What the coalition got right

Politicians must resist the temptation to bend economic rules
June 18, 2014

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 we have a recession, the first thing to get cut is public investment, the last few years being an unfortunate example.

In this light, the first of the “fiscal rules” imposed by Osborne—balancing the deficit according to a rolling five-year period rather than a fixed deadline—looks sensible. It is close to what theory suggests and has allowed flexibility when forecasts proved too optimistic. Rather than sticking to its original plan, which would have meant doubling down on austerity at precisely the wrong time, the government was able to be more flexible without breaching the target. By contrast, the second rule—that the debt should be reduced at a fixed point in time (originally 2015)—always appeared arbitrary and rigid. Fortunately, when push came to shove, the government sensibly ditched it.

The UK should keep the five-year rolling target, but we recommend three modifications. First, the rule should only apply when interest rates are above zero. Second, looking forward five years, there is no need for cyclical adjustment. Third, the target should be for all new borrowing, including investment spending—but to deal with the UK’s historic tendency to short-termism, there should also be a specific target for the ratio of public investment to GDP.

But numerical targets alone are not enough. No matter how good the rules are in theory, it is always possible to bend them, as Help to Buy illustrates, to the cost of all of us in the long run. To avoid this inevitable temptation, the OBR should be given a much wider remit. It should look not just at the numbers and the fiscal aggregates, but what’s going on behind the headlines, and give a view on whether the government is observing not just the letter but the spirit of the target, and not just over five years but the longer term.

Rules based in theory, but flexible enough to cover very different economic circumstances, combined with independent expert judgement to minimise the temptation for governments to play political games. This would be the best way forward for the UK.