The coalition government in the UK has just updated the fiscal rules that govern how it decides budgetary policy. I think it is helpful to distinguish between the form of those rules and the particular numbers attached to them. I and many others have already discussed the numbers on various occasions. My bottom line: it is stupid to commit to further significant fiscal contraction (‘austerity’) when interest rates are still at or close to their lower bound. It means we become more vulnerable to adverse shocks to demand. An academic quibble? No, it is what happened in 2010. Unlike 2010, however, no one with any sense thinks we must have austerity to avoid being punished by the markets.
I want to talk in this post about the form of the rules. Here the change compared to 2010 appears minor. The primary mandate now has a 3 rather than 5 year rolling horizon, and the date for the secondary target of a falling debt to GDP ratio has just been shifted ahead to 2016/7.
In my paper with Jonathan Portes (here or here), we argue that fiscal rules can have two goals. They can try to mimic optimal fiscal policy, or they can be effective at restraining a government that is subject to deficit bias (basically spending too much and taxing too little). The main point about optimal fiscal policy is that government debt and deficits should be shock absorbers, and spending and taxes should be adjusted slowly to meet any debt target.
In this context the coalition’s secondary target remains a bit of nonsense. Getting the debt to GDP ratio to fall at some stage is a good idea, but having a target for a specific year is silly. It is not optimal because if some shock hits the economy before 2016/7 which means debt tends to rise relative to GDP, it is crazy to try and counteract that to meet the target in such a short space of time. It is not effective because it can be gamed by the government fiddling the timing of expenditures.
In contrast, Jonathan and I argue that the form of the original primary mandate makes a lot more sense, as long as interest rates are not at their zero lower bound. Having a five year rolling target for the deficit allows fiscal policy plenty of time to adjust to shocks. We saw this in action over the last few years, as the Chancellor was able to reduce the pace of fiscal consolidation from 2012 when the economy failed to recover as quickly as he had hoped. Changing this mandate from five to three years gives any Chancellor less time to adjust, which is why it is a backward step.
In talking about the change, the Treasury says it “reflects the progress that has been achieved in tackling the deficit, which means that the mandate can be safely shortened to create a tighter constraint on future fiscal policy choices.“ This is one of those lovely phrases that sounds plausible until you think about it. The whole point of having a rolling target is that it gives you time to adjust to shocks, when too rapid an adjustment would be costly. Has the expected size of shocks got smaller, so we can safely create “a tighter constraint on future fiscal policy choices“? I don’t think so.
Of course I know, and indeed everyone knows, that the reason for this change has nothing to do with economics and everything to do with politics. Whether it is clever politics or not I will leave to others to debate. In addition on this occasion the numbers in the rule, and the risk he is taking because we are still at the zero lower bound for interest rates, matter more than this change from a 5 to 3 year rolling target. But it is still a shame we are going backwards. I have just finished an article, due to appear in February, on the coalition’s macroeconomic policy, and to set against the obvious mistake I was able to count two successful innovations: the creation of the OBR and the 5 year rolling fiscal mandate. Now we are left with just one.