The writer is director of the National Institute of Economic and Social Research
Rishi Sunak, Britain’s new chancellor of the exchequer, has been presented with a unique opportunity but a tough challenge. The opportunity is the remit to raise government spending on schemes to “level up” the UK’s regions. The challenge is the need to do this within the constraints that the Treasury has traditionally imposed on government departments.
At the heart of this dilemma is what are known as the fiscal rules, a set of numerical targets that limit how much the government can borrow and when. Having a system of controls over tax and spending is a good idea, of course. Financial markets will know how much debt the government will need to raise. Markets’ confidence in the capacity of the state to stabilise the economy should itself support growth. Yet we have struggled to define a rule that is timeless and that acts to support growth.
The problem comes from the rules themselves. For the purpose of setting interest rates, it is relatively straightforward to set an inflation target as a measure of achieving the desirable objective of price stability. Fiscal policy is much more complex to define in such a manner.
The latest set of fiscal rules, announced almost on the hoof in November, framed this problem in a particularly poor manner. First, the idea that government borrowing for investment should be no more than 3 per cent of gross domestic product is likely to be a fillip to such investment when it is not required, but a constraint when significant investment is required, as now.
Second, a target of balancing current (or day-to-day) spending rarely make much sense as it will be undermined by news on economic performance. The target for a balanced current budget in 2022-23 fails to deal with current economic requirements and will only be achieved if the economy surprises us. We should not adopt a target that we cannot control.
This failing is not unique to the current government. Fiscal rules have been around since the Labour government brought in its own version of them in 1997. That first set of rules included the “golden rule” to borrow only to invest over the economic cycle and another to keep debt at 40 per cent of gross domestic product. But lower than expected growth meant the government missed the golden rule and continually sought to extend the length of the cycle to allow time to make the books balance. After the global financial crisis, the Conservative-Liberal Democrat coalition government set a target to eliminate the current deficit over five years, a target not met until 2018. To paraphrase Jonathan Swift, fiscal rules, like promises and pie crusts, are made to be broken.
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So, what is the alternative? First, the control of public debt is necessary in order to prioritise current expenditure plans, but also to maintain the capacity to deal with an uncertain economic future. Large expenditure shocks should generally be financed by gradual increases in taxes and immediate (and strictly temporary), increases in public debt.
The UK has not defaulted on public debt in its modern history. Previous episodes of high public indebtedness have seen it reduced, as a share of GDP, by targeting a series of primary fiscal surpluses (a surplus without including interest payments on the national debt). At the same, growth in nominal GDP — the cash value of the economy — was allowed in order to make the level of public debt more affordable as a share of output.
Rather than arbitrary and unrealistic rules that will be subject to constant revision, the government should set a general objective for low and stable public debt, and then publish forecasts of the current and future primary fiscal surpluses that may change given economic circumstances — just as the Bank of England does for inflation.
Ultimately, it is questionable whether the chancellor should be solely responsible for setting the path of the fiscal surplus. It may be preferable for a fiscal council, possibly chaired by the chancellor, to set the path of the primary fiscal surplus with the aid of independent economic forecasts.
There are times when debt should ratchet up rapidly and moments when it can be cut relative to national income. While good fiscal policy should try to stick to orthodox budget practice, at times of severe economic downturns, when people are at risk of losing their homes and jobs, it will need to diverge from that path. As long as this is done under the auspices of an independent body, it should not be a cause for concern.
It is time we learnt to think of the path of primary surpluses as a tool that can change in response to changing economic demands. The aim of fiscal policy should be to offset short-run economic pain and ensure long-run financial stability.