Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 6 February 2024

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.

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