What the call for fiscal headroom reveals

 

Everyone, including the IFS, is agreed that the Chancellor should in the budget create more fiscal headroom than she did previously. Rather than match forecasts for taxes to expected current spending (plus or minus ten billion, say), she should aim for forecast taxes to be significantly more above expected current spending, to allow for headroom against unforeseen negative shocks. This seems very reasonable, doesn’t it? Well consider some analogies.

I have the thermostat set at 20 degrees centigrade, because I find that a comfortable temperature. But sometimes if there is a cold wind outside the temperature inside can dip below that before the boiler and the radiators can respond to put it back up to 20. I feel cold as a result. So I should set the thermostat to 22 degrees, to provide headroom in case a cold wind blows.

Hopefully you can see the fallacy in that strategy. Or take the Bank of England’s inflation target of 2%. Now, as we have seen, shocks to inflation like wars can happen that will take inflation well above that target. We cannot have that, can we. So the Bank should in practice aim for zero inflation, to provide headroom so that it doesn’t get caught out with above target inflation following inflationary shocks.

Now fortunately those who designed the UK’s inflation targeting regime were sensible enough to emphasise that the 2% target was not short for ‘2% or less’, and that inflation falling short of 2% was just as bad as inflation exceeding the target. So allowing headroom for the 2% target would make no sense. So why does it seem to make sense in achieving a fiscal rule but not an inflation target?

Why does everyone seem to be calling for greater fiscal headroom in the budget? I think it is because the taxes=current spending fiscal rule is not seen as a symmetrical target. If shocks turn out to be positive for the public finances so borrowing is less than expected that is not seen as a problem, but if negative shocks occur such that current spending exceeds taxes then that is seen as a problem that the government has to fix immediately. That is why we had the nonsense of welfare cuts in the Spring.

The analogy that comes straight from the term ‘headroom’ is making sure you design doors such that hardly any people hit their head on when they walk through them. If you make your door too small many people will hit their head, which is bad. If you make your doors too tall then there is no equivalent injury suffered. The costs and benefits are not remotely symmetric.

The financial analogy might be a bank current account. I keep a positive balance in my account because I cannot predict precisely every payment going in and out of the account, and I don’t want the balance to go below zero and incur overdraft charges. But is a bank account an appropriate analogy for a government? Who is going to slap an overdraft charge on the government?

One answer might be the markets, in the form of higher interest rates on government debt. But that should already be in the forecast. Borrowing moderately in excess of the fiscal rules might lead to a small increase in interest rates on government debt, not because of supply and demand for government debt but because it would signal higher aggregate demand and therefore higher interest rates set by the Bank of England. On the other hand higher borrowing caused by weaker aggregate demand (leading to lower tax receipts|) could have the opposite effect, leading to lower interest rates on government debt. All this is quite different from overdraft charges.

In my view fiscal rules should be like the inflation target. They are and should be symmetrical: it is just as bad to miss the rule by borrowing too little as it is by borrowing too much. If you borrow too little you are taxing people too much or not giving people enough public services, or the economy is in a downturn. Those are all bad things that should be rectified. If this is the case, then you don’t need any headroom at all, just as the Bank of England doesn’t allow headroom for its inflation target.

But this is not how the media and the current government see things, and for that we probably have the reaction to Liz Truss's fiscal event partly to thank. In the Spring the government did not take the “grown up” decision (to quote Charlie Bean, ex LSE, Bank of England and OBR) to allow the OBR’s forecast to show the fiscal rule not holding with a promise to fix it in November. Instead it decided it had to act immediately, cutting welfare spending to meet the rule. Presumably it thought being ‘grown up’ and not doing this would cause the markets to panic, or more likely the media would generate lots of bad publicity.

Given this view held by the Chancellor, then it does make sense to create lots of headroom against borrowing more than the fiscal rule allows. But that in turn inevitably means that fiscal policy is going to be tighter than the fiscal rule implies it should be. If in practice you always plan for forecast taxes to be £20 billion or more above expected current spending, then given forecasting errors can go both ways the government is enacting a tighter policy than the fiscal rule on paper suggests. Furthermore in practice how much tighter will depend on the whim of the Chancellor at the time in setting the amount of headroom, which in turn will depend on the circumstances they find themselves in.

Now I admit neither of these problems (moderately tighter policy on an inconsistent basis) is that great in the overall scheme of things, but I think someone should at least recognise these issues. If you think government debt should fall faster than is implied by the golden rule, then it is better to get that rule to target a small surplus than mess around with headroom. But the headroom issue is a symptom of a bigger and more serious problem. 

As a result of a combination of mediamacro’s reading of the Truss debacle, and the constant stories in the press about bond vigilantes and impending doom from the imagined actions of these imaginary people, we are returning to a world where policymakers see deficits and debt as always a problem, rather than as something that allows better fiscal policy making. 

The government’s debt and deficits are meant to go up as well as down, because they allow smoother taxes and spending and can also allow both to support the economy when needed. Government borrowing is therefore a very useful tool, and not some problem that needs to be eliminated as much as possible. If, in contrast, the media and governments start seeing government borrowing as a problem rather than a useful tool, then this can interfere with good fiscal policy making. At its very worst, it can lead governments to start trying to reduce deficits during economic downturns or recessions, as it did from 2010 onwards. As I have noted elsewhere, that is a possibility that is more likely to happen as a result of recent change to fiscal rules.

Exaggerated claims about market reactions to debt and deficits infantilize fiscal policy, and that infantilisation can be very dangerous.  Talking about the UK as part of some impending advanced economy debt crisis is almost as silly as talk about a possible IMF bailout. Such talk is only magnified by a right wing press desperate to replace the memory of a recent crisis that was the result of a fiscal event they lavished ecstatic praise upon. The main reason we have a fiscal problem in the US is not because politicians are being irresponsible about debt but because a populist dictator is denying economic reality at every turn. One pretty foolproof way of encouraging right wing populism in the UK is to pretend the market requires public spending cuts when public spending levels are already weak.