The UK’s falling debt to GDP fiscal rule is a rule to suppress public investment

 

Let me start by apologising to any regular readers of this blog. None of the arguments in this post are particularly new. But with a new PM and possibly a new Chancellor, and with Andy Burnham committed to high public investment including many more council houses, it seems appropriate to make this argument once again in as clear a way as I can.

The UK has for some time had two fiscal rules. One targets some measure of the future deficit as a ratio of GDP and the other requires debt to GDP to be falling. The second rule is about the change in debt, but the first rule is about the deficit which is the change in debt. So why do we need two rules which essentially target the same thing? [1]

Here are the variables relevant to the two current fiscal rules since 2000.

The red line, the ‘golden rule’ that targets the current balance, shows the impact of the two recent recessions quite clearly. As I have long argued, fiscal rules should be abandoned during recessions and the subsequent recovery. The blue line, which is the change in the government’s net financial liabilities as a ratio of GDP, is the falling debt to GDP rule. It is much more erratic, which automatically makes it a bad target for any fiscal rule, but it essentially follows the path of the current balance. The main difference is that, for a given deficit, when GDP is falling then debt to GDP will rise sharply, and equally when GDP is growing strongly debt to GDP will tend to fall.

So why two rules? Why not choose the more stable of the two, the golden rule for the current balance? The technical answer, which many of you will have already noted, is that the current balance excludes public investment. Without the second rule, then in theory public investment could be very high leaving debt to GDP rising even if the current balance was zero.

As I have argued many times, the golden rule makes good sense in principle. As long as we measure the current balance some years ahead to strip out erratic elements or the impact of the business cycle, and as long as we have an opt out from the rule in major recessions when interest rates are likely to hit their lower bound, then it makes sense to aim to have a fiscal policy that neither adds to nor subtracts from aggregate demand. A current balance target is a shorthand way of doing that. [2]

Why exclude public investment from the deficit rule? There are many reasons, but one of the more compelling is that politicians will often try to meet any total deficit rule by cutting public investment rather than current spending, because the political cost is less immediately visible. 2010 austerity was a clear example of that, and we are still suffering its effects. Better to target the current balance, which forces politicians to make choices that don’t damage the economy in the longer term. A second, and at least as important, reason is that individual public investment decisions should be based on whether the projects themselves are worthwhile, and not on some aggregate financial number. When a business sees a good investment opportunity it borrows to invest, so why shouldn’t the government do the same?

But that compelling logic means that it makes no sense to have a second fiscal rule, the only purpose of which is to constrain aggregate public investment. The logic that removes public investment from the deficit rule is just overridden by having this second fiscal rule! At best the falling debt to GDP rule just duplicates the golden rule, and at worst it constrains public investment and adds an erratic element to fiscal policy as well.

This case against the falling debt to GDP rule is overwhelming. I have been arguing against this rule for a very long time, and I challenge anyone to come up with a justification for it that I cannot debunk pretty quickly. It is true that a zero current balance rule will not guarantee falling debt to GDP, but if the government really wants to be absolutely sure that debt to GDP falls it can achieve that by targeting a small surplus for the current balance. (See the section headed “Why not focus solely on the current budget balance?” in Ben Zaranko’s discussion.)

I don’t think the reason we have the falling debt to GDP rule is technocratic. Nor do I think it is just because some want low public investment for political reasons. Instead I think it is part of what I call mediamacro. According to too many journalists in the media, government debt is bad, so a good fiscal rule has to ensure that this bad thing is getting smaller. If the rule doesn’t actually specify that directly, then from a mediamacro point of view that is a problem.

I became convinced of that when I was on John McDonnell’s Economic Advisory Council when he was Shadow Chancellor. I wrote a paper for the Council arguing for a form of golden rule and ditching the falling debt to GDP rule, and the only dissent on the Council (chaired by John) was from those against having any rule at all. But later I got a call from John’s team, saying that their political/media advice was that a form of a falling debt rule had to be included as well. (They did, however, try and reduce the eratic nature of that target.) I suspect every Chancellor before or since has been getting that advice, and as ever politics trumps economics.

If we combine the falling debt to GDP rule’s constraint on public investment under a Labour government with the Conservative predisposition to cut this investment anyway, and it becomes much easier to understand why UK public investment is unusually low. There may be occasions where the pressure on real resources is such that the additional domestic demand generated by additional public investment in the short term might lead to unacceptably high interest rates, but that is not always the case and the falling debt to GDP rule applies whatever. This constraint on public investment also means that Labour governments search for other less sensible means to increase public investment that avoid immediate public borrowing, such as PFI for example.

If public perception, which in reality means media perception, is really believed to be a binding constraint, then there is a way around the problem, a route that John McDonnell later took. Rachel Reeves has already redefined the measure of debt in the rule to include financial assets held by the government. The obvious next step would be to include physical assets as well, meaning that public investment would have no long term impact on the measure of debt [3] The disadvantage of taking that route is that it brings the falling debt to GDP rule even closer to the golden rule. but if that hastens the eventual demise of the falling debt to GDP rule so much the better. [4]

So my advice to a new Chancellor, if we have one, is to get the Treasury to write a paper setting out why the falling debt to GDP rule along side the golden rule simply acts as a barrier to public investment, and how under reasonable assumptions the golden rule achieves falling debt to GDP in the medium to long term. [5] At the same time commission an analysis of where the public sector capital stock has declined over the last twenty years, together with a sector by sector analysis of possible supply side constraints on increasing public investment today.  

The argument in this post is not that the government should never try to reduce debt if it can. I think there is a good reason why it might wish to, which is to make room for large increases in debt following a major recession. It can do this by, if necessary, setting a non-zero target for the current balance. Instead my argument here is that public investment should not be the means by which that debt is reduced, which is the inevitable consequence of having falling debt to GDP as our second fiscal rule.

[1] Why not target the level of debt? Targeting debt makes no sense, because debt is the shock absorber that allows governments to avoid erratic movements in spending and taxes following shocks to the economy. But debt (or money creation) has a downside, which is that it allows politicians to avoid tax increases or spending cuts not for the sake of the economy but for the sake of their popularity (‘deficit bias’). That is why it makes sense to target the difference between spending and taxes, which is the deficit.

[2] Why not just look at inflationary pressure directly, as MMT would argue? Well if the central bank is doing its job then it will always ensure inflationary pressure some years ahead is zero.The reason to have a balanced fiscal policy is to avoid our central bank having to raise interest rates just because politicians don’t like making unpopular decisions..

[3] Indeed, if the asset was worth more than than its initial cost, it would increase public wealth

[4] Subtracting physical assets from debt is a logical next step to the change made my Rachel Reeves to subtract public sector financial assets. It transforms debt into a measure of public sector wealth or net worth, that many including another Andy have suggested as a traget in the past. 

[5] While supportive of looking at public sector net worth, a standard line from the IFS among others is that looking at gross debt is still useful because public sector assets don’t necessarily yield a financial return. But this doesn’t matter, because in that case the government can just raise future taxes following the golden rule. Indeed that is the right outcome from an intergenerational point of view, because those who benefit from the investment pay for it.

I think this and similar arguments for retaining a rule involving gross rather than net debt owe something to the concept of ‘fiscal space’, which is the idea that there is some upper limit to what public debt can be, and crucially that we are always close to that limit. There is an upper limit to public debt, which is the level of debt where the government would rather default than raise taxes to service that debt. That level is an order of magnitude above current levels. Other attempts to suggest a much lower limit to the public debt tend to fall apart empirically.