UK General Election 2019: Fiscal policy - a credibility deficit

• Labour and the Conservatives have proposed major innovations to their fiscal rules that allow both parties to borrow billions more in the next parliament, compared to the existing rules. 

• The Conservative proposals could allow debt to rise to around 100% of GDP from 82% today, representing a sudden reversal their mantra of fiscal control of the past decade. Perversely their rules facilitate profligacy in day-to-day spending in the short-term but create a straight-jacket preventing fiscal policy from supporting a recession-hit economy – perhaps in the wake of a no-deal Brexit - in the medium term.

• Labour’s proposals could allow debt to rise to around 170% of GDP. In principle their rule to ensure rising ‘net worth’ of the public sector improves the scope for productive investment and removes the temptation for off-balance-sheet borrowing. But in practice the rule could encourage creative accounting and risks being derailed by rising interest rates causing a drop in the value of public assets. These issues would present problems for any government operating under such rules, but the credibility deficit is made more acute by Labour’s plans for a range of radical economic reforms such as its nationalisation programme.

• Both parties’ adoption of debt interest rules does little to constrain their short-term spending. The long-dated nature of UK government debt means that higher interest rates would take time to drive debt service costs higher. This means that excessive spending today might only break the rules long after those responsible have left office.

• Despite some good innovations, both parties’ rules are insufficiently credible from a market perspective. They weaken constraints on borrowing for current spending in the short term. But at the same time they are at risk of being broken due to unforeseen events even if spending was restrained. Given the wider political context, securing fiscal credibility is particularly critical at present. The hunt for a truly credible fiscal framework goes on.

The financial crisis led to a sharp rise in the government deficit which reached around 10% of GDP in 2009-10. After a decade of fiscal consolidation, the deficit is roughly back to its pre-crisis level of around 2% of GDP (largely on the back of cuts in public spending). 

The Conservative Party’s proposals for new fiscal rules to govern borrowing represent a big change with their plans from recent years. After their victory in the 2015 General Election, the Conservative Government promised to run an overall budget surplus by 2019–20 – bringing total spending into line with tax receipts, not just current spending – which would have reduced the debt-to-GDP ratio quite rapidly over the medium term. 
Weak economic growth resulting from the uncertainty caused by the vote to leave the European Union put paid to these plans, but a year later with a new Chancellor at the helm the Conservative Government’s plans still involved steady reductions in debt as a share of GDP over the medium term, according to the OBR.
The Conservatives and Labour have now announced some radical new innovations to these fiscal rules, which have not been tried elsewhere in the world (see table below). These rules allow for potentially much higher levels of borrowing in the next parliament, to fund investment but also more day-to-day spending. The reversal of stance represented by the Conservatives’ new proposals is striking. 

The shift comes just days after one of the world’s largest bond investors raised concerns about the prospect of rising UK government debt. The ratings agency Moodys has also downgraded UK government debt, citing concerns over erosion of the strength of UK institutions owing to Brexit, evidence of weaker spending control, and the absence of plans from the major parties to spend public money effectively. In this note we provide some initial analysis of the advantages and risks of the new approaches to fiscal policy.

2019 General Election: where the parties stand

Recent Fiscal Rule Announcements

There is a strong case for moving away from the last Chancellor’s more austere fiscal rules: to have the structural deficit below 2% of GDP and debt falling as a proportion of GDP next year. Advocates for higher spending point to two significant adverse effects of a decade of austerity. First, the focus on deficit reduction over the last decade has had the unfortunate effect of reducing productive investment in infrastructure and education and training. However, these are precisely the types of spending which are most likely to help the UK is to restore its productivity and GDP growth rates. Second, during the years of deficit reduction, the Bank of England had to provide monetary policy stimulus to stabilise the economy, support economic growth and thereby achieve its inflation target.  Given that interest rates remain very low, it is appropriate to change the current rules to allow for both more investment and stronger counter-cyclical fiscal policy taking a larger role in any future economic downturn.  

Both parties’ new fiscal rules allow for much more public borrowing over the next five years than the current framework. But it is important that such fiscal loosening is carefully controlled to ensure that the government retains the confidence of bond market participants in the sustainability of public debt. This is all the more important today since public debt-to-GDP stands at its highest level since the 1960s, and points to a need for workable and credible rules for the public finances. 

Well-designed fiscal rules should ensure that the public finances remain on a sustainable path in the long run. Without such rules, governments often run-up unsustainable debts, introduce policies that amplify rather than dampen boom and bust, and cut back on productive investment rather than day-to-day spending when the deficit gets too high. These are all highly undesirable. Such policies harm economic growth, increase the depths of recessions and raise debt interest payments that have to be paid out of taxes in the future. But fiscal rules should also allow for sufficient flexibility to respond to unforeseen economic events. Otherwise, governments will abandon their rules just as they are most needed to reassure lenders. 

Fiscal rules have been a feature of the UK policy environment since 1997, but their success has been mixed. Resolution Foundation analysis suggests that they have reduced the tendency for fiscal policy to amplify boom and bust. However, 10 out of the 15 fiscal rules introduced since 1997 have been abandoned or broken, generally because governments have found them too rigid to respond to economic shocks. Most recently this has particularly been the case for the rules adopted since 2015. A slower than expected recovery meant that debt did not fall as a share of GDP in 2016–17 as planned, and the adverse shock of the Brexit referendum led to the target of a budget surplus in 2019–20 also being abandoned. Adjusting fiscal policy to meet these targets would have involved tightening policy in response to a weaker-than-expected economy, which is the sort of pro-cyclical policy that well-designed fiscal rules are intended to avoid. 

All of this adds to the credibility problems. Abandoning overly rigid fiscal rules today may lead to sensible rules being abandoned tomorrow if the political cost of doing so appears to be low. The new fiscal rules from both main parties seek to be better suited to the UK’s need for investment and also more flexible, and hence more credible. How well do they achieve those goals?

Sensibly, both main parties propose rules that would constrain their ability to borrow to pay for day-to-day spending but allow borrowing to invest and some flexibility to respond to shocks. The most striking feature of the proposals is the elimination of any rule on level of the public debt, with both parties relying on alternative measures to ensure sustainability. Both proposals have targets for balancing the current budget (i.e. taxes and day-to-day spending), a limit on debt interest payments, and rules on investment. We discuss each of these aspects in turn below. 

CURRENT BUDGET BALANCE RULES

On the face of it, the two parties have rules on the current budget balance with similar consequences in the short term, but different in the medium-term. The Conservatives would target a current balance in three years’ time, and Labour at the end of a rolling five-year horizon. 

The Conservatives’ rule perversely allows the flexibility for short-term fiscal profligacy, but imposes potentially damaging rigidity in the medium term. Targeting a current budget balance in three years’ time allows (in theory unlimited) current budget deficits in years one and two. Their proposed restriction on total debt interest (see below) might curb excessive borrowing but it is a blunt tool that implies a large amount of headroom. The current balance rule could therefore allow significant current deficits in the short term even in benign economic conditions, which is hard to justify economically and appears to be an attempt to hide the negative impact of Brexit on the public finances by letting borrowing take the strain.

At the same time, the three-year time horizon could paradoxically give a Conservative government little flexibility to respond to adverse shocks. A particularly significant risk in this regard is the potential for a no-deal Brexit at the end of the transition period, currently scheduled for the end of 2020 if Boris Johnson’s Withdrawal Agreement passes the Commons.  To reach a current budget balance within less than three years of such a major shock to the public finances would require severe tax rises or day-to-day spending cuts at a time when the economy was weak.

Consequently it is not credible that the rule would be adhered to under these circumstances. Faced with the situation of a high current deficit in 2010, the Coalition government only targeted a cyclically-adjusted current balance at the end of a rolling five-year horizon. Even then, they did not deliver a balanced current budget within the original time horizon – in the event it did not balance until 2017–18 – and the austerity measures pursued to meet the original target arguably slowed the recovery as interest rates were stuck close to zero. 
Labour’s rolling five-year horizon for achieving current balance allows much more flexibility to respond to shocks. However, to an even greater degree than the Conservatives’, the rules allows substantial scope for an unfunded spending splurge. The main constraint on such behaviour for Labour is their commitment to ensure that public sector net worth should rise over the parliament (see below), but the headroom for unfunded spending remains large in the short-term at least.

DEBT INTEREST LIMIT

Debt ceilings have been a staple of fiscal rules over the years, but now both main parties have junked them. In their place the two parties propose similar-sounding rules limiting debt interest payments: the Conservatives would restrict them to 6% of tax revenues, Labour 10%. At around £40bn, debt interest payments currently stand at approximately 5% of government revenue.

The Conservatives’ rule is clearly more restrictive, but translated into an implied debt ceiling both allow huge scope for borrowing. Assuming current tax revenues and interest rates on government borrowing, the national debt would be restricted to around 100% of GDP under their rule, whereas it could increase up to 170% under Labour’s, allowing headroom for Labour to pursue their nationalisation plans. 

However, both parties’ rules pose problems. Most importantly, they act as only a weak constraint on the next chancellor because there is a time lag between policy action and borrowing costs changing. Interest rate changes only feed through to government debt service costs slowly due to the long time to maturity on UK government bonds. As a result there is a significant risk that both parties could pursue unsustainable fiscal plans that drive up interest rates but only break their debt interest rules many years after the damage has been done. 

What’s more, these rules are also vulnerable to events beyond the government’s control. The Conservatives’ 6% limit is highly vulnerable to a rise in global interest rates. If the interest rate paid on debt increased significantly, this would lead almost inevitably to the rule being broken, even if borrowing to fund current spending had been tightly controlled. This severely impairs the credibility of the rule. While the Labour limit, at 10%, offers more headroom, this could largely be eaten up by nationalisation plans, exposing it to similar risks.

INVESTMENT

The clearest difference between the two main parties’ new fiscal rules is on how much investment they would allow. The Conservatives would place a strict limit on investment each year of 3% of GDP, well above the current rate of 1.8%, but nevertheless somewhat arbitrary. By setting a limit on capital spending but not current spending in the first two years of the forecast horizon, the combination of the Conservatives’ fiscal rules runs the risk that an increase in debt could be used to finance day-to-day spending rather than productive investment.  

Labour’s rule, by contrast, allows essentially unlimited investment so long as it increases the ‘net worth’ of the public sector over the course of the parliament (i.e. provided public sector assets rise at least as fast as public debt). In principle this rule makes good sense, since the traditional focus on gross debt distorts government policy, encouraging it to shift borrowing off the public balance sheet, while also discouraging valuable and much-needed investment. 

But the practicalities are less simple and the rule carries significant risks. It is hard to value many government assets – there is no liquid market for many of them – so this rule might not prevent purchases of unproductive assets or actions that would have a negative impact on the value of assets purchased. This would be a concern at any time, but it is made more acute in the face of Labour’s radical plans to embark on a widespread programme of nationalisation, where changes in management objectives could impair the value of the assets. It may also create incentives for government to hide a decline in asset values for a long period and hence avoid breaking the rule in the short term, even though policies had actually led to a reduction in the net worth of the public sector. 

Moreover, the rule is vulnerable to things beyond the government’s control. A reduction in the value of the government’s assets might lead to a breach of this rule. This could occur if global interest rates increased, pushing down the value of government-owned land. So rising interest rates could cause twin problems for Labour, with growing debt interest costs threatening their debt interest rule just as asset values decline, jeopardising their net worth goal. 

To meet its rule under these circumstances, a Labour government would have to run a large current budget surplus, which would probably not be economically optimal or credible. Adjusting the book value of assets more gradually over time might avoid these problems, but would create a temptation to fudge the valuations leading to the problems described above. 

After a decade of cuts the pressure on public services is huge, and more spending is needed to rebuild the public realm. But this should be done responsibly and not by using borrowing to fund day-to-day spending in normal economic times.

The new fiscal rules proposed by Labour and the Conservatives contain some good new ideas that obviate some of the problems of the past. But they offer rather too much scope for unfunded short-term fiscal splurges on current spending, and both suffer from a credibility deficit.

Both parties appear to agree that the national debt should increase to pay for more public investment over the next five years, which is reasonable. However, their fiscal rules are not sufficiently well designed to ensure that additional borrowing is only used for productive investment. The Conservatives’ rules are not strict enough to prevent unjustified borrowing to pay for day-to-day spending, whereas Labour’s might fail to prevent a very large increase in debt being used for unproductive purposes.

Both parties may also find that their rules are derailed by unforeseen developments in the global economy, notably a no-deal Brexit in the case of the Conservatives, which weakens their credibility and therefore undermines part of their purpose. The hunt for a truly credible fiscal framework goes on.