A farewell to ‘fiscal rules’?

Dirty secrets?

Yesterday (5 March) the Financial Times published an article by its economics editor Chris Giles, under the title “The Treasury has two dirty secrets on its fiscal rules”. Underneath that, the sub-heading read “What is the use of gleaming new hospital equipment if there is no money to pay staff to operate it?”.

Now this is all rather amazing, given the degree of deference generally shown to ‘fiscal rules, Though this debunking is no doubt timely for new Chancellor Rishi Sunak - as he prepares his first budget - squeezed between the Scylla of the coronavirus’s economic consequences, and the Charybdis of the Office for Budget Responsibility’s likely downbeat assessment. After all, the Conservative governments since 2010 have sought to convince us since 2010 that fiscal rules are essential tools - and they were given statutory underpinning in 2015 when George Osborne as Chancellor introduced the requirement to have a Charter for Budget Responsibility which includes the Treasury’s fiscal rules.

The Tory complaint was that Gordon Brown’s 1998 “golden rule” (Borrow only to invest) had not been stringent enough, though the modest deficits of the era played no part in the great financial crisis. Osborne himself tightened the austerity screw further when he imposed a ‘balanced budget’ rule which meant that future government should not be able to borrow even for investment purposes.

The Conservative Party 2020 manifesto included reference to its fiscal rules:

“We will not borrow to fund day-to-day spending, but will invest thoughtfully and responsibly in infrastructure…. Our fiscal rules mean that public sector net investment will not average more than 3 per cent of GDP, and that if debt interest reaches 6 per cent of revenue, we will reassess our plans to keep debt under control.”

No magic in balancing current budget

But as we have long argued - and Chris Giles here accepts - there is no clear logical division based simply on capital / revenue definitions as to what is in the long-term interests of the nation:

“Why should paying the salaries of further education staff be considered less of an investment in the UK’s future than building the HS2 high-speed railway? Isn’t current spending on policing and public safety vital for future economic prosperity? What is the use of gleaming hospital equipment if there is no money to pay staff to use it? There are no satisfactory answers to these questions, casting doubt on the wisdom of setting a rule to balance the current budget.”

The Treasury guarding the secrets

But Mr Giles - a fiscal austerian by nature - goes on to explain “two dirty secrets of fiscal rules that the Treasury has guarded for almost a generation.”

First, while the ‘borrow only to invest’ rule was mostly just words “for public consumption”, it was liked by officials as in general terms they thought it would lead to the public finances being “broadly sustainable in the long term.”

Second, says Giles, “the main use of fiscal rules within the Treasury is not to ensure the sustainability of public finances but to control the activity of spending departments.”.

Which leads us to the third (and not well kept) dirty secret, that the true purpose of the rules for the post-2010 governments has been to enforce a shrinking of the state and therefore of public services - using arguments about fiscal sustainability as a fig-leaf.

Javid wanted rules for low tax, low spending

We await with acute interest the outcome of the tensions within the current government - will they loosen the rules to enable more spending on public services and projects, or maintain (as Sajid Javid was going to do) to continue the reduction of the state’s role, but thereby risking alienation of many of their recent voters who have suffered from austerity. Here is Javid’s defence of fiscal rules (from his resignation speech):

At a time when we need to do much more to level up across the generations, it would not be right to pass the bill for our day-to-day consumption to our children and grandchildren. And, unlike the US, we don’t have the fiscal flexibility that comes with a reserve currency.

So that’s why the fiscal rules that we were elected on are critical.

To govern is to choose.

And these rules crystallise the choices that are required: to keep spending under control, to keep taxes low, to root out waste, and to pass the litmus test — rightly set in stone in our manifesto — of debt being lower at the end of the parliament.

The Labour rules

The Labour Party in 2017 had also tied itself to a self-imposed fiscal rule, also along the lines of “borrow only to invest”. To my mind, this was seriously misguided in a specific major respect, as it stated that fiscal policy should only be used when monetary policy had reached the “zero lower bound”, as decreed by the Bank of England’s Monetary Policy Committee, which thus was assigned as technocratic gate-keeper to elected government’s use of fiscal policy.

Time to do away with fiscal rules

Last year, in the many-authored book “Rethinking Britain - policy ideas for the many” of which I was co-editor (published by Policy Press), I wrote a contribution which asked “Should we have fiscal rules?” My answer was a clear No. I argued that what matters most is the state of the overall economy, of which the public finances are just a part, though certainly an important part. Public spending and tax income depends on the state of the economy, and public spending can itself affect - in a positive way - the state of the wider economy. My conclusion was that

Fiscal rules are dysfunctional instruments for successful economic management, and should be avoided. In place of such ‘rules’, there should be full transparency of the government’s main economic objectives and assumptions.”

In a 2015 article on PRIME, “How should Labour react to Osborne’s ‘vacuous and irrelevant’ Fiscal Charter?” I had already given some indications of how this approach might be used, to set ‘whole economy’ objectives.

In conclusion, “fiscal rules”, if not legally binding, are a sham since - far from being reliable guidance to long-term policy - they are used for purposes of propaganda and short-term expediency, then cast aside and replaced with another equally ephemeral set. If legally binding, they can be even more dangerous, in enforcing perverse economic policy, as in the eurozone.

You’re much more likely to get good economic policy by … setting good economic policy!

My contribution on fiscal rules to “Rethinking Britain” is set out below.

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Should we have Fiscal Rules?

What’s the Issue?

Over the last 25 years , governments in most countries have become subject to some type of “fiscal rule” for the management or control of public finances. Such rules set caps or limits on government debt or annual budget deficits, or lay down numerical targets for limiting or reducing public debt and/or deficits

Question 

Are “fiscal rules” for public debt and budget deficits beneficial tools for controlling or helping elected governments in managing the public finances?

Analysis

Since the early 1990s, there has been a near (though never perfect) consensus among economists that (a) the role of governments in managing the economy and public finances should be legally or institutionally constrained, and (b) the role of technocratic input should be enhanced. 

One favoured principle is that central banks must be independent of any government influence or control in relation to monetary policy.

A second holds that governments must be constrained by “fiscal rules”, which may be laid down in law or self-imposed.  Fiscal rules normally set numeric limits on the permitted level of budget deficits or of public debt as a share of GDP, and/or set targets for ongoing reductions. Alongside the rules, some countries have set up technocratic monitoring bodies known as ‘fiscal councils’.  In the UK, the Office for Budget Responsibility (OBR) plays this role.

This policy of controlling or reducing governmental powers in economic and fiscal management has coincided with the peak period of financial liberalisation and deregulation.  Prior to 1980, budget deficits tended to be quite low, with borrowing largely for capital investment. During the 1980s and 1990s, however, many economies’ deficits grew faster than their GDP, leading to a higher level of debt as a percentage of GDP. 

Deficit bias

For their advocates, the principal purpose of fiscal rules is to combat what is seen as an inbuilt “deficit bias” on the part of governments.  Rules are required to keep governments on the path to fiscal rectitude.  However, some of those arguing for hard fiscal rules have an ulterior political motivation – to reduce the size and role of government and public services. For them, the answer is almost always to cut public spending rather than raise taxation.

Many mainstream economists consider deficits to be the mark of ‘bad’ governments, acting  against their citizens’ best “welfare-maximising” interests.  Deficit bias arises, they believe, from a willingness to yield to interest groups and “push out the discipline burden to future governments or even to future generations”.

There is however huge variation between eras, between countries, and within countries at different times.  In reality, deficits arise from specific political and economic circumstances, not least an economic system prone to financial crises. 

Today, the danger facing many ‘advanced economies’ arises more  from a “surplus bias”, most strictly expressed in the  ‘budget balance or surplus’  which Eurozone states signed up to in 2012.  Such rules risk turning a recession into deep depression, as they will require even stronger austerity measures to meet their harsh requirements.

 It’s the overall economy that matters

A big weakness of fiscal rules is that they focus on just one aspect of the overall economy – and miss the interactions with, or impacts of, the other parts.  For example, in the lead-up to the great global financial crisis of 2007-8, public debt to GDP ratios were mainly fairly stable or falling. The crisis, caused by private sector excesses and mismanagement, reduced government revenues and saw social expenditure rise (through “automatic stabilisers”).  Moreover, several governments felt obliged to take on private finance liabilities (via “bail-outs” etc.) to prevent further economic and social collapse. 

A blinkered focus on reducing deficits or debt can damage the economy – and make the target even harder to reach. If there is slack in the economy, shrinking the public sector will tend to lower economic activity and output.  In such a case, a deficit reduction target via public spending cuts may lead simply to a lower (or slower rise in) GDP – so that the ‘cuts’ have to be increased further to meet the target. This is what happened in the Eurozone and UK, under austerity policies. 

Conversely, a decision to maintain public service expenditure in the aftermath of crisis may speed the path to private economic recovery, so that even if the nominal value of debt increases, as a percentage of GDP it declines.

Fiscal rules – the UK experience

In 1998 the new Labour government first introduced formalised fiscal rules into the UK. It committed itself to the “golden rule” that – over the (undefined) “economic cycle” – current budget spending should be matched by income.  This therefore permitted borrowing for the types of investment that counted as capital spending. A second rule stated that public debt as a proportion of national income would be “held over the economic cycle at a stable and prudent level”.

In 1997, UK public debt was around 44% of GDP, and virtually the same in 2007.  But once the Global Financial Crisis hit, deficits and debt soared.  This led, in pre-election political panic, to the UK’s most prescriptive fiscal rules, in the short-lived Fiscal Responsibility Act 2010.

Since the Coalition government of 2010, the UK’s “rules” have been set out in a series of statutory Charters for Budget Responsibility.. Under its 2011 mandate, the government only aimed at a current budget balance; borrowing for investment was still to be ‘allowed’.

In 2015, Chancellor Osborne changed tack. He proposed that henceforth, all future governments should commit to achieving an overall budget surplus. He gave himself a let-out clause - the target would be suspended if the OBR advised there was “a significant negative shock”, i.e. GDP annual growth was likely to fall below 1%.

Chancellor Hammond’s latest (late 2016) version of the Charter drops the aim to run a surplus.  The government aims “to return the public finances to balance at the earliest possible date in the next Parliament”, reduce the deficit to below 2% of GDP by 2020-21, and see public sector debt as a percentage of GDP falling. 

The Labour Party ‘rule’

Since 2016 the Labour Party has also committed itself to a set of ‘rules’.  A Labour government would “target balance on current spending after a rolling, five-year period.”  It would however “retain the ability to borrow for investing in capital projects which over time will pay for themselves”, which is seen as essential to future prosperity. Third,  government debt as a proportion of ‘trend GDP’ should be lower by the end of each Parliament..

There is once again a let-out clause, in case of severe economic difficulties, but this is obliquely and controversially expressed:

“We will reserve the right, for as long as monetary policy is unable to undertake its usual role due to the lower bound, [to] suspend our targets so that monetary and fiscal policy can work together.”

Any suspension of the rule must be authorised by the Bank of England’s Monetary Policy Committee.

This formulation is the subject of vigorous debate.  Why wait in crisis for the ‘lower bound’ to be reached? Why should monetary and fiscal measures not be put to work in tandem from the outset? The economist Wynne Godley – back in 2005 – argued:

“Monetary policy cannot maintain stable growth and full employment regardless of fiscal policy - although many people write as though it can.”

Both monetary and fiscal policies, depending on circumstances, have their specific roles and limitations; the art is to combine them effectively.  In the USA, the Economic Stimulus Act was passed in February 2008 – at peak crisis - when the Fed’s federal funds rate was still 3%.  In the severe early 1990s recession, central bank interest rates never got close to the “lower bound”.

What can we do?

• Fiscal rules vary from those that are legally enforceable (the Eurozone and other  “debt brake” laws) to those which are in essence political commitments.

• A monetary union (a special case) may indeed need some “backstop” enforceable rules, but these should not  be as constrictive  as the present ones, which require budgets to always be in balance or surplus.

• Rules also face the weakness that governments that share their policy goal do not need them, while governments that do not agree with the goal will either change the rule, or find ways of avoiding it in practice - or worse, bring in harmful policies just to stick to the letter of the rule.

• The case for fiscal rules has weakened further since 2008. For most advanced economies, interest rates have stayed low, and debt interest payments as a share of GDP are at historic lows despite nominal debt rising. 

• Where arguably inappropriate deficits exist (e.g. in the USA under President Trump) enforcement of a strict rule would almost certainly be regressive - targeting social spending for the poor, not higher taxes for the rich.  Fears that “excessive” fiscal deficits will lead to inflation, or “crowding out” of private sector investment, have proven far wide of the mark.

• Even the “golden rule” (borrow for investment only) suffers from the problem that the capital/current borderline (set out in accounting rules) does not help in deciding what spending is in fact for long-term benefit.  For example, much education and health ‘current’ spending will benefit future generations, since this is as much due to the staff (teachers, nurses) as to the buildings and equipment (see ‘Investing in Social Infrastructure’.

Conclusions:

In a nutshell, fiscal rules are poor instruments for successful economic management, and should be discarded.

In place of such ‘rules’ we should require full transparency of each government’s main economic objectives and assumptions. , Governments should therefore - at the outset of their term and annually - provide a public, unified “Statement of key macroeconomic and public finance objectives”.  Changes should be explained in annual updates.  

This process should provide closer linkage between the overall economic goals for a government for the economy, and the subset of the economy which is the public sector (and thus the public finances).

The Statement would set out (a) the government’s economic objectives/targets, and (b) the other main assumptions that underpin its policy. These may vary; one government may have a primary policy objective for unemployment, while another may prioritise  inflation, or the level of GDP per head, etc.

This Statement then forms the basis for a democratic accountability for economic management in the round. 

When events cause a government to change (or miss) its key objectives or targets, this is a matter for political explanation and debate, not legal sanction. And its assumptions or targets for the public finances will be placed in their broader economic context, not simply as narrow “fiscal rules”.

A role may remain for bodies such as the OBR in offering an external interpretation of government finances and assumptions, provided it does not take the form of policy control. But a proposal to give another body power to decide whether government may use fiscal policy in a crisis should be rejected outright on grounds of democratic principle.