Like many developed economies, Britain faces a paradox: it has too many fiscal rules and too little purpose. Its fiscal watchdog keeps an eye on the numbers, but no one is keeping an eye on growth. Innovation has become a slogan, not a strategy. Institutions designed to ensure prudence have become an obstacle to progress.

Chancellor of the Exchequer Rachel Reeves’s self-imposed fiscal constraints illustrate the larger problem. They will deter productive investment, especially in innovation, even though increasing government borrowing to fund public research and development would not break the rules.

Making matters worse, the Office for Budget Responsibility (OBR), the country’s fiscal watchdog, clings to implausible assumptions about productivity trends, while overlooking what the recipients of this year’s Nobel Prize in Economics (Philippe Aghion, Peter Howitt, and Joel Mokyr) have shown: disruptive innovation, properly nurtured, is the wellspring of long-term prosperity.

Despite all the recent commentary about the “fiscal hole” created by the OBR’s upcoming productivity downgrade, few have noticed a larger problem. The OBR is assuming that the effects of most government policies on productivity vanish after five years. That is simply indefensible.

Recent evidence from the US shows that government spending can have both significant and persistent effects on output and productivity. When governments invest in R&D or infrastructure, the economic gains are realised not over quarters or even electoral cycles, but over decades.

The OBR’s short horizon reflects a deeper error. Productivity is treated as an external, policy-independent trend – in keeping with what economists call an exogenous growth model – implying that innovation, education, and R&D appear as residuals of progress, not as its engines. But Aghion and Howitt’s endogenous growth theory has overturned this view, demonstrating that productivity is shaped by policy, institutions, and ideas.

The OBR’s assumption that fiscal policy’s impact on productivity fades after five years effectively erases the link between government investment, innovation, and long-term growth. Yet as Mariana Mazzucato and William Janeway point out, many of the technologies that have defined the modern economy – from semiconductors to the internet – were seeded by public investment in basic research, later amplified by private enterprise.

A country whose policymakers rely on models that assume away innovation cannot hope to achieve it. Britain’s challenge is not fiscal capacity but institutional imagination. My own recent empirical work on the US quantifies the macroeconomic returns to public and private R&D investment, which can be used to generate productivity projections within a framework analogous to that used by the OBR. My co-authors and I find that a permanent 1% increase in R&D investment in the whole economy raises productivity (and thus GDP) by about 0.18% over a decade.

Moreover, our estimates suggest that, in Britain’s case, £1 ($1.32) of additional public R&D investment crowds in between £0.57-1.03 of additional private R&D. So, to achieve a 1% increase in R&D investment for the whole UK economy, public R&D expenditure would have to increase by £360-460mn per year, a rise of 2-2.6%.

These findings demonstrate that public spending on innovation generates durable productivity gains well beyond the five-year horizon embedded in the OBR’s models. And other research has reported similar findings for the US and for the UK.

For its part, the Congressional Budget Office, the American equivalent of the OBR, has embraced Aghion and Howitt’s model, stating that:

“In contrast with the national income accounting approach and on the basis of published studies of the US economy, CBO estimates that an additional dollar’s worth of infrastructure capital increases real potential (maximum sustainable) GDP by 12.4 cents, on average... Increases in federal spending on physical infrastructure, research and development, or education would boost private-sector TFP [total factor productivity] in the coming decades, contributing to economic growth that could lower the budgetary cost of that spending.”

Ignoring the long-run effects of both government-funded and privately funded innovation leads to systematic underestimation of potential output and fiscal headroom. A fiscal “hole” can appear or disappear not because policy has changed, but because one’s assumption about productivity has. This is not fiscal discipline; it is a fiscal illusion. Britain’s institutions, designed for prudence, have become prisoners of their own short-term calculus.

To restore credibility and a sense of purpose, the OBR’s independence must be matched by intellectual openness. One reform would be to establish an independent rotating panel of academic experts in macroeconomics and public finance who review the OBR’s framework every five years or so and issue methodological recommendations. Transparency about modelling choices is as vital as transparency about fiscal data.

A separate but complementary reform concerns how the OBR communicates uncertainty. At present, it focuses on a single point estimate of future potential output, which then immediately becomes a numerical constraint on how much the government can spend. This approach mistakes precision for prudence. A better method would be to mirror the way the Bank of England conducts and communicates monetary policy, namely with fan charts that show a range of possible productivity, output, and debt-to-GDP paths over a ten-year horizon.

Under this reformed fiscal framework, the government should be required to act only when current or proposed policies are projected to push fiscal sustainability outside the guided ranges. In other words, fiscal policy should respond to genuine risks, not to decimal-point revisions.

The power of public policy to raise productivity may be difficult to quantify, but it is real. If Britain wants to recover a spirit of enterprise, it must escape the tyranny of short-horizon policymakers who are constrained by the next fiscal event. Prosperity will not come from ever finer rules or ever gloomier forecasts. It will come from the courage to invest, to innovate, and to imagine again what Britain can achieve. A country that guards only its guardians risks guarding nothing at all. – Project Syndicate

 

  • Paolo Surico is Professor of Economics at London Business School.