Christopher Smallwood: We're in desperate need of new roads and railways – so let's borrow while we can

Borrowing to invest is an attractive option when interest rates are so low
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The Independent Online

As the dust settles on the Autumn Statement, two things are becoming clear. The economic outlook is far worse than the Chancellor imagined when he put his strategy (Plan A) in place last year. Not only have the growth forecasts for this year and next been revised down to nearly nothing, but the upturn pencilled in by the OBR for succeeding years also looks a long shot, assuming, as it does, that the eurozone's problems will quickly be resolved. A period of stagnation lasting for several years seems distinctly on the cards.

Should this prove to be the case, unemployment will continue its remorseless rise, the objective of eliminating the current structural deficit will slip steadily out of sight, and a different type of approach will be needed to get the economy out of the mire.

In this event, there will be no point in announcing further tax rises or spending cuts; these would delay recovery still further. What will be needed is a major and sustained fiscal stimulus of the sort Keynes advocated in the 1930s. The key question is how this could be delivered without adding to the underlying deficit.

Ed Balls has said he favours cuts in VAT. Tory backbenchers prefer income tax cuts. The problem with both proposals is that they would add further to the debt mountain. If the Government is to borrow more, as Labour wants, it needs to use the extra funds borrowed to invest in profitable investment projects.

It is vital to get rid of the "current structural deficit" as Plan A envisages. Once recovery has taken place, the Government should not still be borrowing to finance current spending. Borrowing for investment, however, is a different matter, and it is an attractive option when interest rates are so low. As Joe Stiglitz, a Nobel Prize winner in economics, points out, profitable capital projects earning rates of return for the Government higher than its borrowing costs pay for themselves over their lifetime, and, hence, do not add to the underlying deficit.

In a rational world, the Government would undertake as much of this type of spending as necessary to return the economy to full employment, while continuing to pursue Plan A to eliminate the underlying current deficit. There are many possibilities, some of which were mentioned in Mr Osborne's statement. There could be direct public investments, for example, in motorways delivering reliable returns from tolls. The Government could invest in the major utilities, all of which have long lists of projects disallowed by regulators wishing to restrict price rises to consumers. It could make loans for huge infrastructure projects like the Thames estuary airport, provided that the returns offered exceeded its cost of borrowing. Critically, all this extra activity and associated tax revenues would actually accelerate the achievement of Plan A, strengthening the underlying budgetary position.

Ministers, however, are petrified that any deliberate rise in borrowing would be interpreted by the markets as a weakening of resolve, leading to a loss of confidence and soaring bond yields. They don't believe that the markets could be convinced to see public borrowing in two separate boxes: one marked "for investment" and the other "for consumption". So the Treasury has come up with all sorts of ingenious ideas to stimulate investment without increasing public borrowing.

One approach is to use private rather than public finance as far as possible. Mr Osborne's national infrastructure plan envisages pension funds paying for lower- risk projects offering reliable income streams. The Government would also put in cash to finance projects which would achieve an adequate return, although this would be offset by cuts elsewhere. Toll roads are ideal, but there are solid projects – rail, power stations, ports, IT – across the whole regulated sector.

A second approach is to provide loan guarantees to underpin bank lending to small and medium-sized companies (SMEs), so enabling the interest they pay to be reduced.

The infrastructure plan in its present form may well disappoint: in reality, the proposals are at an early stage. The pension fund industry has yet to be convinced to commit substantial funds to infrastructure projects, and Government spending here will be matched by cuts elsewhere. As for the "credit easing" plan, the banks say repeatedly that they already finance 80 to 90 per cent of SME loan applications. The prime need is for more demand. And, of course, the impact of the proposals is already captured in those disappointing forecasts.

If, as I suspect, the performance does not live up to the billing, the Government must be more courageous, straightforwardly issuing long-term gilts to finance long-term projects in an urgent programme to re-equip Britain. The country desperately needs new roads, high-speed rail, Boris Island and the rest. The truth is we can easily afford it all, with interest rates now lower than Germany's – effectively almost nothing.

Ministers need to explain to the markets that borrowing to finance profitable investment does not undermine Britain's finances; it may indeed be the only way now to achieve the central target of eliminating the underlying budget deficit.

Christopher Smallwood is a former group economic adviser to Barclays