More austerity is precisely the wrong response to this crisis. What is the right one?

Austerity didn’t cause Covid-19. But the pandemic has thrown into sharp relief the misplaced sense of priorities of those who have governed us since 2010. The idea that the best measure of the country’s preparedness for a crisis—health, economic, or indeed any other—is the size of its fiscal deficit or its national debt was always absurd. Now the Sunday Timesinforms us of the grim reality of what that meant in practice: “We were the envy of the world… but pandemic planning became a casualty of the austerity years, when there were more pressing needs.

But while the policy errors of the austerity era are now obvious to all, what does that mean for economic policy when the crisis has passed? One thing is certain—we will have a much higher national debt. The Office for Budget Responsibility estimates that our debt-to-GDP ratio will rise to 95 per cent at the end of this financial year. But this assumes a sharp, V-shaped recovery. By contrast, a more realistic assessment from the Resolution Foundation projects increases to well over 100 per cent of GDP on the most optimistic scenario, while on an—admittedly very grim indeed—assumption that the lockdown lasts for a full year, it rises above 160 per cent.

Fortunately, this already seems implausible, as we, along with most other European countries, are beginning to formulate a phased approach to ending lockdowns. But, even if the worst does not materialise, there is no question that debt and the deficit will rise at unprecedented speed. And there will be some who insist that, when the crisis passes, the remedy is yet more austerity. Yet worrying about the size of the debt or deficit misses the point, and risks leading policy astray, just as it did in 2010. Instead, the government needs to focus on two issues in formulating its economic plan.

The first true policy dilemma will be demand management. And here the uncertainties are huge. A “normal” recession—and in this sense the financial crisis, extraordinary in many ways, was still “normal”—is caused by a fall in demand, and the economic response (monetary, fiscal or both) is to increase demand by reducing interest rates, cutting taxes, or increasing government spending. Here we have the complete opposite—a deliberate reduction in the supply capacity of the economy, imposed for health-related reasons. So there’s no point in worrying too much about demand now.

But when the affected sectors reopen, what will happen? Will we face a “normal” recession, as unemployment remains high, nervous households hold back on spending, and businesses fear to invest? Or will those of us—the majority—whose incomes have held up well, either because we can still do our jobs or we’ve been furloughed, want to spend the money that we’ve saved during the lockdown period? If the latter, we might actually see excess demand—particularly if some of the supply capacity of the economy has disappeared for good—resulting in higher inflation and interest rates.

Right now, we just don’t know. But the good news is that either way, the implications for fiscal policy are clear. If—as seems most likely—consumer and business spending is depressed, then the last thing we should worry about is the deficit. Even in a normal downturn, the right prescription would be—as we learned after 2008-09—for the government to keep on spending. The case for that is even stronger if the lack of demand is driven, above all, by fear and uncertainty. Meanwhile, such a deficit should be relatively easy to finance, since by definition the fundamental cause of low demand would be high levels of private savings by risk-averse households and businesses. That saving needs to go somewhere, and if it does not finance private investment then, directly or indirectly, it will finance government spending, meaning the government is likely to be able to continue borrowing at very low interest rates.

What if the problem is the reverse—too much spending? Compared to the alternative, this would be good news for the economy. Indeed, a period of excess demand, pulling people back into the labour market, raising wages, and perhaps even boosting productivity, might be exactly what we need. But it would make managing large deficits harder. In particular, interest rates on government debt would rise, perhaps sharply. Fortunately, inflation is good for government finances—revenues rise faster than expenditures, and the real value of outstanding government debt falls. Nevertheless, taxes would have to go up considerably sooner in this scenario.

Getting short-term macroeconomic management right will be important. But even more vital is to minimise the long-term damage done by the crisis. Some simple arithmetic illustrates the point. Suppose that the lockdown does indeed reduce output by 35 per cent for three months, as the OBR assumes. That’s a bit under £200bn, or 9 per cent of annual GDP, and an increase in net debt of £260bn. Bad, but what about if—as the Resolution Foundation assumes, under its most optimistic scenario—there’s a *permanent* hit to GDP of 3 per cent? Even under very conservative assumptions about how to discount the value of future incomes, the damage to the UK’s economic welfare would be at least ten times as great.

Similar arithmetic applies on the fiscal side. At current yields we can finance an extra £260bn of debt for less than £2bn a year. By contrast, a 3 per cent permanent hit to GDP means at least a £35bn a year hit to the public finances. The implication is clear. We should be willing to endure a considerable amount of short-term economic pain, and spend almost any conceivable amount of money, if it avoids long-term damage to the supply side of the economy.

During the crisis itself, that means, as I and others have written, preserving businesses and jobs, even if the businesses are closed and the workers at home. That will be the easy bit. As the restrictions are eased, it would be easy to withdraw support too early—to save money or to try to show that things are getting back to normal. But there’s also a risk of doing so too late, and propping up businesses that simply won’t be viable in the medium term.

At the same time, new forms of support—perhaps most importantly, a return to the active labour market policies that have largely been abandoned over the last few years—will be required. We’ll obviously need to spend more on the NHS, but this would also be the right time to reconsider other policies, such as the punitive and divisive approach to the benefit system that has characterised the last decade. None of this will be easy; and all of it will cost money. Some of us—especially the better off, and people like me and, I’d guess, most of those reading this, whose incomes have held up well during this crisis—will need in due course to pay more tax. But this time we should focus not on short-term fiscal targets but rather on building a genuinely resilient economy—and society.