The UK Treasury are reported to be working on plans to reform the two fiscal rules introduced by Gordon Brown. These are the ‘Golden Rule’, that over the cycle the government’s current account be in balance or in surplus and the ‘Sustainable Investment Rule’ that the ratio of net general government debt to annual GDP be no more than 40 percent.
Before reforming the substance of the rules, the UK government should think about how it would enforce whatever rule or rules it comes up with. Both the ‘Golden Rule’ and the ‘Sustainable Investment Rule’ were respected only as long as they did not bind. When they became binding constraints on the government’s ability to borrow they were bent, fiddled and now ‘reformed’, that is, ignored. The fiscal rules of the EU’s Stability and Growth Pact – the general government financial deficit should not exceed three percent of GDP, and over the cycle the general government financial deficit should be close to balance or in surplus – to which the UK also signed up, have been ignored/violated with equal equanimity. With zero credibility as regards its willingness to respect its own fiscal rules or those of the EU, why would anyone pay any attention to a new set of rules that the Treasury may come up with?
Neither the Golden Rule nor the Sustainable Investment Rule make much economic sense. The same is true for the fiscal rules of the Stability and Growth Pact, but that is beyond the control of the Treasury.
The Golden Rule, which can be restated as the requirement that over the cycle the government can only borrow to finance investment, not to finance government consumption spending, reflects an inappropriate application of misunderstood private sector financial criteria to the public sector. In the private sector, investment is undertaken in the hope, if not the expectation, that the return to the investment would cover the cost of the investment, including any cost of borrowing external funds to finance the investment. Private investment is therefore, in present discounted value terms, self-financing. Borrowing to finance private investment is therefore ‘sound’. Consumption yields no such cash returns and is not self-financing. If you borrow to finance consumption today, you will have to cut future consumption (compared to the level of future consumption you could have enjoyed if you had not borrowed today) by the same amount in present value terms. This is not ‘sound’, if the borrower for consumption purposes is myopic or might be tempted to default.
The argument is bogus. First, borrowing to smooth consumption over time is, or should be, the ultimate purpose of all honest borrowing. Investment is just part of the mechanism for smoothing consumption over time. Ultimately, all loans are consumption loans.
Second, public investment often yields no cash returns at all to the government. Even when it brings in cash revenues through user charges, this is often insufficient to cover the total cost. Public investment in social housing is an example. Much infrastructure investment also falls into that category (toll roads and toll bridges that cover both operating costs and capital costs are few and far between). Some public investment may raise the government’s tax revenues indirectly, even when the services produced by the public sector capital are not sold, through user charges etc., to the public. Roads and railroads raise productivity and output and thus the tax bases for the personal and corporate income tax and VAT. When the return to public investment is public happiness, there need be no cash returns of any kind: funding the construction of a children’s play ground or a park are examples. From the point of view of the budget, therefore, it makes sense as a rule to treat public investment as if it were public consumption and to expect no cash returns from it at all. Remember, we are talking the general government sector here. This excludes whatever market-active state-owned enterprises may still be around (e.g. EDF in France).
Cyclical corrections are as much art as science. Even as art, however, they should be honest art. The government’s starting date for the current cycle has been shifted repeatedly for no other reason than that without such shifts, the Golden Rule would have been violated. The current cycle has, according to the Treasury, started in 1997. It could have been 1887, had the political need for a little more deficit spending been sufficiently strong. As long as the Treasury determine the beginning date and end date of the cycle, the concept of cyclically adjusted fiscal rules will be a joke (a bad one).
The Sustainable Investment Rule takes an arbitrary number, 40, as the percentage of annual GDP that the net general government debt cannot exceed. Why 40? Perhaps because 40 was the number of days Noah spent on the Ark. Or maybe because life begins at 40.
Outrageous fiddling has kept the official measure below 40 thus far. Public private partnerships were promoted even where they made no sense at all. Examples include the construction of state schools, NHS hospitals and other ventures for which the cash revenues will never cover current costs, let alone current and capital costs. The Bank of England is not part of the general government sector. This permitted the Treasury to keep its exposure to Northern Rock off its balance sheet before Northern Rock’s nationalisation. Since Northern Rock’s nationalisation this ought to have been on the government’s balance sheet, but inexplicable delays in sorting the technicalities have so far kept it off the Treasury’s books.
I also believe the Treasury bills issued to be swapped, through the Special Liquidity Scheme administered by the Bank of England, for illiquid private asset-backed securities owned by crippled banks, are not on the Treasury’s books. Apparently, Treasury Bills with maturity less than one year don’t figure in some of the politically embarrassing debt measures. From an economic point of view, this is insane. To the government’s credit, the net debt measure in question only subtracts liquid assets from the government’s gross debt, so the illiquid stuff held on the asset side of the SLS balance sheet is effectively valued at zero, which is probably a tad pessimistic.
The net debt concept defining the 40 percent of GDP ceiling follows current practice (except in some havens of enlightenment like New Zealand) in not including any allowance for contingent liabilities. The Treasury’s exposure to Northern Rock through its guarantee of Northern Rock’s deposits and most other non-secured debt is therefore ignored. This common practice is worst practice.
Despite its best efforts, the 40 percent net debt to GDP ceiling is about to be exceeded. With the economy slowing down rapidly and quite possibly already in recession, the general government financial deficit is already above 3 percent of GDP (violating one of the EU’s Stability and Growth Pact rules). With only North Sea oil revenues buoyant, but all other major tax bases shrinking, the deficit is likely to exceed five percent of GDP even without any discretionary tax cuts or spending increases.
The government, quite rightly, does not want to act procyclically by raising taxes or cutting public spending to prevent public debt and deficit from rising more than the existing rules permit just as the economy is tanking. That they would have been forced to do so if they had stuck to their existing rules is evidence either that these were the wrong rules, and/or that the government failed to abide by the rules when times were good.
What would a good rule look like?
A good rule focuses on the painful part of the budget, that is, on taxes, and leaves the fun part (public spending on investment, consumption and transfer payments) alone. It focuses on the financial deficit of the consolidated general government and central bank (net of central bank monetary financing), to prevent the central bank from being used as a quasi-fiscal agent of the government. It focuses on a net debt measure that subtracts the fair value of all government assets (that is, either their market value or the best estimate of the present discounted value of their future cash flows) from the fair value of all government liabilities(including contingent liabilities) on the assumption that the government does not default on its liabilities. For net debt too, the relevant definition of the government is the consolidated general government and central bank, and only the non-monetary liabilities need to be considered.
A conceptually attractive rule might look like the permanent balance rule advocated by Clemens Grafe and myself (see (in increasing order of illegibility) “How to reform the Stability and Growth Pact”", “Ten Commandments for a Fiscal Rule in the E(M)U” and “Patching up the Pact; Some Suggestions for Enhancing Fiscal Sustainability and Macroeconomic Stability in an Enlarged European Union”.)
Its basic logic is that permanent public spending is financed with taxes. Temporarily high or low public spending are financed by borrowing or retiring debt. Effectively, you set the share of taxes in GDP equal to the permanent share of public spending in GDP. It does not matter whether spending is for consumption, transfers and subsidies or investment. Permanent means approximately ‘expected future long-run average’. The permanent balance rule therefore allows for deficit financing during recessions but also requires reductions in the net public debt to GDP ratio during cyclical booms. Wars (which we hope if not expect to be temporary) can be partly deficit-financed. Temporary revenue windfalls have to be saved and used to retire debt.
An attractive modification of the permanent balance rule (and without which the steady-state net debt to GDP ratio would be history-dependent) might be to augment it with some ‘error correction’ term for the net public debt to GDP ratio. This would anchor the long-run net public debt to GDP ratio.
Can governments be relied upon to apply such a rule honestly? Outside New Zealand, no. Therefore, some outside, independent body (a Fiscal Policy Committee) should determine, each year, the required ratio of taxes to GDP that meets (in the opionion of the independent body) the permanent balance rule. The mix of taxes that makes up this required ratio of total tax revenue to GDP is up to the government.
In the weakest version of the FPC, the independent body (whose members would be appointed by a qualified majority (not less than two thirds) of the relevant Parliamentary committee (say the Treasury Select Committee) would make a public recommendation for the required tax burden. The government would have to explain and justify any departures from this recommendation.
A stronger version of the FPC would have the independent body make a binding recommendation. If, in the opinion of the FPC, the government’s proposed taxes do not add up to the required permanent balance tax ratio, the FPC could vary a specific set of tax rates to correct the shortfall or excess. This residual tax rate would have to apply to a broad tax base. An example would be the standard rate of the personal income tax, the standard VAT rate or the employee’s national insurance contribution rate.
It is clear that myopic and opportunistic governments (that is, any government of whatever political colour this country is likely to elect), cannot credibly commit themselves to run surpluses or to consciously reduce the net debt to GDP ratio when the economy is booming. The real choice is therefore between the boom and bust mess that is being revisited on us as we speak and taking the debt and deficit key away from weak-kneed governments.
Even when it comes to monetary policy, there is something deeply unattractive about rule by independent technocrats. In the fiscal field the arguments against delegating public debt and deficits to an unelected ‘agent’ or ‘trustee’ are even stronger. Admittedly, taking the authority over public debt and deficits away from elected politicians does not limit the size of the state (as measured by the scale, scope and composition of public spending) or the structure of taxes. But the ability to determine, for any given programme of public spending over time, the distribution of the tax burden across time and generations is a non-trivial economic instrument with important political and distributional consequences.
Insisting on strong democratic accountability for public debt and deficits, including the right to throw the rascals out – the only true, substantive accountability there is – means that public debt and deficits will be opportunistically manipulated for party-political advantage. You take your pick.