps involve transport, thinking about what businesses are doing, and most of all what is happening to our housing stock. All of these become much harder problems. It would be great to have a frictionless carbon tax that delivered wonderful outcomes here that moved us swiftly to net zero, but unfortunately the reality is that that would involve slapping huge costs particularly on low-income households. If you do that through energy bills, that is proportionately a bigger hit for low-income households, because they spend a bigger share of their income on energy, and you do not want to do it through the tax system, because, as we have discussed, nobody is talking about expenditure on the type of scale that we are talking about here. That would involve a massive increase in taxes.

Addressing that distributional problem is the next big front for the net-zero transition.

The Chair: Thank you.

Q121 Lord Razzall: Clearly, the British economy does not exist in a vacuum, and we are witnessing huge geopolitical developments at the moment that are feeding into economic changes throughout the world, whether we are talking about the effect of the Ukraine war, the war in Gaza, what is happening in the Red Sea, Chinese pressure on Taiwan, mass migration from Africa, people wanting to come and live in Europe.

Bearing in mind all these developments, do you alter your views on the likely sustainability of UK debt?

Julian Jessop: On the short-term geopolitical risks, the main thing that people are talking about is the additional disruption to supply chains from the events in the Middle East and elsewhere. That does, at least, appear to be significantly less than the disruption that occurred during the pandemic; there have been increases in shipping costs, for example, but they are nowhere near as big as those that we saw during Covid. Obviously, there is no good time for these sorts of things to happen, but because global trade is weak in any event, they will probably not be too disruptive.

On the bigger issues, I tend to try to stick to my knitting. I am not an expert on the geopolitics, but in the financial markets there are two things to look out for. One is the possible erosion of the dollar’s status as the global reserve currency. If the US has to start paying much higher interest rates to service its debt than it did before, that will have big knock-on effects on interest rates and competing bonds, including UK government bonds. So that is one thing to watch. That is a very glacial shift, but it could be a big geopolitical risk if the dollar loses that status.

The other thing, which is a bit narrower, is what is happening in Japan. Japan is slowly edging towards normalising monetary policy there and, at some point, will raise interest rates towards what we would consider more normal levels. Again, that would mean that there are higher yields available investing in Japanese government debt than there are—

Lord Razzall: Am I not right that most Japanese debt is funded by the Japanese themselves, historically?

Julian Jessop: Historically, yes, because the yields have been unattractive to foreign investors, so it has just been the domestic investors buying them, because why would a foreign investor invest in zero-yielding Japanese government debt? If that changes, that is another challenge to the UK, which feeds back into the kindness of strangers problem.

Danisha Kazi: There are a lot of uncertainties. Obviously, the geopolitical picture is very uncertain, but I would argue that, even as that potentially eases up, there are still issues such as how climate change will affect our supply chains. We know that it is really affecting agriculture, food prices, energy prices. That still presents a challenging picture for us.

On the sustainability of our public finances, I would bring this back to how well our economic institutions are managing the structure and the costs of debt. There could be a lot more working closely together to manage that effectively for the public. Better co-ordination between the Treasury and the Bank of England on those issues is really important.

A second element is the need to focus on long-term investments. If we are going to borrow, it should be for long-term investment to create resilience against these shocks. As we have been discussing, there should be a fiscal rule about that and a framework to support that.

James Smith: To the comments I made earlier, if you look at the path of debt that we are on and think about whether it is okay to continue down that path and end up with debt rising in the years to come, you might think that maybe the next 15 years will not be as bad as the past 15 years. I think there are reasons to be optimistic that that is true, but from the list that you came up with it is clear that the world is not a warm, fuzzy place in which shocks are pretty unlikely. We are seeing fragmentation of trading structures, political risk, the end of the peace dividend, all of which feeds into a need to be even more conscious and mindful of building fiscal space.

Q122 The Chair: Do you think we should be focusing more on US debt as a potential risk to our own debt sustainability, if it continues to clock up, certainly in terms of debt interest? I see that debt interest now exceeds defence spending in the US. Is that right?

Julian Jessop: Yes. I am worried about the US financial system and the US economy. Indeed, I think the IMF has flagged up concerns about this too. Obviously, in the short term, the US economy looks very strong, but that is being driven essentially by two things. One is a big fiscal expansion. The other, which is not unrelated to that, is that US consumers have been relatively enthusiastic about running down the excess savings they built up during the pandemic, so they have been willing to be the world’s consumer of last resort.

So the numbers have looked good, but that may well change. When the US economy cannot continue at this current pace it will turn down sharply at some point, and at some point people will lose their appetite for holding enormous amounts of US government debt. If you look at the US financial system more generally, the stock market has been very strong, but that has been dominated essentially by seven high-tech companies whose valuations are plucked out of thin air. So there is a risk there too.

So there are a number of things that could go wrong in the US, and geopolitics plays into this, with Russia, China and Middle East countries being less willing to hold US assets—for different reasons, but all pointing in the same direction. So, yes, I would be concerned about the US, and if the US suffers, that will have a big impact on our financial markets.

Q123 Lord Razzall: Is Chinese investment in the US coming down now?

Julian Jessop: They have the problem that they have built up so much US government debt as holders that they cannot get rid of it, because doing so would cause such a big fall in the price of their remaining holding. So, in a sense, they are trapped there.

Lord Razzall: They are not buying as much as they did.

Julian Jessop: They are not buying as much. More generally, the incorporation of China into the global economy had a big downward effect on global inflation, but that has now levelled out. So there are lots of things to look for when it comes to what is happening in China.

The Chair: Very good. Thank you all very much. That was an extremely good session. We have covered a lot of ground, and we thank you for all your very comprehensive answers.