Playing by the fiscal rules

The UK’s fiscal rules – the targets set by the chancellor for how much debt and borrowing the government can take on – are under attack again. But this time the heaviest blows are landing from some unlikely sources, including from some of the strongest institutional defenders of public finance ​‘discipline’. At the spring budget last month, the chancellor declared that his plan to reduce government debt was ​“on track”. But before he had even sat down, Paul Johnson, director of the Institute for Fiscal Studies (IFS), was lamenting ​“the silly fiscal rules tail wagging the sensible fiscal policy dog”. The following morning, Richard Hughes, chair of the government’s own spending watchdog the Office for Budget Responsibility (OBR), said the ​“fiscal framework is being increasingly gamed”.

But the issues run far deeper than the usual fiscal ​“tricks” that were picked up following the budget. Beneath such political gaming lie three far deeper issues with the fiscal rules themselves.

The first is a lack of institutional bite. When any particular debt or borrowing rule becomes too tricky to meet, the chancellor can simply change it at their discretion. In the past nine years there have been six sets of targets. Each of these was intended to guide policy for the following three to five years – but on average, each lasted less than 18 months. Before the creation of the OBR, government used to get accused of marking its own homework when it came to assessing the impact of the economy on public finances. Now, it simply changes the assignment whenever it doesn’t like the mark it’s given.

The second issue is a failure to reflect uncertainty. Targets for debt and borrowing are intended to reflect something called ​‘fiscal space’ – the room that the government has to increase borrowing safely. But true fiscal space is complex. It is underpinned by the interaction between three things: the amount of underutilised resources – labour or capital – in the economy, also called the ​‘output gap’; the perceived credibility of economic policy institutions like the OBR or Bank of England; and the global economic and political environment. Economists are unable to reliably measure these factors for the recent past, let alone gauge exact fiscal space for the present, or forecast it several years into the future.

So in place of direct targets for fiscal space, we get a largely arbitrary substitute: crude limits to debt or borrowing as a proportion of GDP. It’s a classic case of the ​‘streetlight effect’, where the proverbial drunk searches beneath a lamppost because that’s where the light is, even when they know they dropped their wallet on the other side of the road. Fiscal rules are the prime example of a policy framework prioritising spurious precision over genuine accuracy.

The third problem is a lack of symmetry. Current fiscal rules are intended to limit excessive borrowing today (‘deficit bias’), in order to preserve fiscal space for tomorrow. This is a legitimate problem to guard against. But governments also regularly underuse fiscal space as well, for example during economic downturns, or to prevent future climate breakdown. In both cases it is wise to invest more earlier if this averts higher unemployment, or higher sea levels, later. Investing today can also give a country more resources tomorrow, which therefore raises fiscal space in the future. Yet governments often disregard this logic, and fiscal rules make no attempt to guard against such ​‘surplus bias’.

“Though the current formulation of fiscal rules is fundamentally compromised, there may be a relatively straightforward answer: take the power to set fiscal targets away from the treasury and give it to someone else.”

Though the current formulation of fiscal rules is fundamentally compromised, there may be a relatively straightforward answer: take the power to set fiscal targets away from the treasury and give it to someone else.

That someone else could be a new fiscal council, housed for example at the OBR. The council could be asked by parliament to recommend an ideal range for borrowing over the forecast period at each budget, based on their collective judgement over the availability of fiscal space, using the latest evidence. If the chancellor failed to keep government borrowing within this range, they would have to say so in their budget speech, and follow up with a written and oral explanation to parliament.

Under this new arrangement, a chancellor could no longer evade targets by simply changing them. But the primacy of democracy would also be preserved: a government could choose to miss the recommended range at any time, so long as they were willing to take on the argument.

Aiming for a wider range, rather than a narrow target, for borrowing would also better account for uncertainty. The width of the range, as well as the level, could vary at every forecast, depending on the level of confidence in the evidence at the time. The new approach would also guard against both over-borrowing and under-borrowing, since the target would be considered ​‘missed’ whether borrowing fell above or below the recommended range.

With the UK debate apparently sobering up to the fact that we need wholesale change to our fiscal rules, this may be a once in a generation opportunity to drag an arcane 20^th century approach into the 21^st century. As we draw closer to next year’s general election, the political reward for the first mover could be considerable. But if no one takes a lead, we’ll all be consigned to continue staggering under the streetlight, on the wrong side of the road.

Image: iStock