When a policy that would save billions doesn’t create more spending headroom, our fiscal rules aren’t fit for purpose
Gordon Brown has said the UK needs to get out of its “doom loop of poverty”. In doing so, he has endorsed a proposal from us at NEF to change the way the Treasury currently subsidises the Bank of England’s interest payments to the banking sector. He’s right that the Treasury could make billions from changing these interest payments – but the problem is, it could have no impact at all on how much the government lets itself spend. These savings might not be a magic wand for the country’s economic woes if we stay ruled by our arbitrary debt and borrowing restrictions (known as “fiscal rules”) . Here’s why.
Private banks hold reserves at the central bank, and the central bank pays interest to the private banking sector for holding them. These interest payments began when quantitative easing flooded the banking system with excess reserves in the aftermath of the 2008/09 financial crisis. The level of interest paid on these reserves is determined by central bank interest rates, which are raised or lowered in order to shape the economy using monetary policy.
However, as we have argued since 2022, paying interest on all reserves is not necessary for monetary policy to have its desired impact on the wider economy – and it was not central bank policy before 2009. Instead, by requiring banks to hold some reserves that pay zero interest and only paying interest on reserves in an excess tier, central banks can save money. Since September 2023, the European Central Bank (ECB) stopped paying interest on required reserves which, they say, “improves the efficiency of monetary policy”.
While the ECB has changed, the Bank of England continues to pay interest on all reserves. We calculated tiering reserves could save the Bank between £1.3 – 11.5bn a year. The range of estimates depend on the level of reserve requirements. A 1% reserve requirement, equal to the ECB’s, would save £1.3bn; a 2.5% reserve requirement, equal to the Swiss National Bank’s, would save £3.3bn; and a 10% reserve requirement, lower than the requirements the UK had in the 1970s, would save £11.5bn.
Due to an indemnity between the Bank of England and the Treasury, the Treasury has effectively been funding the interest on reserves. Therefore, tiered reserves wouldn’t just be saving money for the Bank of England’s monetary policy operations but taxpayers too. As Gordon Brown argues, the money saved could be spent on reducing child poverty. With higher reserve requirements, it could also help fund mass insulation of our draughty, damp homes, keeping households warm, energy bills affordable, and carbon emissions down.
However, as the chancellor has obsessed over in the past few budgets, spending decisions are subject to our “fiscal headroom” – meaning the amount the chancellor can borrow before breaking our fiscal rules. This headroom is based on the fiscal rules set by the government itself, which require the Office for Budget Responsibility (OBR) to forecast that debt will be falling in 5 years’ time. Importantly, falling here doesn’t mean debt being lower than it is now, just lower than it is in 4 years’ time. Therefore, making a fixed saving of billions of pounds every year, starting in the first year of the forecast, could make no difference to the fiscal headroom. It wouldn’t change the amount by which government debt falls between the 4th and 5th year of the forecast and therefore wouldn’t show up as extra headroom for government spending. Think this sounds ridiculous? It’s because our fiscal rules are.
This doesn’t mean politicians couldn’t spend the money the Treasury saves – in fact, headroom would come out the same whether they spent this saving or not. But the point is it reflects how such a blunt metric is not adequate to assess the UK’s ability to spend and borrow. When such metric receives countless speculation and media coverage, we should hold it to a higher standard than for it to fail to account for a yearly saving. It’s partly why many have come out to say our fiscal rules are fundamentally flawed.
Not only does this headroom not grow when the Treasury makes savings, it also is modelled as immovable even when government investment could change our outcomes. The OBR, who conduct the UK’s fiscal forecast, have modelling assumptions that assume by default fiscal policy has no effect after five years, meaning any increase in government spending does not affect the economic output forecast after five years. It is no wonder then that the UK has an underinvestment problem when our economic forecaster shows negligible effects from cutting investment and the Treasury cuts investment budgets to meet fiscal rules. As shown in the OBR’s latest forecast, public investment will flatline in the next five years.
Both the Conservatives and Labour see fiscal rules as sacrosanct. Jeremy Hunt has fixated on fiscal headroom despite criticism and Rachel Reeves has announced Labour won’t be too different. Meanwhile, our US peers have seen a globally exceptional recovery from the pandemic, likely spurred by its pandemic stimulus and Inflation Reduction Act. Rather than force debt and borrowing down, the US is expected to continue to increase borrowing while its economy recovers. This has funded an expansive green industrial strategy that is already seeing results in mitigating dangerous carbon emissions.
Rachel Reeves is right to identify the success of the US’s economic recovery as something the UK government should follow. But her “Bidenomics on a budget” is setting Labour up to fail. Without the funds necessary to unlock investment, the UK will continue to stagnate, the cost of living will continue to bite, and our people and planet will continue to suffer from the effects of the climate crisis. The UK needs more investment, not more fiscal restraint, and its our fiscal rules that are holding us back.
Image: iStock
