This is the second in ConservativeHome’s series of posts counting down to the Autumn Statement. Yesterday, Tim Montgomerie said that George Osborne’s economic narrative is taking shape.
When George Osborne encoded two fiscal rules into his first Budget, it was basically to get the moneymen and credit-rating agencies off his back. “Look,” the rules said implicitly, “we’re all about restoring sanity to the public finances. There’s no need to worry.”
And yet, since then, it’s the rules themselves that have set people worrying. I warned last year, in an article for the Times (£), that one of them could be broken. And now, as the Autumn Statement approaches, Westminster has started twitching at that very prospect. December 5th could be a very nasty day for the Chancellor: he could miss one or both of his fiscal rules, meaning that austerity will continue longer into the future, with the implication that there are more spending cuts or tax rises to come.
Before we get into all that, however, let’s just remind ourselves of what the two rules are. Here’s a more detailed post I prepared earlier, but just to recap…
The rules in brief
1) The deficit rule. The main fiscal rule relates to what Mr Osborne calls the “structural deficit,” but what Whitehall’s number-crunchers call the “cyclically-adjusted current budget”. And it reads thus:
“Balance the cyclically-adjusted current budget by the end of a rolling, five-year period.”
This means that the Chancellor intends to get his “structural deficit” down to zero within five years. When he delivered his first Budget, this five year period ended in the financial year 2015-16. Now it ends in 2016-17. This may seem a strange sort of rule — one that keeps on keeping on into the indeterminate future — but the Treasury argues that it at least shows a commitment to eradicating the deficit, and relatively quick.
So, how’s the Chancellor doing? Truth is, he’s lucky that it’s a rolling target. In June 2010, the Office for Budget Responsibility forecast that the cyclically-adjusted current budget be balanced around 2014-15. Now, thanks largely to weak growth and the effect that has on tax receipts, the date has been put back to 2016-17. The rule still hasn’t been broken, but there’s been some dangerous slippage:
And it could easily slip further. The Institute for Fiscal Studies this week released a paper to show how weak economic growth could continue to undermine the fiscal rules. Even under their “optimistic scenario” for growth, the cyclically-adjusted current budget follows the same trend as it is now — reaching surplus only in 2016-17. But under their “pessimistic scenario”, the deficit remains in 2017-18 and beyond. The rule would be broken.
2) The debt rule.
The second, supplementary fiscal rule relates to the national debt. It is to:
“Ensure that debt is falling as a percentage of GDP by 2015.”
In diagrammatic terms, this is the “tailing off” shown on the pink line below. The OBR’s current forecasts have our debt peaking at 76.3 per cent of GDP in 2014-15, but then declining to 76 per cent in 2015-16:
But, thanks again to weak growth and specifically to the more persistent deficit problem, these forecasts have also slipped from those made at the start of the Coalition. At the time of Mr Osborne’s first Budget, the debt was expected to peak a year earlier (2013-14); at a lower level (70.3 per cent of GDP); and then fall more sharply (to 67.4 per cent in 2015-16). This is shown by the dark blue line above.
This is the rule that was expected to be broken first. Indeed, even under the IFS’s “optimistic scenario” — mentioned above — the debt rises from 79.5 per cent of GDP in 2014-15 to 80.5 per cent in 2015-16. Under their “pessimistic scenario”, of course, it’s even worse
Osborne’s four options
If Mr Osborne is likely to break one of his fiscal rules — and we should still leave open the prospect that he won’t — then he is basically left with four options:
i) Bend the rules. This month has suggested one way for George Osborne to meet the rules without really even trying: the Treasury has announced that it will retain the interest payments that it currently makes to the Bank of England’s “Asset Purchase Facility” as part of the Quantitative Easing Programme. This, in effect, means that £34.8 billion that has already been paid will be recouped by the Treasury over the next couple of years, such that the debt will be £34.8 billion lower than it would have been. This could also lower the deficit in the short- to medium-term, but that largely depends on how these transfers are classified by the Office for National Statistics.
ii) Meet the rules. Putting the changes mentioned in point i), above, aside, the Chancellor could meet his rules by quickening the pace of deficit reduction; probably mostly through further spending cuts, given his reluctance to increase the overall tax burden. Under the IFS’s “pessimistic scenario” this extra deficit reduction would have to total £23 billion by 2017-18.
iii) Break the rules, but keep the rules. In other words, Mr Osborne admits that he’s currently on course to break (one or both of) his rules, but that he will stick it out in hope of meeting them once the economy improves.
iv) Ditch the rules. Yep, not only does Mr Osborne admit that (one or both of) his rules (is/are) set to be broken, but he also scraps them entirely.
So, which should he choose?
First, let’s just dismiss the idea that he should go with the first option, above. Relying on a £34.8 billion windfall from the Bank of England may not sound much like “bending” the rules, but it is really. As the IFS explains:
“…as the OBR has stated, this ‘should not in itself have a significant impact on the eventual aggregate net profit or loss to the Exchequer from QE’. In other words, this change will not have had a direct material impact, either for better or for worse, on the underlying long-term strength of the UK public finances.”
“Given that the change does not directly improve the health of the public finances in a significant way, even if this change did appear to make it easier for the Chancellor to meet his fiscal targets, it would be inappropriate for him to use these adjusted numbers as the sole basis for judging compliance against his fiscal rules. In particular, were the change to make the difference between one or both of the fiscal targets being met rather than missed, this might lead to accusations that the Chancellor had made the change purely to ensure that he complied with his self-imposed fiscal rules rather than based on sound economic principles. This would risk undermining the credibility with which he is managing the UK public finances.”
But, as for the other options, I must admit that by own thinking has changed — hardened, even — over the past year. I used to think that Osborne should do everything he could to meet the rules: more spending cuts and tax rises, if necessary. Then I thought that, if they were to be broken, he should keep them as a guide for restoring the public finances back to health. Now I think that he should ditch them.
This change of opinion has partially been brought about a strange thing: the effect of credit-rating downgrades on the cost of other countries’ debt. You see, George Osborne’s rules — and particularly the second rule — were designed with the credit-rating agencies in mind. The idea was that we’d keep our AAA credit-rating by persuading these agencies that we’re restoring sense and order to our public finances. And, by keeping our AAA credit rating, we’d keep down the interest rates that we pay on our borrowing.
But the past few years have undermined this idea. It turns out that those countries that have experienced a ratings downgrade — e.g. America — haven’t necessarily seen their borrowing costs rise. A recent survey by Bloomberg showed that, in fact, “in about 47 per cent of cases, countries’ borrowing costs fall when a rating action suggests they should climb, or they increase even as a change signals a decline.” With the global economy as it is, the markets are paying less attention to the rating agencies and simply investing their money where it still seems like a safe bet. No-one really thinks that the US won’t pay back its debt, and so they’re not demanding higher interest rates.
But while this diminishes the necessity of the fiscal rules, it isn’t the only factor that’s changed my mind. Another is more political: so long as Osborne retains these fiscal rules, he makes himself a hostage to economic fortune. If growth continues to be weak, then he’s just going to break the rules constantly. The bloodbath that we might see next week — if the Chancellor does indeed break his rules — could become a twice-annual occurrence, whenever there’s a Budget or an Autumn Statement. Ditching the rules would cauterise this wound somewhat.
Of course, this isn’t to say that scrapping the rules would remove Mr Osborne’s political problems. He’d be chided not just for missing his targets, but also for putting the targets aside as though they didn’t matter in the first place. But this seems to me the best of several bad political options. Even if the Chancellor were to try to continue meeting the rules, it would mean £billions more in spending cuts and tax rises as the elections approaches — and with no guarantee that more wouldn’t be needed. This could have a dampening effect not only on Tory electoral hopes, but also on the course of the recovery.
But the main reason I’ve turned against these rules is because I’ve become increasingly sceptical about long-term forecasts and goals from governments. Even in the good times, from 1997 to 2007, New Labour managed to borrow over £10 billion more than they originally thought they would. Now, in the bad times, things like borrowing and debt are even less under the Government’s control, buffeted as they are by global economic problems.
So, we should stop pretending that neat arbitrary levels can be met and set. Budgets should concentrate much more on the here and now, as well as on those things that the Government has greater control over, such as the levels of spending and taxation.
And the future…
The thing to stress is that, even though I think George Osborne should ditch his fiscal rules, I don’t think he should reverse from the path of deficit reduction, nor turn away from rules entirely. In a very useful recent report, the IMF looked at the sorts of rules in operation around the world: it might be that a rule setting a target for overall spending might be more applicable to Britain’s current situation. I shall probably blog about these options in the near-future. In the meantime, a “zero-based” review of government spending would probably be a good start.