Detoxifying government debt, part 3. The Truss crisis has no relevance for Labour borrowing to invest

 

Over the last fifteen years the UK has experienced or witnessed three crises stemming from financial markets, the Global Financial Crisis, the Eurozone crisis and Truss’s ill-fated ‘fiscal event’, all of which have led to a view that government debt is in some way toxic, and therefore public investment needs to be curtailed. Because it is more recent I will focus on the last, but it is worth just repeating why the other two have no relevance whatsoever.

The Global Financial Crisis occurred in large part because banks started treating risky assets issued by the private sector (US subprime mortgages) as safe assets. US, UK or Japanese government debt, by contrast, really is a safe asset. There is a literature that argues that one of the reasons for the GFC was a global shortage of genuinely safe assets, or in other words that there was too little government debt. The big increase in government debt that occurred after the GFC can be seen as a correction to that problem, rather than the problem it is usually portrayed as in the media. When Conservative politicians tried to link the Global Financial Crisis to UK government debt or deficits, they were at best ignorant or at worst lying,

The Eurozone crisis was all about financial markets refusing to buy the government debt of certain Eurozone countries. The media and political narrative was all about how these governments needed to borrow less. But the reality, hardly ever described in the media, was that the crisis arose because the European Central Bank (ECB) initially made it clear they would not be a last resort buyer of national government debt, which meant that governments could be forced to default if no one bought their debt. Once markets knew that, they were perfectly right to worry about whether they would get their money back if they bought government debt, and once that concern became significant it was almost inevitable that a crisis would unfold, and governments could be forced to default.

The moment the ECB policy changed (‘we will do whatever it takes’), and agreed to become a last resort buyer of most Eurozone government debt, then the Eurozone crisis ended. The implication, which again the media hardly ever draws, is that the Eurozone crisis has zero relevance to advanced countries with their own central bank like the US, UK or Japan.

So of the three crises, the only one relevant to the market for UK government debt is what happened before and after Liz Truss’s disastrous fiscal event. This can be thought about in three stages [1], using my simple guide to the bond market outlined in part 2 last week.

Stage one was happening before the fiscal event itself, once it became clear the event would involve tax cuts without any announcement of specific spending cuts. That put money into an economy that already had an inflation problem, so meant the Bank of England was likely to increase interest rates as a result of the fiscal event. As explained above, that means interest rates on government debt will rise. The bond markets were acting as a pricing mechanism.

Stage 2 involves uncertainty. Because spending cuts were not announced, we had no idea how plausible they would be, or even if they would happen at all, given that public services have already been cut to the bone. The uncertainty about cuts to public spending mattered to the markets because any cuts would influence aggregate demand and therefore Bank decisions on interest rates. Greatly increased uncertainty about future interest rates made markets more reluctant to hold sterling assets in general, which is why sterling depreciated despite higher expected interest rates. It made traders reluctant to buy government debt, pushing interest rates on that debt up further. (This was sometimes called the ‘moron premium’.)

Stage 3 involved UK pension funds needing to sell a lot of government debt because of a combination of their Liability Driven Investment (high leveraging) strategy and higher interest rates. Supply increased, but demand had fallen because of much higher uncertainty. We had an unusual example where supply and demand in the market for government debt influenced its price, but as we noted last week that is also when central bank intervention is likely to happen. Sure enough, It was at this point that the Bank of England stepped in as the buyer of last resort for UK government debt. However the Bank made it clear their role was to only allow pension funds time to sort themselves out, and not to reverse the impact of stages 1 and 2. [2]

The key point to note is that none of this has anything to do with ‘borrowing too much’, in the sense that an individual borrows too much and cannot pay the money back. Instead it has everything to do with trying to guess future interest rates set by the Bank of England, during a period in which further cuts to public spending were no longer politically credible. At the only point where it looked possible that a funding crisis could emerge because there were not enough people in the market willing to buy UK government debt, the Bank acted as the buyer of last resort, just as it did at the start of the pandemic.

What relevance does the Truss episode have for a future Labour government wanting to borrow to invest? It tells us that if the economy is at full capacity, and the UK government increases public investment by more than expected, paid for by borrowing rather than higher taxes, then the central bank is likely to raise short term interest rates because investment and aggregate demand will be higher. As the bond market acts as a pricing mechanism, that will raise interest rates on government debt, although by less than the increase in short term rates. [3]

In economic terms this is exactly what needs to happen. If the government wants to pay for many more people insulating homes, it needs to create the extra workforce to do that, which means reducing the demand for workers in other areas of the economy. Higher interest rates is one way the government can shift resources from the private to public sector. Note crucially that interest rates are increasing because of pressure on aggregate demand, not because government borrowing is higher. If government borrowing rose because the economy moved into recession, interest rates on government debt would follow short term rates down, not up.

Critically, however, interest rates would not rise by nearly as much as they did under Truss, because there would be no uncertainty involving possible cuts to public spending. Truss helped create a crisis because of two mistakes. The first, generally recognised, was to announce tax cuts without announcing cuts to public spending at the same time, and refusing to publish an OBR forecast that would have had to pencil in numbers for cuts. The second was to imply possible spending cuts in an environment where further cuts to spending were almost politically impossible to implement. In that sense it was a disaster created by the small state obsession of the Conservative party hitting the rocks of the political reality that you couldn’t make a state in charge of health, education and much more any smaller. It was this combination of lack of information and credibility that created the large increase in uncertainty that led sterling to fall despite higher expected interest rates.

As higher public investment should be paid for by additional borrowing, there is just no scope for the kind of shift up in uncertainty that led to stage 2 of the Truss crisis, which in turn precipitated stage 3. In that sense, the Truss crisis has no relevance to a future Labour government wanting to increase public investment.

So why is Labour acting as if the opposite is true? They may have trimmed their public investment plans on greening the economy to diminish a potential attack line from the Conservatives at the next election, but they didn’t need to justify doing so by implying the economy could no longer afford additional public investment. As I noted in part 1, saying the economy can no longer afford to borrow to invest makes no sense in economic terms, and indeed additional much needed public investment is a key way the UK gets out of its current stagnation. Starmer even talked about this government maxing out its credit card, which is a terrible analogy to use and is indicative of basic macroeconomic muddled thinking.

Next week, in the final part of this series, I will look at why there are so many myths surrounding government debt, and why it is so important that a new Labour government does not succumb to these myths.

[1] Use of the term ‘stage’ is not meant to imply a strictly sequential process, as the stages undoubtedly overlapped

[2] The Bank was undoubtedly right not to try and counteract the increase in bond rates generated by market expectations about its own future decisions on short term rates (stage 1). They were also right to intervene to provide a buyer for the government debt pension funds needed to sell (stage 3). Others can debate whether they were right or wrong not to intervene to try and offset the additional uncertainty (the ‘moron premium’) created by the government’s actions.

[3] Long term interest rates depend on expected short term rates over the period until the maturity of the long term asset. Central banks are not normally expected to keep short rates high for prolonged periods, so the interest rate on long term assets will rise by less than short term rates. 

Detoxifying government debt, part 2. Market myths

 

“Labour’s biggest opponent is no longer the Conservative Party. It is the bond market.” That was the first sentence I read a few days ago in an article in a respected publication. It works as a first sentence because it sounds all too plausible given the way the media treats the financial markets in general, including the market for government debt (the ‘bond market’). I once described the media as seeing financial markets like a vengeful god: a powerful but mysterious entity that has the potential to create havoc, and that therefore has to be treated with great respect and offered the occasional sacrifice, like less help insulating homes.

Who do you get to explain the behaviour of a vengeful god? The high priests of the vengeful market are the small band of economists working for City firms who get quoted in newspaper articles or appear on our television screens because they are 'close to' the markets. But these economists are no closer to the financial markets than someone on the till at Tesco’s is close to supermarkets. They are employed by City firms mainly to sound knowledgeable to wealthy clients rather than advise market traders. The unfortunate truth is that what they tell the media is pure guesswork, based on no evidence at all.

When one of them tells you ‘the markets are nervous at the prospect of’ some event, do you think they have conducted a survey of the thousands of people trading in the market that morning to ask them how they are feeling? Of course not. But the media want them to appear like experts with knowledge, so they tell what they think are plausible stories related to recent (often political) events.

All this adds to the perception that how financial markets work is deeply mysterious, and beyond the understanding of anyone unfamiliar with finance. It also adds to the idea that market traders are making judgemental decisions about political actions. The truth is very different. When it comes to the bond market the way it works is normally very simple, and easily understandable for anyone who has thought about saving in a fixed interest rate savings account, or anyone with a mortgage who has wondered about whether to get one with a fixed or variable rate. In reality financial markets are not a vengeful god but a pricing mechanism. The best way to detoxify market myths is with some knowledge, so here is a simple guide to how the bond market works.

Imagine you need to decide whether to invest your money in a variable interest rate savings account, or one that has a fixed interest rate for 3 years. If you think the variable rate will be above the fixed rate for most of those 3 years you would choose the variable rate and vice versa. In other words your choice is based on how you think short term interest rates will vary over the next three years, plus some allowance for any lack of freedom tying your money up for three years implies (the ‘liquidity premium’).

As most government debt has a fixed interest rate for a number of years, this is all that the bond market is doing. This pricing mechanism is often called arbitrage. There is nothing inherently difficult or complex involved that is beyond the understanding of most people. Market traders are trying to guess how central banks will set interest rates in the future, and they can get that wrong as much as any macro forecaster. The aim of these traders is just to make money, not to pass judgement on some political decision. The media stories you hear are plausible if and only if political events or decisions influence central bank decisions about short interest rates over the next few years. Those central bank decisions, as we know, depend on the Bank’s expectations about inflation. [1]

If arbitrage is the right way to think about how the bond market works most of the time, it is worth mentioning two alternative ways which are wrong most of the time. The first is to think about supply and demand. That works with the market for apples, because people have preferences for consuming apples and are often prepared to pay more if the supply of apples becomes scarce. But those preferences generally don’t exist for financial assets. [2] These assets are just a way of earning interest, and are not a consumption good. If some established national bank is offering permanently 0.25% higher interest on savings than some other bank, there is no reason to stick with the other bank.

If that seems obvious, then think about how often people in the media use supply and demand in talking about government borrowing. We were told after the Global Financial Crisis (GFC) that because government borrowing was going up sharply, so would interest rates, and so we had to get borrowing back down by cutting spending. In reality interest rates on government debt fell after the GFC because central banks cut short term rates, just as you would expect from the arbitrage process described above.

The second bad analogy often used for government debt comes from personal experience in borrowing, and involves repayment risk. If you are trying to borrow money, any lender will look at how likely you are to repay that money, and what the risks are that you will default on the loan. A similar logic will apply to individual firms that borrow to invest. However this way of thinking just isn’t relevant to the debt of advanced countries with their own currency like the UK, US or Japan. The reason is that these governments can always create the money to pay back the debt.

This is why the government debt of these countries are called safe assets. There is no risk of forced default, and these governments will never choose to default because of the cost that involves. There is a risk that inflation will devalue these assets (unless they are index linked), but because high inflation will lead to central banks raising interest rates that is already part of the arbitrage pricing mechanism described above.

How can governments create money when their central banks are independent? Central banks do it for them, by creating money (called ‘reserves’) to buy government debt. The central banks of the US, UK and Japan, along with other advanced countries that borrow in their own currency, are the buyers of last resort for government debt.

While the analogies of supply and demand or individual repayment risk are inappropriate to thinking about the way markets deal in and price UK government debt, we do need to add one final factor to the more realistic arbitrage model. While traders can make their best guess about where central banks will set short term interest rates over the life of the debt they are thinking of buying or selling, that forecast is uncertain. Because government debt is a safe asset, the people ultimately buying the debt (pension funds, banks etc) want less uncertainty, not more.

If the prospects for inflation, and therefore for future short term interest rates set by the central bank, become so uncertain they are almost impossible to forecast, buyers may decide that, for the moment at least, it is better to keep their money in short term assets or some other country’s government debt. The most charitable explanation for City economists talking about ‘nervous markets’ is that they think the level of forecasting uncertainty has increased. In extreme circumstances the uncertainty may be so great that traders withdraw and the market becomes very thin. Only at that point do considerations of demand and supply matter, but equally that is exactly the point at which central banks become the debt buyer of last resort to stabilise markets.

As the job of central banks is to stabilise inflation, the economy and financial markets, they will act when the market for government debt stops working well because it has become too thin. To a first approximation ‘not working’ means that arbitrage, the pricing mechanism of the bond market, is no longer working.

We saw this globally as the pandemic hit. In those initial days that Covid swept across the planet no one knew how to forecast anymore, and the markets for government debt in the major economies froze. The central banks stepped in to buy government debt. Hardly anyone outside of the financial markets noticed.

As we will see in Part 3, this again became important in the much misunderstood crisis following the fiscal event of Truss’s ill-fated premiership. Like it or not, the major fear in politician’s minds about additional government borrowing comes from fear of a crisis like this. During the Truss crisis we will see the three elements discussed in this post at work: arbitrage (expectations about central bank decisions), uncertainty about these expectations, and finally central banks stepping in to stabilise markets.

The key point of this post is that equating higher interest rates with more borrowing will be wrong most of the time, just as it was during the GFC and the pandemic. If you want to borrow larger amounts from the bank you may have to pay more (if you can get a loan at all), but just as in part 1 we see that governments are not like individuals. Unlike an individual, there is no risk of UK government debt not being repaid. Nor is the price at which the government borrows determined by supply and demand, because in normal times arbitrage ensures it is tied to expectations about future central bank decisions about short term interest rates. On the odd occasion that arbitrage fails because of extreme uncertainty, the central bank steps in as the buyer of last resort.

So the next time some City economist is quoted in the media relating interest rates on UK government debt to some political decision or event, ask yourself how that event relates to central bank decisions about short term interest rates. The next time they say the market is nervous about something, ask yourself has there really been a step change in forecast uncertainty? The media may treat the bond market as some mysterious entity that only those ‘close to it’ can interpret for us, but in reality it all comes down to the basic macroeconomics of central bank interest rate setting.

[1] This makes it sound as if central banks have complete control over longer term interest rates through their setting of short rates. But the aim of central banks is to control inflation, and what level of short term interest rates achieve that control will depend on what is sometimes called the neutral or natural rate of interest (or r*), which in turn will be influenced by various factors beyond the central bank’s control.

[2] At the extreme, supply and demand for government debt may influence rates if either demand dries up (see discussion below) or demand increases dramatically. The latter was one theory behind Quantitative Easing (QE): that by buying huge quantities of government debt, the central bank could have some (small) additional influence on longer term interest rates. The extent to which that is true in practice is still subject to debate, but because QE involved huge changes in demand it is not relevant to the discussion here.

Detoxifying government debt, part 1. Debt is also an asset

 

Perhaps Labour scaling back its proposed green investment is just a pre-election ploy, and will have no implications for what they do in government. Perhaps. But perhaps they genuinely think the country can only afford a modest increase in public investment; much less than the economy and public services need. As we shall see, this idea that the nation cannot afford to increase worthwhile public investment because it requires more government borrowing is quite wrong.

In my last post I noted that both Shadow Chancellors Rachel Reeves and John McDonnell had adopted the falling government debt to GDP fiscal rule, even though it has the real potential to hold back valuable public investment for a prospective Labour government. [1] I know in John McDonnell’s case, and strongly suspect with Rachel Reeves, that the reason for doing this has nothing to do with good macroeconomics, and everything to do with public perceptions about government debt.

In either case it looks like we need to unlearn once again all the myths about government debt that the media constantly feed us. Any advances those who argued against austerity might have felt they made may have been undone in the UK by misinterpretations of what happened under the leadership of Liz Truss. In contrast, as I showed last week, the US government under Biden has ignored worries about government debt, and partly as a result is currently in economic terms the international success story. So this post will be the first in a series that tries to unpick why politicians, the media and large parts of the public think high government debt is a bad thing, and why they are wrong to think this. My apologies in advance to those who are already familiar with some of these arguments from my earlier posts, MMT or elsewhere.

Let me start with some basic economics. There is no empirical evidence or economic theory relevant today that tells us that the level of government debt currently in the UK is too high. Advanced economies like the UK after WWII had much higher levels of debt to GDP than we do today, and that was the start of a golden era of economic growth. Serious econometric studies find no causal correlation, and one that did and got a lot of publicity around 2010 quickly fell apart on inspection.

What economists are concerned about is that fiscal plans should be sustainable, which means debt shouldn’t be constantly increasing as a share of GDP. That implies something like the golden rule, aiming to roughly match day to day spending with taxes, but it does not imply current debt to GDP is too high and needs to come down. There is no economic basis for the falling debt to GDP rule. That rule is there for political reasons, and perhaps in Labour’s case because they believe the media and the public want it there.

That people can be made to worry about government debt is not surprising. The idea of debt worries many people, and people have been conditioned to believe that they should also therefore worry about government debt. This, probably more than any political bias, was why the media completely adopted the necessity for austerity before, during and for many years after the 2010 election.

As I argued here, for both individuals and firms it is understandable that debt is worrying, because the consequences of having too much can be devastating. But I also pointed out that debt is at the same time a wonderful device, because it (in the form of mortgages) allows most individuals to buy their first house, and it allows many firms to invest and grow. Our society would be a lot poorer if debt didn’t exist.

However government debt is not like an individual’s debt or a firm’s debt in many crucial respects. One in particular means that government debt should not be something people in general should worry about. Government debt is not society’s debt, because it is also society’s asset. Most government debt is owned domestically by domestic residents or institutions, so from society’s point of view it is debt that it owes itself. You could think of it as a loan from domestic savers to taxpayers, one that both savers and taxpayers are grateful to have..

Imagine you were someone that had a mortgage purely for tax purposes, but you also had personal wealth in the form of liquid financial assets of a similar amount. Every time your mortgage interest rate changed, the interest on your savings changed by exactly the same amount. Would you worry about having to pay your mortgage in those circumstances? Of course not, because you can pay it back at any time of your choosing.

For society as a whole, in most advanced countries, government debt is just like this example. People don’t think about it this way partly because taxpayers are a different set of people to savers, and savers may not realise they hold government debt through their personal savings or pensions.

Does the fact that a significant proportion of government debt is owned overseas change this logic? Not really, because equally UK residents own the debt of overseas governments. Roughly speaking, for every £ of UK government debt there is a similar asset owned (directly or indirectly) by UK residents. To go back to the analogy with an individual with a mortgage and equivalent financial assets, it would be more realistic to imagine an individual who has a mortgage and also holds most of their personal wealth in liquid financial assets whose interest rate moves with their mortgage rate, but a proportion of their wealth is in other overseas financial assets where the interest rate might be higher or lower.

So for society as a whole, government debt is nothing like the personal debt of a normal individual with a mortgage and few financial assets. The question that is never asked when people talk about government debt is debt to whom. If instead of the term government debt we talked about non-government financial assets in government issued instruments, and talked about the government deficits as the increase in those non-government assets, I suspect many people’s views about government debt and deficits would change.

In passing we could note an interesting contrast here. When the government reluctantly raised a windfall tax there were articles in the right wing press about how this would hurt savers and pension holders who indirectly owned shares in these companies. Such claims were not empirically valid, but when it suited certain interests the connections between assets and individuals were made. So it would be perfectly possible for the media to note that UK government debt was a key asset for many savers, but this is rarely done.

What is sometimes done is divide government debt by the population or number of households and say, or imply, that this is some kind of personal liability for each person or household. This alone is just wrong, because it completely ignores that most of this debt is held as assets by domestic residents or households (and the remainder is held in the form of other financial assets). Government debt is not collectively our debt, it is collectively our debt and our assets.

Another implication is that it is wrong to say 'the nation cannot afford' more public investment financed through borrowing. Additional government borrowing creates an asset for those who buy the debt, and as we have noted most government debt is domestically owned. So directly or indirectly domestic residents are lending willingly to allow the government to invest. UK politicians would be delighted if firms increased private investment through borrowing, and are very unlikely to suggest they cannot afford to do so. It makes no sense to think in different terms when it comes to public investment.    

One reason people don’t think like this is that the media doesn’t talk about domestic residents directly or indirectly owning or buying government debt, but instead talks about ‘the markets’ doing so. For most people ‘financial markets’, like the economy itself, is something mysterious and a little frightening, because a crisis that affects everyone adversely can occur when the markets go wrong. But once again, this gets things backwards, as I will explain in a subsequent post.

[1] As James Meadway reminded me, McDonnell’s rule involves the ratio of debt to trend GDP, which is better than using actual GDP but still is likely to unnecessarily constrain public investment.

One Rule to bring them all, and in the darkness bind them

 

What a future Labour government will be able to do in terms of repairing both our broken public services, our broken economy, and getting cheaper green energy will depend in part on its decisions about fiscal rules. [1] When hopes and expectations are frustrated as a result of these rules, you will hear a lot about how such rules are neoliberal and should be scrapped. So are fiscal rules neoliberal, by which I mean are they just instruments designed to suppress public spending and cut taxes?

The answer to my question is of course yes and no. First the no. Fiscal rules arose out of a problem that can occur under any government, including neoliberal ones. Politicians, particularly before an election, will be tempted to increase spending or cut taxes and pay for it by borrowing or creating money because for many voters that seems costless: there appear to be only winners and no losers. This problem used to be called deficit bias.

We can see this happening right now in the UK, with the Chancellor wanting to cut taxes in an effort to boost the government’s popularity, and his own fiscal rules reportedly constraining him in the amount he can do. When Trump was President he and a Republican Congress cut taxes, mainly on the wealthy, by increasing the deficit rather than cutting spending or raising other taxes. He was able to do so because the US government does not follow the golden rule, which aims to roughly match day to day spending against tax revenue. [2]

Why does it matter that politicians can fool voters in this way? Increasing spending or cutting taxes when the economy is not in a recessionary period [3] will increase aggregate demand, putting upward pressure on inflation. The central bank will raise interest rates to stop inflation increasing. Eventually a government is likely to have to reverse the giveaway by raising taxes or cutting spending [4]. On both counts there will be a cost to many people of unsustainable fiscal giveaways. As long as those costs are not acknowledged by politicians or the media, democracy suffers.

Other reasons often given for the need to have fiscal rules are less convincing in my view. It is often suggested that we need rules to appease the financial markets. I see no evidence for this for any advanced major economy. Did the bond markets refuse to buy US government debt when Trump cut taxes? Have the bond markets raised rates every time this Conservative government changed its fiscal rules because the old ones would be broken? The Truss episode was about interest rate uncertainty created by cutting taxes in a situation where spending plans were not specified and might not have been credible if they had been, not about breaking fiscal rules.

Another unconvincing reason for having fiscal rules is that a higher level of government debt will harm the economy. Again, for advanced major economies there is no evidence of this. Will a higher level of government debt impose a burden on future generations? It may or may not, depending on the future relationship between interest rates and economic growth, and the evidence from the past is that on average it has not. It is particularly hypocritical to use this ‘burden’ claim to stop governments borrowing for spending that will benefit future generations.

Making our democracy function better by making governments more fiscally responsible is nice to have but hardly of critical importance. It is why I have often said that bad fiscal rules are worse than having no rules at all. If you want a vivid illustration of this, compare the recovery from the pandemic in the UK and US.

Eurozone performance has only been slightly better than the UK. What do the UK and the Eurozone have in common? Adherence to fiscal rules that have constrained the recovery from the pandemic. If similar rules had been applied in the US, we would probably not have seen the post-pandemic Biden stimulus and the Inflation Reduction Act, both of which have been important in making the US an outstanding success in terms of economic recovery from the pandemic (as well as reducing inequality, tackling climate change and a lot else as well).

One class of bad fiscal rules are rules used to promote an ideological goal, like shrinking the state. A clear example of a fiscal rule that could be justly labelled neoliberal is one that limits government spending but not taxes. Unfortunately a section of the governing elite in Brussels has tended to see fiscal rules as a way of constraining expenditure. When France initially raised taxes in the early 2010s to reduce the deficit, then Commissioner Olli Rehn said “Budgetary discipline must come from a reduction in public spending and not from new taxes.” But even rules that appear balanced may in practice not be, which brings me to the UK’s debt to GDP rule.

Although the fiscal rule that debt to GDP has to be falling by the end of five years may (and I emphasise may for reasons set out here) be constraining this government’s ability to cut taxes, what it has already done is reduced their plans for public investment, which is now set to fall steadily as a share of GDP over the next five years. Indeed, when the falling debt to GDP rule is combined with the golden rule then most of the time all the falling debt to GDP rule adds to the golden rule is to place a limit on public investment. For that reason, the falling debt to GDP fiscal rule could reasonably be called the ‘reduce public investment’ rule.

Governments should always have robust means of deciding whether individual public investment projects are good value for money, and the more open these are the better. As long as this test is passed, what benefit can there be in constraining public investment at the aggregate level? Another way to see why any fiscal rule that constrains aggregate public investment is a bad rule is to go back to reasons given for having fiscal rules in the first place. 

I argued that fiscal rules are useful in stopping governments bribing the electorate by cutting taxes or increasing spending and concealing the costs by borrowing. But if public investment projects are individually worth doing, it should be paid for by borrowing just as an individual pays for a house by taking out a mortgage, or a firm undertakes an investment by borrowing. Even the unconvincing reasons for having fiscal rules don’t apply to public investment: future generations benefit, debt is matched by useful assets that benefit the economy and so on.

If bad fiscal rules like the falling debt to GDP rule are worse than no fiscal rules, why isn’t the second best of getting rid of all fiscal rules a less risky way forward? Second best is reasonable when it is much easier to achieve than the first best. But with fiscal rules the opposite is true. There is no way a Labour government is going to abandon all fiscal rules, whereas there is at least some prospect of it getting rid of bad rules and keeping the better rules. In this particular case, first best is more achievable than the second best.

In opposition Rachel Reeves has already adopted the falling debt to GDP rule, just as John McDonnell did. This rule and this alone is the reason Labour are in such a mess over its sensible £28 billion pledge to green the economy. In a rational world it would be obvious to ditch the bad fiscal rule to enable desperately needed green investment. In the run up to an election, with the media we have, we are very far from a rational world.

But once in government, what Labour says and does has to change, even if their only goal is to be re-elected. With time and new leaders memories of just how bad this Conservative government has been will fade, and are in danger of being replaced with the disappointed expectations of those that voted Labour expecting major change. Being only slightly less bad than this current government will not see a new Labour government last as long as the last one. For that very narrow reason alone, one of a Labour government’s first acts needs to be to discard the falling debt to GDP rule, or change it in such a way as to prevent it constraining investment. Labour’s success in revitalising our moribund economy will depend perhaps more than anything on getting rid of this anti-investment fiscal rule.

[1] It will depend at least as much on their willingness to raise taxes.

[2] I use ‘roughly match’ rather than ‘equal’ deliberately, because there is no magic about trying to hit a zero current balance. I also use ‘aiming to’ deliberately. For various reasons tax revenue and spending fluctuate year to year and it would be bad economics to try and suppress or counteract those short term fluctuations. Instead policy should aim to hit a rolling target for the current balance in five years time, using forecasts produced or verified by an independent fiscal watchdog. For reasons discussed here, the OBR is not sufficiently independent to play this role.

[3] Recessionary periods are times when there is either a significant chance that output growth will be substantially below trend or negative, output growth is substantially below trend or negative, or the economy is recovering from output growth having recently been substantially below trend or negative. During recessionary periods, any fiscal rule should be suspended and fiscal policy should aim to restore the economy to good health as quickly as possible.

[4] Running deficits of a sufficient size to make the debt to GDP or reserves to GDP ratio rise forever is not sustainable. Eventually the government will choose to default on its debt rather than raise taxes to pay ever higher debt interest, or more probably inflate away the debt. For this reason advanced economies do not permanently run these large deficits. It is important to distinguish this situation, of unsustainable permanent deficits, with a one-off but permanent increase in the level of debt to GDP caused by temporary large deficit, which is sustainable.