On 30th October Rachel Reeves will be setting out her first budget, rather than responding to someone else’s decisions. She will be leading the public discussion, not following the narrative set by another. That will be obvious in terms of tax, because she will be raising taxes rather than pretending to permanently cut them. But it should also be true for the fiscal rules that she commits the government to follow.
In his first budget of 1997, Gordon Brown set out his own fiscal rules. They were very different from anything followed by his predecessor, and they were innovative at the time. They lasted for ten years, derailed only by a global crisis and the worst recession since WWII. The forthcoming October budget is also a chance for Rachel Reeves to establish her own fiscal rules that are better and last much longer than those of her predecessors. [1]
Last week’s discussion of why we have fiscal rules gives us three basic properties that good fiscal rules should have:
-
They should discourage politicians from using deficit finance (paying for higher spending or lower taxes by borrowing or creating reserves (money)) simply to avoid the unpopularity of raising taxes or cutting spending, rather than for any good economic reason.
-
Conversely they should not prevent deficit finance when this makes sense in economic terms. For example there are good reasons why fluctuations in public investment should be financed by borrowing, and overwhelming reasons why a deficit financed fiscal stimulus should be used when an economy is at risk from, in, or recovering from a recession.
-
Fiscal rules should focus on underlying trends, rather than short or medium term fluctuations in spending (wars, pandemics, greening the economy) that have no strong implications for sustainability.
Fiscal rules that do not have these properties are bad rules, and it is better to have no fiscal rules than bad fiscal rules.
One of the fiscal rules that Reeves says she will follow largely has these properties, and one clearly does not. The rule that does is sometimes called the golden rule, and it states that in the medium term day to day public spending (all spending except investment) should be equal to total taxes. Specifically this involves a rolling five year ahead target for the current budget deficit (public spending excluding public investment minus taxes) of zero. However, as governments since Cameron/Osborne have acknowledged, and as first proposed in Portes and Wren-Lewis, this target has to be conditional on the economy not being close to, in or recovering from a recession. [2]
The conditional golden rule achieves property (1). It achieves (2) because it doesn’t apply during a recession, and the current balance excludes public investment. A rolling five year ahead target helps achieve (3), because forecasts five years ahead almost always involve the economy being on its medium term path. It is often suggested that having a rolling target rather than a target for a fixed date is bad because it ‘lets politicians off the hook’. This is false, particularly if forecasts are done by an independent body like the OBR. In contrast having a target for a fixed date fails property (3). As we move closer to that date fiscal policy will be responding to short term shocks, which makes for bad policy.
Although a conditional medium term golden rule goes a long way to satisfying property (3), it fails to take account of spending that is medium but not long term. The clearest example of that today is spending that helps the transition to green energy. For this reason, if I were Chancellor I would task the OBR with calculating how much of the current deficit is due to policy aimed at encouraging this green transition, and adjust the target to exclude this spending. Any government that lets a fiscal rule delay the green transition has got its priorities criminally wrong.
I have seen it recently argued that the last year of the last government showed that deficit based fiscal rules failed, because it didn’t prevent that government from making incredible assumptions about future spending so it could cut taxes. That is a misunderstanding. What the fiscal rules did, combined with an independent OBR forecast, was force the last government to make assumptions that amounted to further austerity in order to make tax cuts. That these plans amounted to further austerity was widely commented on by experts in the independent media. Without a fiscal rule and the OBR to monitor compliance, I’m sure the last government would have claimed that it would cut taxes and increase public spending! [3]
The other fiscal rule that Reeves appears to have adopted, which does come from her predecessor, is for a falling debt to GDP ratio five years ahead. This, when you already have the golden rule, is a terrible fiscal rule. I have not come across a single serious economist who defends it, and plenty of eminent economists who understand the damage it is doing (e.g FT here, or ungated here). The rest of this post is about all the reasons why this rule is not fit for any purpose except keeping economic growth down.
The first point to make is that, if the medium term conditional golden rule is in place, there is no need for an additional rule to achieve property (1). The golden rule does that just fine. In that sense the falling debt to GDP rule is completely superfluous [4]. Unfortunately that rule fails properties (2) and (3), because it discourages much needed investment. This is the reason I sometimes call it the suppressing public investment rule.
Suppressing public investment is exactly what the previous government was doing for fourteen years, and the terrible state of our public sector is partly a result of that. This was perhaps why that government was so attached to this rule. In contrast, Reeves has spoken many times about the need for additional public investment, so it makes no economic sense for her to adopt a rule designed to suppress that investment.
We currently need a surge in public investment to catch up all the ground we have lost. But the case for much higher public investment is even stronger than that, as recent research from the OBR clearly shows. Their paper first shows how public and private investment are really low in the UK compared to other G7 countries.
Public investment began rising towards the G7 average in the first decade of this century, but austerity cuts set that back. Private investment is no better, but that is partly because public and private investment are often complements.
The OBR, using very reasonable assumptions, calculates that if public investment was increased by 1% of GDP permanently, potential output would be 0.4% higher after 5 years. The impact on potential output goes on rising steadily, to reach 2.4% after 50 years. The paper also looks at what these assumptions imply for average rates of return and benefit to cost ratios. Of course the whole point of a good investment strategy is to choose individual projects that have a high return, and make sure these projects are not thwarted by some archaic fiscal rule. What the OBR’s analysis shows clearly is that increasing public investment is an excellent way to help improve the UK’s recently dire growth performance.
The falling debt to GDP rule is classic mediamacro. It comes from the idea that government debt is a 'bad thing' by making false and selective comparisons to household debt, that current levels are 'obviously' too high, and so debt needs to be brought down. It’s a rule that economists advise against but political advisers say is essential to maintain ‘political credibility’, which is code for what non-economists in the media think should happen. Everyone from political journalists to the great and the good like to opine about fiscal rules while having little knowledge. It is they, not economists, the markets or even GOD, that think maintaining such a bad fiscal rule is essential for credibility, and they are wrong about this just as they were wrong about 2010 austerity.
Reeves should take the opportunity of her first budget to consign this rule to the dustbin. The new OBR analysis of public investment provides the perfect excuse to do so, if she needed an excuse. [5]
What should take its place as Reeves’ second fiscal rule? Nothing. You don’t need a second fiscal rule. It serves no purpose, beyond the bad one of suppressing useful public investment. As I argued here, replacing it with a target for falling net public sector worth to GDP is just double counting. It makes sense to look at public sector net worth when looking at sustainability over the longer term (beyond five years), but having it as part of a fiscal rule is not sensible.
Yes, the Conservative opposition will claim that abandoning the falling debt to GDP rule allows the Chancellor to have slightly higher spending (about half a percentage point of GDP, according to the last OBR forecast) and higher public investment. Most voters will be happy about that. No one in the bond market will be worried - why should they be, when the OBR calculates that public investment almost pays for itself in generating higher taxes. [6] Much more importantly, abandoning this rule will allow the Chancellor to expand public investment to boost economic growth and green the economy. Getting rid of the falling debt to GDP rule is really a no-brainer for any Chancellor whose main concern is the health of the economy rather than the media commentariat might say.
[1] Part of the cynicism surrounding fiscal rules is a consequence of the last government, which changed fiscal rules even more frequently than the Prime Minister. Sometimes this wasn’t because the rules they replaced would have been broken, but just as a political ploy to wrongfoot the opposition. Essentially the last government used the misconceived media credibility they got from austerity to devalue the concept of a fiscal rule.
[2] Formally, the lower bound for nominal interest rates makes it essential that we have fiscal stimulus to prevent, moderate or recover from a recession. The exact form this conditionality takes is a second order, though important, problem.
[3] There is an issue about the OBR being forced to make forecast assumptions it strongly suspects are false, which I discussed here. This is an issue about the OBR's mandate, not about fiscal rules.
[4] In fact the falling debt to GDP rule has nothing to do with the basic principle of ensuring debt sustainability. Instead it is based on the presumption that the current debt to GDP ratio is too high, and as I discussed in my previous post there is no evidence for this.
[5] If Reeves is planning to keep this silly rule, and has already adjusted her plans so that the rule is met, it is not too late. She could be politically clever and announce both the end of this rule, but also that her fiscal plans would have met the rule anyway, showing that the rule is being ditched on good economic grounds rather than so she can spend more or tax less.
[6] That doesn't mean that long term interest rates will not rise. They may if additional public investment adds to already strong aggregate demand (in the face of weak aggregate supply), and markets anticipate that this will put upward pressure on interest rates. The obvious way to avoid that is to increase taxes.
