October Budget 4 - Good and bad reasons to have fiscal rules, and why bad fiscal rules are worse than having no fiscal rules

 

I was going to write a post about current UK fiscal rules, but judging by comments I get I think I first need to set out why fiscal rules exist in the first place. There seems to be a lot of misunderstanding about why some countries have them and what they are designed to do. So this blog post is a background piece to a later post that will talk about the specific fiscal rules the UK currently has, and what Rachel Reeves should do about them in the Budget.

Let me start with one reason often given for fiscal rules which is just wrong. This says that government debt as a share of GDP is too high, and we need to bring it down. This is not valid because we have no good reason to believe that current levels of debt are too high. After all, from WWI to WWII UK debt to GDP was much higher, and they are much higher in Japan today. The ‘debt is too high’ argument often implicitly assumes that government debt is a bad thing, and as I explain here that is wrong because it appeals to incorrect analogies with household debt. So any fiscal rule (like the current UK 'falling debt to GDP' rule) that presumes lower debt is good is a bad fiscal rule.

However, is there some level of debt to GDP beyond which bad things might happen? A government that borrows in a currency it can create can never be forced to default by the financial markets. However a very high debt level normally involves paying high levels of debt interest, and to do that a government has to raise taxes or cut spending. At some point the political cost of very high taxes or low spending can be so great that the government chooses to default on those interest payments. A more likely option is that the government creates high levels of inflation to devalue that debt. Both outcomes are pretty bad.

The problem with this upper limit to debt to GDP is that it is very hard to work out what it is, because it depends on political choices. What we can say with certainty is that it is much higher than current levels of debt to GDP. That needs to be the case, because often large increases in debt to GDP are absolutely necessary (think of shocks like wars, or major recessions, or pandemics), so governments would always want the ability to raise debt to GDP substantially without risking going past that upper limit. Of course we have little idea when these shocks will happen and how big they will be, so we have little idea how far we need to be away from any upper limit.

While this gives us no guide to what appropriate levels of debt to GDP are, it should make us nervous about forecasts where, because of the current fiscal policy stance (i.e planned tax and spending decisions), debt to GDP is rising inexorably throughout the forecast period and beyond. Economists call this an unsustainable fiscal stance. An example is the US today, which I will come back to. We can say, with a lot of confidence, that dealing with this is something that will have to be solved at some point to ensure sustainability. But is there any reason to believe that it will be better from society’s point of view, or politically easier, to solve it later than solve it now? [1] If not, why not achieve sustainability now?

If sustainability is the goal, this suggests fiscal rules should focus on some measure of the governments deficit, rather than the stock of debt. In addition it is the path of the deficit in the longer term that matters, rather than temporary movements due to economic shocks, or changes to public investment, or temporary changes in spending or taxes. Any fiscal rule that mistakes temporary deficits for a permanently unsustainable path is likely to create bad outcomes. 

 

Why do governments sometims choose to put sustainability at risk? Here we get to the heart of why we have fiscal rules. It is because increasing debt (or bank reserves i.e. creating money) is normally a lot less unpopular than raising taxes or cutting public spending. Generally speaking, voters worry much more about higher taxes or worse public services today than the very uncertain prospect of a future government default. For this reason, politicians who want votes will often be tempted to cut taxes or raise spending by increasing the government’s deficit.

This explains one rather odd feature of fiscal rules. They are commitments governments make themselves to constrain their current and future actions. Why would a government do this if they didn’t have to? The reason is that they know they will face future temptation, particularly as an election draws near, to cut taxes or raise spending (or both) for no other reason than to win votes, and pay for this by increasing the budget deficit. Fiscal rules are their commitment device to stop that happening.

Think of Trump’s tax cuts, for example. Funding these by issuing debt was more popular than cutting spending or raising other taxes, which is why Trump and other Republican politicians did it this way. But by creating a deficit which, at some point, another government might feel they should reduce, Trump was buying popularity at a future government’s expense. It wasn’t a very responsible thing to do, and a system which encourages irresponsible governments isn’t a good system.

Of course that argument is harder to make if we are talking about saving lives by having more doctors rather than cutting taxes paid by the rich. But if the argument for having more doctors is strong, why not ‘pay for them’ with higher taxes rather than a larger deficit? Suggesting that the spending will not happen without deficit finance either suggests that it shouldn’t happen in a democracy, or that we have politicians who are out of touch with what voters want. In reality I think the UK experience suggests balanced budget increases in public spending can be pretty popular.

If you find worrying about unsustainable deficits that might lead at some future date to high inflation or government default too abstract, then there is a more immediate argument for fiscal rules that I set out here. It uses the same idea about governments being tempted to deficit finance to get votes, but the cost is not default at some date in the distant future but higher inflation very shortly. If we start from a position where inflation is stable, then tax cuts or spending increases will lead to inflationary pressure and therefore to central banks raising interest rates.

Why will governments be tempted to do this? Because moderately higher interest rates are often not connected by many voters to tax cuts or spending increases. Central banks rarely say we increased interest rates because of the government’s fiscal actions, which allows governments to deflect blame. Low information voters may therefore credit the government for lower taxes (say) and not punish them for higher interest rates. Again this suggests fiscal rules based on the deficit rather than debt.

It’s a trick that doesn’t always work for governments, as the Truss fiscal event showed. However we know this trick often did work, because of what economists call deficit bias. Government debt in the OECD almost doubled between the mid-70s and mid-90s, for no good macroeconomic reason. Unlike the last two decades, there were no record recessions or pandemics that could explain this increase in debt.

Of course there are some circumstances where deficit finance is appropriate. Public investment that benefits future generations is an example (with the added benefit that this will boost future GDP) or spending in a recession which is essential for Keynesian reasons (where interest rates are unusually low). Often it is responsible to deficit finance and irresponsible not to, which is why fiscal rules have to be more sophisticated than simply always balancing the budget. Anyone in the media who thinks this complexity just represents loopholes for the government shouldn't be commenting on fiscal rules.

Note that, for the UK’s fiscal rules at least, there is a symmetry between spending increases and tax cuts. In that sense, these rules are neutral in terms of the size of the state. In my view that is an important attribute for a good fiscal rule to have.

So fiscal rules are a commitment device for a government that knows it will be tempted to deficit finance to gain votes, which will either add to inflationary pressure in the short term or threaten an unsustainable path for debt in the long term. They will be tempted because a significant proportion of voters don’t see those costs, or do not connect them to the government which uses deficit finance for party political ends.

I started by noting one incorrect reason often given for fiscal rules, which amounted to a presumption that government debt was too high. Let me discuss two other reasons, one of which is simply incorrect and one of which is much more complex than normally suggested.

There is a widespread but incorrect view that fiscal rules are there to reassure financial markets. This motive is hardly ever mentioned in the academic literature on fiscal rules, for a very obvious reason. Fiscal rules are there because governments can exploit low information voters, or voters that are not worried about debt sustainability. By contrast financial markets involve high information actors. They don’t need fiscal rules, or ratings agencies for the major countries for that matter, to tell them about the implications of fiscal decisions.

A second reason often given for fiscal rules is that increasing government debt represents a burden on future generations. I wrote extensively about this a decade ago (see here, for example). This claim is neither unambiguously true or false. One of the odd features of a government living forever is that it can make the current generation better off without penalising any future generation, but only if certain conditions hold and they may not hold.

Getting the reason for fiscal rules right tells us about their importance. Of the many problems in this world, moderately higher interest rates or the cost on future governments of restoring sustainability are not top of the list. This is important when trade-offs between following rules and other issues arise.

The most obvious example is climate change. If action to reduce climate change is prevented by fiscal rules, then the government (or courts) involved have got their priorities very wrong (I would say criminally wrong). Indeed, as fiscal policy designed to promote green energy will only be needed to quickly phase out energy that creates CO2, it will not be permanent and will therefore not threaten sustainabiitty (see also here).

This is also why I often say that a bad fiscal rule is worse than no fiscal rule. A bad fiscal rule could prevent a government enacting fiscal stimulus in a recession, for example. That has consequences that are far worse than allowing the irresponsible behaviour outlined above. A government that failed to enact fiscal stimulus in a recession would be far more irresponsible than one that broke a bad fiscal rule that stopped it from doing so.

The same issue arises in the United States. The US has some really dumb fiscal rules, like the debt ceiling, which are worse than useless and should be thrown away. But equally, the US doesn’t have an overriding deficit type rule like the one we have in the UK, for example. In addition, the US is currently running deficits that do not look sustainable. Would it be a good idea for the US government to impose a sensible fiscal rule that avoided this?

Until recently the US was a good example of where a good fiscal rule would have been helpful. Typically the Republicans gained votes by cutting taxes and running up deficits and the Democrats worried about deficits, tried to bring them down and probably became unpopular as a result. A fiscal rule that stopped the former would have produced better outcomes.

However right now the Republicans under Trump look like they have given up on democracy, and as a result it is essential that they are kept out of power as far as possible within the constraints of a democracy. If the Democrats were forced to follow a fiscal rule that meant higher taxes or less spending, this might harm their electoral chances (see above), and that could end democracy in the US. It is also quite clear that if the Democrats introduced a deficit rule, if the Republicans gained power they would rip it up in order to cut taxes for the better off.

One final point is the mirror image of the last. Many of those who oppose fiscal rules cite 2010 austerity. But the world-wide move to austerity in 2010 had very little to do with fiscal rules, and much more to do with political actors who wanted to shrink the state. That is obvious in the US, where there was no deficit-based fiscal rule, but it was also true in the UK. Labour rightly abandoned its fiscal rule of 10 years standing to enact fiscal expansion in 2009, and the Conservatives chose a rule that enabled them to enact austerity. To suggest that their fiscal rule caused austerity gets cause and effect wrong. Indeed, a sensible fiscal rule like the conditional golden rule proposed by Shadow Chancellor John McDonnell in 2016 might have exposed austerity for the stupidity it was if it had been in effect under the previous Labour government. [2]

Understanding the case for fiscal rules is crucial for any sensible analysis of them. Often criticism of these rules presumes a responsible government, or highly informed voters, assumptions that if they were true would indeed make such rules pointless. Equally often, misunderstanding what these rules are designed to avoid can lead politicians or others to propose or insist on following harmful fiscal rules, with far worse outcomes than if we had no fiscal rules at all.  

[1] In contrast to the US, in the OBR’s 50 year projections for the UK, debt to GDP only increases above current levels around 2040. That is a good reason why political action, although not thought, can be delayed.

[2] The Eurozone is more complex, because what led to the Eurozone crisis spreading beyond Greece was the actions of the central bank. But otherwise I think the points made in relation to the UK also apply there. In particular German politicians and many voters have a phobia about government debt, which leads to the imposition of damaging fiscal rules.