Can governments afford the multi-trillion dollar clean transition required to meet climate targets? The safest way to restore health to the public finances, says Dimitri Zenghelis, is to target specific investment in properly measured assets that generate economies of scale in production and discovery, and drive long-term growth.

Budget deficits across the world ballooned during the Covid pandemic and public debt as a percent of output has attained new highs in many countries. To compound the issue, rising interest rates have subsequently pushed debt servicing costs higher, requiring additional borrowing to pay off the interest. Policy interest rates in leading economies have risen to more than 5% from around 0% in less than two years. At the same time, ageing populations are putting pressure on healthcare bills while the invasion of Ukraine and increased tension between the US and China has prompted policymakers to increase defence spending.

What do these immense budget pressures imply for another global imperative: the net zero transition? Climate change and natural capital degradation threaten public finances and, in poorer countries especially, increases sovereign risk of default. But can governments afford the multi-trillion dollar clean transition required to meet climate targets? Recently, the US Inflation Reduction Act committed $391 trillion over a decade to support clean growth while in the UK, the Labour Party promised to ramp up public spending on green tech to £28 billion a year by 2030 if it comes to power. Meeting these commitments in an environment of constrained fiscal space and concerns about public debt sustainability will be challenging.

There are only four ways to improve debt sustainability as a proportion of GDP (gross domestic product). The options, set out in Table 1 below, involve either a nominal restructuring, through debt default or higher inflation, or a real restructuring through tightening the fiscal screws or boosting growth in GDP. Of these only the latter two ‘real’ options are sustainable.

It has been demonstrated that the collective drive towards fiscal austerity in large economies since the great financial crash of 2008 throttled productivity-enhancing government investment, thereby making the debt-to-GDP ratio higher. Furthermore, after years on underinvestment in  public services these countries have little appetite for a further bout of fiscal austerity.

Table 1. Options for reducing the public debt-to-GDP ratio
Reduce numerator (debt)Default, restructure or creditor “haircut”
– Cost to economic reputation
– Increased future borrowing costs (default premium)
Austerity (cut spending/raise taxes)
– Taxes up/public spending down
– High cost to the economy and society
– Can be ineffective (because of denominator effect)
Increase denominator (GDP)Inflation
– Effective, but at economic cost
– Hard to restore monetary credibility
– Uneven distributional impact on society
– Increased future borrowing costs (inflation premium)
Growing the economy and raising GDP
– Effective if sustained
– Positive impact on numerator by raising net public revenues
– Positive for the economy and society

Whether to focus on austerity or borrow to stimulate growth will depend on the scope for expansionary fiscal policy to generate so-called growth multipliers, where the economy expands by more than the additional borrowing, with the policy thereby potentially paying for itself.  

Three years ago, we advocated just such a fiscal stimulus recognising that short-run and long-run multipliers were aligned, positive and greater than one. Back then, there was spare capacity in the global economy and excess saving by nervous households and business. Today, the outlook is more complex.

In many countries, labour markets are tight, capacity is constrained and inflation remains stubbornly high. In such circumstances, additional public borrowing is likely to crowd out scarce private investment. Moreover, central banks can be expected to respond by pushing policy rates higher to offset any additional demand in order to control inflation, thereby obviating any GDP impact and aggravating the cost of interest on public debt.

Yet the evidence increasingly suggests long-run multipliers from targeting public investment in clean growth sectors are likely to be strongly positive. Both the risks associated with locking into high carbon infrastructure and the opportunities associated with developing clean markets, have been shown to be much higher than economists previously suggested. Even fractionally higher productivity growth will compound over years to make the economy significantly larger swamping other drivers of debt/GDP. To put this in perspective, the US and EU economies were of similar size at the time of the 2008 global financial crash. Now the US economy is more than a quarter larger than the EU and the UK (both of which applied much tighter fiscal policies), primarily because of stronger US productivity growth in the interim.

There is a clear role for the public sector to stimulate investment in new technologies and behaviours, which improve the efficiency of the economy and drive productivity. The competitive economy of the twenty-first century will be based on getting more out of the resources we have, and rely less on carbon- and resource-intensive production. But it requires early investment in a range of future-proofed assets.

As I have argued before, there is no shortage of global saving. Real interest rates remain around or below zero and investors are hungry for positive real returns. But unlike policies seeking to stimulate demand in the short run, fiscal policies to restore long-term growth must be targeted towards specific investment in properly measured assets that generate economies of scale in production and discovery.

Not all demands on the public purse can be funded by borrowing, and tax revenues will need to rise, but those which spur productive investment can. Moreover, it may not require huge public subsidies to support deployment and innovation. Resource and carbon pricing (which raises public revenues) and tighter standards or regulations are highly effective in shifting private activity. By contrast, inaction in a rapidly changing economy is likely to prove costly to economic competitiveness and financial resilience.

Higher inflation has recently eroded the real value of public liabilities (pushing them onto bondholders), allowing global public debt-to-GDP to fall from its 2020 peak and generating unexpected fiscal space. Italy’s debt-to-GDP ratio, for example has fallen seven percentage points in the year to 2022 Q3, while that of the US is estimated to have fallen 20 percentage points from its pandemic peak. What matters is how that space is utilised.

There is clear evidence that sustainable, inclusive and resilient growth is the most secure and least risky way to address public sector indebtedness over the medium term – even though the short-term challenges are genuinely daunting.

This commentary was first published by the Bennett Institute for Public Policy at the University of Cambridge on 27 June 2023.

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