Politicians must resist the temptation to bend economic rulesby Simon Wren-Lewis / June 19, 2014 / Leave a comment
The government’s “fiscal rules” have been sensible, up to a point. © Rex Features
This government’s fiscal policy is a bit like marmite: you either love it or hate it. Those that love it say it rescued the economy from a fate similar to Greece; and those who hate it say it deepened and prolonged the recession. Yet even those inclined to the latter should acknowledge two features of the policy that should not be discarded: the establishment of the Office for Budget Responsibility (OBR) and the “fiscal mandate.” As both come up for review, it is worth spelling out why they should be preserved.
Economics gives us a fairly clear answer as to how to run fiscal policy. If interest rates are not—as now—effectively stuck at zero, monetary policy, rather than fiscal policy, should be responsible for steering the economy. Debt and deficits should act as shock absorbers, allowing us to cope with unexpected developments without having to adjust taxes or spending too quickly, either up or down. The “automatic stabilisers” (tax receipts fall when the economy is weak, while benefits spending goes up) are one example of this. So if, as now, a recession raises debt levels, governments should reduce deficits and then debt only when the recession is over, and then pretty slowly.
But there’s a problem here. This “relaxed” attitude can be exploited by governments, either deliberately for political gain, or just because there is uncertainty and politicians are always tempted to be too optimistic. Economists call this the “deficit bias.” It means that we might want much tighter rules than theory alone suggests, especially in countries where this behaviour is common.
What does this mean for the UK? Experience over the last few decades suggests that, in contrast to others, UK governments have been relatively prudent. Outside recessions debt fell fairly steadily up until 2008, from its post-1945 peak of well over 200 per cent of GDP to under 40 per cent. The subsequent increase is the result of sensible attempts to mitigate the impact of the financial crisis. Indeed, the main mistake made by the current government was to cut the deficit too quickly, unnecessarily prolonging stagnation. But past UK governments were not perfect: the last one certainly circumvented at least the spirit of its own rules. Moreover, every time…