Fiscal rules: what value if they change whenever politically convenient?

The UK has had seven different sets of fiscal rules since 2010, suggesting that they are simply not fit for purpose. Sound fiscal policy urgently needs the Chancellor to accept accountability and transparency, including an annual ‘state of the economy’ address outlining progress – and failure.

When we look at the UK’s desperately poor recent social and economic performance, whom do we hold responsible for such an enormous failure of public administration?

I believe that we need a serious examination of our economic progress to be thoroughly and comprehensively produced every year. In this way, we can all gauge progress and the Chancellor can explain what has gone well and what could go better. Over time, this would bring about more focus on and resolution of our economic malaises.

The trivalisation of fiscal policy debate

The UK’s fiscal rules are clearly not fit for purpose. Indeed, they are ‘more honor’d in the breach than the observance’.

They have introduced a trade away from public investment towards government consumption. They have led to a trivialisation of the fiscal policy debate centred on arbitrary fiscal space. And they have taken attention away from the failures of economic policy, which, on the assessment of the Office for Budget Responsibility (OBR), have significantly damaged potential output, leading to a country that is more prone to inflation and which has developed a structural fiscal deficit.

The fundamental tension lies in the need to retain flexibility to respond to emerging problems, such as a substantial shortfall in investment or a pandemic, without prejudicing the government’s future ability to respond in the same way. So we also need to build in some stronger mechanism for ensuring that there is a longer-run appetite for investors to hold UK government bonds.

This will require some way of providing assurance to bondholders that the tax base of the country will grow in the longer run to ensure that debt service costs neither impinge on the future provision of essential public services and infrastructure, nor on the central bank’s ability to control inflation with its policy tools.

What should a rule seek to target?

It is almost impossible to write a credible rule for the ratio of public debt to GDP. But it is, of course, an aspiration to lower the debt burden relative to GDP over time.

The problem is that large economic shocks will lead to long adjustment periods, during which any pre-committed target will be consistently missed and there will be some optimal speed at which it is returned to some proportion of GDP. Note that the historical UK experience highlights the substantive role of real growth in any long-run reduction in the debt-to-GDP ratio. It is almost true to say that we grow out of debt burdens.

Rather than focusing on debt as an abstract quantity, we should start planning for contracted and contingent claims on the state in order to understand better the prospective liability side of the government balance sheet and set those against assets that may yield an immediate financial return or indirectly so via their implied impact on the economy. Further transparency in this area will support the trust of the financial markets for any new investment plans that we may collectively wish to develop.

The markets

It is often crassly argued that financial markets will take fright at any prospective increases in public indebtedness. Much of this is based on reactions to the disastrous ‘mini-budget’ of September 2022.

Actually much depends on the reason for the increase in debt, the objectives for the funds raised and the extent to which it is felt that it reflects an economy that is likely to grow robustly or one that is in a secular decline. Our current structural deficit reflects an underperforming economy on which the fiscal burden has become large in comparison, and increasing indebtedness without a credible growth plan may well trigger similar concerns to what we saw in September 2022.

But if debt is raised for well targeted investment under robust appraisal methods and delivered by an operationally independent institution, the markets are unlikely to be concerned about measures that ought to support the development of the supply side of the economic, to crowd-in private investment and, over time, to bolster the tax base.

Forecasts or actuals

Proving assurance on the sustainability of the government’s fiscal plans requires a long view and questions quite profoundly the case for the OBR to be assessing policy over a short-run time frame when shocks and events will almost certainly require some flexibility. The failures of short-run forecasting are quite apparent as productivity has been over-predicted for a generation and, after the Covid-19 crisis, inflation was under-predicted.

That is not to say that forecasts are unhelpful in planning, but they need to be treated as a statement of the measurable set of risks not a concrete statement of what will come to pass. They are certainly of help in trying to understand what is the appropriate fiscal response to current shocks. We do need a serious forecasting function in Whitehall.

But the main risks we face to our longer-term fiscal position - including from demography, health and a failure to nurture growth – are all ones that we can model and produce analysis on what might happen in the case of no change in policy or when policy changes.

That is the kind of forecast that we should be asking from the OBR: whether they think that on current policies, debt will be sustainable in the sense of whether the funding of the debt will capture too much of the likely revenue base or provide a constraint on monetary policy. Such a statement would tie successive governments to longer-term economic management.

Conclusion

What we are looking for is competent management of the public purse by the government in conjunction with the civil service under the watchful eyes of the media, research organisations and the financial markets.

The OBR, as part of the development of a credible fiscal framework, has been an excellent innovation, and it has produced much useful data and analysis of the fiscal position and the UK economy. But a faulty rule and the process for managing fiscal policy do not support competence.

An overview of the government balance sheet, the changes since the previous year and how it is sustainable – both in terms of the market demand for gilts, but also in terms of tax revenues required in excess of the returns from any assets held – would lead to a better set of choices over time. This overview would force the Chancellor to be held to account for economic performance and not hide behind a forecast, which will always be wrong.

All of this could be accomplished with an annual ‘state of the economy’ address, which would be timetabled six months or more in advance, so we can gauge our national progress every year at the main fiscal event.

Where can I find out more?

A consideration of fiscal targetry: October 2024 NIESR report by Jagjit Chadha.
The Guardian view on tax and spend politics: dodging debate by fiddling with fiscal rules: 20 October 2024 newspaper editorial.
The case for a new fiscal framework: NIESR report by Ben Caswell.
It’s time for the OBR to look beyond the fiscal rules: NIESR report by Stephen Millard.
UK fiscal rules: The need for stronger oversight: October 2024 piece by Andrew Sentance.