This may sound like heresy to many economists, not least my former colleagues at the Treasury, but I’m coming around to the view that fiscal rules are overrated. Of course, fiscal credibility is important and must be protected. But fiscal rules are often more of a hindrance than a help.
For a start, rules on borrowing and debt have been broken so frequently that it’s not obvious that yet another iteration would work any better. Indeed, as the IFS has also observed, 10 of the 12 fiscal rules adopted between 1997 and 2016 were subsequently missed or abandoned. The track record of Conservative governments here is at least as bad as those of Labour.
Fiscal rules also often include escape clauses. These are usually based on sound economics; for example, Portes and Wren-Lewis have proposed a ‘knock out’ when rules would be suspended if interest rates are near zero. However, anything that allows the government to slip free could undermine credibility further.
Even if the fiscal rules are obeyed, this can often come at a significant cost. Successive administrations have tried to find cunning ways to get around these constraints. One notorious example was the use of expensive Private Finance Initiative (PFI) contracts to keep spending off the government’s books.
And even with the best intentions, fiscal targeting is relatively hard. The credibility of monetary policy has been strengthened by the setting of simple inflation targets that are easy to understand and which have helped to anchor inflation expectations. However, tracking and predicting the public finances is much more difficult.
That said, I wouldn’t go the whole hog and abandon fiscal rules completely. UK government debt has been much higher in the past: public sector net debt peaked at 259% of GDP in 1946-47. But current levels of more than 80% of GDP are still pushing our luck, especially given the longer-term pressures from an ageing population. While interest rates are currently low, it would be unwise to assume that they will remain low for ever.
The issues also go well beyond the relatively narrow question of whether the public sector can afford to finance its spending and debt. Unless you believe in magic money trees, a pound spent by the government is a pound that cannot be spent by someone else.
The challenge is therefore to design credible fiscal rules that are sufficiently realistic and flexible to be achievable, without being so loose that they might as well not apply at all. Needless to say, there have been many attempts at this. The most influential recent example was a 2019 report by the Resolution Foundation, which made proposals adopted, at least in part, by all three major political parties.
So where are we now? The Conservative Manifesto stated that ‘we will not borrow to fund day-to-day spending, but will invest thoughtfully and responsibly in infrastructure right across our country in order to increase productivity and wages. Our fiscal rules mean that public sector net investment will not average more than three per cent of GDP, and that if debt interest reaches six per cent of revenue, we will reassess our plans to keep debt under control’.
Dealing first with ‘day-to-day’ expenditure, it does feel right that current taxpayers should pick up the bill for current spending, rather than add this to the debt burden for future generations. But this could still be interpreted more flexibly. Government sources (presumably No.10) have suggested that the target of balancing the current budget should be judged on a rolling five-year basis, with a tolerance of plus or minus one per cent of GDP.
This would be less ambitious than the objective set out by Sajid Javid in November, when he said that the current budget would be balanced no later than 2022-23. That deadline was not stated explicitly in the Tory manifesto, although it did make it into the accompanying Costings Document.
Nonetheless, it does make sense to target the budget over a number of years, rather than just one. This would allow for fluctuations in the economic cycle and for the unpredictability of the public finances from year to year. Given this additional flexibility, however, allowing further wiggle room of plus or minus one per cent is harder to justify.
In practice, of course, governments are likely to make the most of this extra space, meaning that current deficits of one per cent of GDP would become the norm. In turn, this could allow the government to borrow an additional £25 billion a year for day-to-day spending.
How big a deal this is will depend in part on what happens to borrowing for investment. Again, it does make sense to have a looser rule for capital than for current spending. This is because capital spending is more likely to boost the economy in the longer term, thus helping to pay for itself, and also making it fairer for more of the burden to be borne by future taxpayers.
Nonetheless, it is surely right to have some sort of constraint on borrowing for investment. The Resolution Foundation proposed (and Labour adopted) a new rule which would shift the focus to ‘public sector net worth’, so that almost any amount of borrowing could be acceptable as long as it is matched by the creation or purchase of an offsetting asset.
This is potentially a blank cheque, and hugely risky. Borrowing is still borrowing, whatever it’s for, and someone has to be willing to buy and hold the new government debt. Valuing assets is difficult, with any numbers intrinsically less certain than the costs of the debt that finances them. Above all, the government’s track record of picking good infrastructure projects is questionable, to say the least.
The current fiscal rule setting a limit of three per cent of GDP on investment spending therefore seems about right. It still allows for a substantial increase in capital expenditure relative to the previous rules – perhaps another £25 billion annually.
If I were to suggest one change here, it would be to express the target in terms of total borrowing, so that if the government is running a one per cent surplus on the current balance, then it would be able to spend four per cent of GDP on investment.
Overall, though, it looks like we’re heading for a new set of fiscal rules which will see total government borrowing average between three and four per cent of GDP for a number of years. In my view, this would be right at the limits of what is acceptable. Provided interest rates remain low and the economy picks up, annual deficits of this size should be small enough to keep debt broadly stable as a share of GDP. But only just.
What’s more, this would only be part of the story. The government would still have to spend other people’s money more wisely than they could do themselves. Here, there’s still an awful lot to prove.
This piece was first published by CapX