The UK’s debt position is poor and the way we make decisions linked to it is often worse. We may see further evidence of this with the Spring Forecast in late March, when the Office for Budget Responsibility (OBR) releases its latest economic projection, pointing to modest growth and lower than was expected at the time of the Budget.
In turn, this may force the Chancellor to cut spending or raise taxes to stop her self-imposed fiscal rules from being broken.
Government debt is high and set to increase because of future demands such as higher defence spending.
When debt is so high, the future relationship between economic growth and the rate of interest paid on the debt becomes critical. Economic growth is likely to be lower than that rate of interest. Thus, the government will need to run budget surpluses to keep debt under control and as we have had only seven budget surpluses since the mid-1960s this does not bode well.
There are five mechanisms to address a debt problem: growth, reform, austerity, tax or borrow. They can be used together. Some would argue to inflate the debt away but that’s not credible.
But growth is modest and public sector reform to boost productivity may take time. So, what does that leave? Curbing public spending, but it keeps rising. Taxes, but they are already high. Or borrow, yet we are already doing that on a grand scale.
How we address it leaves much to be desired and the fiscal rules don’t help.
Gordon Brown introduced fiscal rules in 1997. These rules were met easily when growth was good. Then the 2008 global financial crisis hit. At the first sign of economic trouble the rules were changed. Including that first iteration there have been ten rewrites, with 28 rules in total. Britain has altered its fiscal rules more than any other industrialised country. One wonders why anyone takes them seriously. But the Chancellor does and they are the straitjacket around policy.
Having rules may sound like a good idea. But let’s be clear, they do not address underlying problems such as the lack of growth or the inability to control public spending. They reinforce the short-termism that has damaged our policy debate.
They give the illusion of a credible approach but result in back-to-front policy decisions. That is, policy is not decided on its own merits, and whether it makes sense but on whether the fiscal rules are met. Sometimes it can help, but often it doesn’t.
For instance, Chancellor Hunt effectively left the decision on whether to cut income tax or national insurance up to the OBR. The OBR said that cutting national insurance would boost the labour supply and the growth outlook would be better, so he opted for that.
I like the idea that the OBR may be able to help good policy making, but another example shows where this approach can go amiss. We now know that the previous government realised that if immigration was cut this would dampen the OBR’s view of future growth, and in turn make the fiscal rules harder to meet, ruling out tax cuts. So their desire for tax cuts impacted their approach to immigration policy.
Instead of top-down joined-up thinking, we end up with bottom-up, spur of the moment actions in order to meet fiscal rules.
What makes it even worse is that – like most forecasts – the projections on which these decisions are made have a wide margin of error.
The important thing here is not to criticise the OBR. They do a great job – they are there to inform and to prevent politically motivated wishful thinking driving economic policy. The lesson is to achieve better outcomes through a more effective process.
Every five years there is an external review of the OBR. The latest – conducted by Laura van Geest – was recently released and is excellent. I was privileged to give evidence to it. One of its telling contributions was that, “We observe the short-term focus of this wider fiscal debate, exemplified by the emphasis on discussion of fiscal headroom.”
The whole fiscal – and political – debate comes down to how much headroom there is to meet these arbitrary rules. This headroom is now down to less than £10 billion, or only 0.3 per cent of GDP. With public spending at £1,335 billion this leaves little room for manoeuvre.
The review went on to say, this approach “is unhelpful, as it threatens to obscure broader assessments of UK fiscal sustainability.” The OBR provides a fifty-year ahead view of the sustainability of the public finances. This should be where the focus of the debate is. If we did that then very quickly everyone would appreciate that the most important economic forecast made in the UK may be the OBR’s view of medium-term productivity growth and that short-term tinkering doesn’t help.
The new environment we are entering presents an opportunity for the government to push through necessary but tricky structural economic reforms.
Ideally to get to where we need to be we should get rid of these fiscal rules. Importantly, the markets recognise the shortcomings in these fiscal rules, but it is necessary to have a credible narrative to keep them onside. Paying more heed to the OBR’s view of longer-term fiscal sustainability should achieve that.
Please note, the value of your investments can go down as well as up.
