Ripping up the fiscal rule book

It's 11 years since Gordon Brown made his fiscal rules the cornerstone of Labour's economic policy. Now they are to be replaced by a vague set of principles. Sean O'Grady reports

November 26, 2008

The fiscal rules pretty much died when the credit crunch struck the economy last autumn, though the Government was keen to stress, even at the time of the last Budget, that they were still formally in place.

Indeed in the unusually clement economic decade that has just passed, the fiscal rules were met. The sustainable investment rule stated that net debt – what we used to be called the national debt – should rise to no more than 40 per cent of the GDP, and it never did.

But within a few years, it will spiral to 57 per cent of GDP – without even adding in all the extra debt that has been accrued through the various forms of support to the banks.

On that basis – taking the most pessimistic projections – net debt would exceed the all-time peak it reached in 1946: 262 per cent of GDP. That was as a result of two world wars and a global depression; even the current crisis doesn't really approach that.

Yet at 57 per cent it rests at a 40-year high. In terms of annual borrowing, too. Mr Darling' s plans surpass any previous post-Second World War record (the previous peaks being under the Labour chancellor Denis Healey in 1975 and the Conservative chancellor Norman Lamont in 1993); tapping the money markets for £118bn, equivalent to 8 per cent of GDP, puts Mr Darling and Mr Brown firmly at the top of the borrowing league table.

It all adds up to £1 trillion – £1,000bn – of net debt in a few years, with a debt interest burden to match.

The golden rule stated that the Treasury would only "borrow to invest", and that the budget would balance over the course of a cycle, or deliver a small cumulative surplus. This again was achieved, and rubber-stamped by the National Audit Office.

From 1997 to 2006, the sum total of all the annual deficits and surpluses came to a net figure of +£20bn: just right. That compares with the cumulative deficits of £241bn, mostly gathered under the Tories, from 1979 to 1986; and the Thatcher/Major governments' cumulative total of £341bn worth of deficit from 1986 to 1997.

The problem is what happens now. The independent Institute for Fiscal Studies said yesterday that the period 2006 to 2014 will see a cumulative deficit of £296bn. There is no way the Government will be able to deliver its old golden rule over the next economic cycle, even if, as the Treasury claims, the Government's current (as opposed to investment) spending goes into surplus some time around 2015. For most economists, that time frame is so far away that it inevitably brings to mind the old Keynesian aphorism: "In the long run, we are all dead".

It is worth recalling why the Government felt so proud about the old fiscal rules. As recently as his Mais lecture in October, Mr Darling felt able to declare: "The fiscal rules we introduced in 1997, to target debt and promote investment, meant that, in the last 10 years, we have tripled public investment and at the same time cut debt to one of the lowest levels among the world's major economies. We met the fiscal rules over the past cycle. Because we acted to cut debt and live within our means, we were allowed the flexibility to support the economy. This is how extra borrowing cushioned past slowdowns – in 2000 when the internet bubble burst and in 2005 when the housing market slowed."

For whatever reason – past mismanagement, crazy times in the world economy, the vagaries of the American housing market – that cushion is no longer there. Now, instead of the credible framework of the fiscal rules, we have instead something called the "temporary operating rule".

This is, as Mr Darling put in his pre-Budget report, to "improve the cyclically adjusted current budget each year, once the economy emerges from the downturn, so it reaches balance, and debt is falling as a proportion of GDP once the global shocks have worked their way through the economy in full".

Thus the timing is very different to the old fiscal rules, which operated on a year-by-year or a cyclical basis. The new rule operates on a timescale determined by the scale of the global recession and the credit crunch, a fairly unknowable epoch.

Mr Darling may or may not be right to say that the Government needs a rule that allows them "the flexibility to respond appropriately to those shocks", but the Institute for Fiscal Studies says that that very rubberyness and flexibility renders it "no adequate replacement" for the fiscal rules. More embarrassingly for ministers, the IFS has produced an unflattering chart comparing the Labour Government's performance with its Tory predecessor.

Mr Darling may find that the public finances improve a bit more quickly than he plans, but in any case, as the Governor of the Bank of England, Mervyn King, said yesterday, there is a "long hard road ahead" to restore them to sustainability – rules or no rules.

UK's credit rating could suffer, warns S&P

A top ratings agency analyst has warned the UK may lose its top-notch credit rating unless it addresses issues raised by the pre-Budget announcement. The credit market wants more clarity on fiscal policy after the Government revealed plans to boost spending in the short term and claw back money later.

While the budget is specific on the spending, it is too vague on where money will come from, according to Frank Gill, Standard & Poor's director of European sovereign ratings.

The UK has an AAA credit rating at Standard & Poor's, the highest rating possible, but would have to pay more to borrow money if its rating were to fall.

"Nothing is forever," Mr Gill said. "We are in the process of assessing whether the Government can reverse the damage that is about to be done to its balance sheet over the next three years."

He also said that for any country, carrying net government debt of above 60 per cent of GDP could undermine an AAA rating. Analysts estimate the spending package announced on Monday could leave the UK with a ratio of almost 70 per cent by 2011.

Mr Gill flagged several variables that have yet to be resolved as the UK's lenders decide on whether the PBR is credible. The extent and cost of the ongoing bank bailout is unclear, with the Government having already pumped tens of billions of pounds into the sector. It is also unclear how much of the banks' shares it will be left with and whether it will be able to sell them at a good price.

"The end cost of the financial bailout depends less on how much of the public funds they have to inject up front into the sector and more on the market value of the Government's growing stake in the banking system further down the road," Mr Gill added.

"If this is a short shallow recession, and the financial system is successfully steadied, then the Government should be able to manage through this with the rating intact," Mr Gill added.

"However, if this is long drawn-out recession and the underlying economic structure weakens while financial services cease to be the cash cow it has been for the Treasury, then the net government debt burden will weigh on the rating."

Mathieu Robbins