One way or another, the UK is destined for looser fiscal policy. How much and in what form is unclear, but the one thing that is clear is that it will require a new set of fiscal rules. There are many options and we do not know for sure what the Chancellor will choose. But a target of a balanced “current budget” (excluding investment spending) seems most plausible, with some guidance on the level of debt. That in theory could allow a fiscal stimulus focused mainly on investment worth up to 1.5% of GDP (or around £32bn) in the Autumn Budget on 6th November.
- One way or another, the UK is destined for looser fiscal policy. How much and in what form is unclear, but the one thing that is clear is that it will require a new set of fiscal rules. There are many options and we do not know for sure what the Chancellor will choose. But a target of a balanced “current budget” (excluding investment spending) seems most plausible, with some guidance on the level of debt. That in theory could allow a fiscal stimulus focused mainly on investment worth up to 1.5% of GDP (or around £32bn) in the Autumn Budget on 6th November.
- It is no secret that the Chancellor Sajid Javid is set to revamp the fiscal rules. After all, he is already on course to break the rule left by his predecessor, namely that cyclically-adjusted borrowing is below 2% of GDP in 2020/21.
- The Chancellor could say that the low interest rate climate means that it makes some sense to scrap the fiscal rules altogether in order to implement a radical fiscal stimulus for a post-Brexit era. However, we doubt that the Chancellor will be so bold. Having no rules whatsoever would leave the government open to political attack. It would be far better to set some sort of fiscal rule to at least demonstrate some semblance of fiscal prudence.
- Equally, with both the Labour and Conservative Parties falling over themselves to announce bigger tax cuts and spending rises, the new set of fiscal rules is unlikely to bind the Chancellor’s hands too tightly.
- Some commentators have suggested that the government should target public sector net worth as a share of GDP. We can see the appeal of this ambition. It is a more comprehensive measure of the public sector balance sheet (it includes the physical assets that the government owns such as the road network) than the traditional measure of public sector net debt (which only includes liquid assets such as cash).
- But since it is notoriously difficult to value public sector assets and the relevant figures have not been published since 2012 due to quality concerns, it would not be easy to implement. And if the government needed to meet its liabilities it couldn’t quickly and easily sell assets such as roads. So while the government might target public sector net worth eventually, we suspect a move in this direction is unlikely soon.
- It seems more likely that the government will couch its new fiscal rules in terms of the “cyclically-adjusted current budget deficit” as opposed to the existing rule relating to the overall budget deficit, accompanied by some form of debt guidance. After all, both the Conservative government and the Labour Party have announced a desire to significantly boost infrastructure spending and to take advantage of the exceptionally low cost of borrowing. As the “current budget deficit” excludes investment, this would allow the government to borrow as much as it wishes, so long as that borrowing finances investment.
- What’s more, rather than setting an arbitrary date for the fiscal rule (such as 2020/21 currently), he could instead choose a rolling target five years ahead. If he goes for this, we estimate it could provide the Chancellor room to implement a pre-election giveaway in the Budget of about £8bn a year (or about 0.4% of GDP). And in theory he could announce as much extra infrastructure spending as he wanted, but around 1% of GDP may be plausible.
- Whatever fiscal rule the Chancellor opts for, the big picture is that the Budget will probably mark the beginning of the biggest fiscal boost seen since the financial crisis. This will act as a prop to the economy over the next few years whether there is a Brexit deal or a no deal.
Rewriting the fiscal rules
Things are about to change. After a decade of austerity, a substantial loosening in fiscal policy appears to be on the way regardless of whether there is a Conservative or Labour government, a deal or no deal Brexit. But to do that, the fiscal rules need to be changed, probably in the Budget on 6th November.
Fiscal rules – why and what?
The fiscal rules were introduced by Gordon Brown in 1997 in order to demonstrate the fiscal prudence of the Labour Party after the perceived failings of previous Labour Chancellors. Since removing them would make an incoming Chancellor look lax, they have stuck ever since. Table 1 on page 6 sets out the evolution of the main fiscal rules. The current rules for cyclically-adjusted borrowing to be below 2% of GDP in 2020/21 and for the debt to GDP ratio to be falling in the same year have been inherited from the previous Chancellor Philip Hammond.
Why change them?
With the Prime Minister and Chancellor relatively new in the job, now is a good opportunity for change. The Chancellor could easily argue that the low interest rate environment means that the rules should not be as strict. And the Chancellor is currently on track to break the current fiscal rules. Indeed, a whole host of factors – including the reclassification of some student loans as spending rather than lending, the deterioration in the public finances figures in 2019/20 so far and the £13.4bn boost to spending in 2020/21 announced in the 2019 Spending Round – has meant the OBR might revise up its forecast for cyclically-adjusted borrowing in 2020/21 from £18.9bn (0.8% of GDP) in its spring forecast to about £51.3bn (2.3% of GDP). (See Chart 1.)
Chart 1: Cyclically-Adjusted Borrowing, 2020/21 (£bn)
Sources: OBR, Capital Economics
So while the “supplementary target” for debt as a share of GDP to be falling by 2020/21 is under no immediate threat, the Chancellor is on course to break the 2.0% of GDP (or £45.5bn) cyclically-adjusted borrowing limit in 2020/21. There’s never a better time to move the goalposts than when it looks as though you are going to miss!
What are the Chancellor’s options?
He essentially has three choices:
- Keep rules and announce a fiscal tightening.
- Ditch the fiscal rules
- Alter the fiscal rules.
We can rule out the first. Would the Chancellor really risk announcing 0.3% of GDP (or £5.8bn) of tax rises or spending cuts in 2020/21 in order to bring cyclically-adjusted borrowing back down from around £51.3bn to £45.5bn – with another general election on the horizon? It seems very unlikely. The rhetoric coming from No. 10 is that a further loosening is in store.
Not worth the paper they are written on?
Mr Javid could, of course, go for the really radical option and get rid of the fiscal rules completely. He could argue that with the UK due to leave the EU there is a once in a lifetime opportunity to stimulate the economy. And in this new growth and low interest rate era, fiscal rules are no longer necessary.
But while we might hear similar words in the Chancellor’s Budget speech on 6th November, we doubt he will throw caution to the wind and ditch the fiscal rules altogether.
Admittedly, given the damage to the credibility of the fiscal framework inflicted by the numerous changes made over the years, the government could decide that the political cost of ditching the rules is small. Since 1997, the fiscal deficit rules have been changed six times and, excluding Gordon Brown’s rules, have lasted on average fewer than two years. (See Chart 2.)
Moreover, he could argue that having independent forecasts produced by the Office for Budget Responsibility (OBR) – that remove the chance of politically-motivated wishful thinking – is enough.
Chart 2: Duration of Main Fiscal Rule (Years)
Sources: HM Treasury, Refinitiv, Capital Economics
Meanwhile, such a move wouldn’t necessarily spark a panic in the markets. There is little evidence in the past few years that financial markets have been worried about the level of UK debt. Bond yields have remained exceptionally low even while borrowing has been high and debt rising. (See Chart 3.) And during this low interest rate era, now may be exactly the time to borrow more at historically low interest rates.
Chart 3: Government Debt & Bond Yields
Sources: OBR, Refinitiv
What’s more, with many other countries seemingly unwilling to loosen fiscal policy even when they have scope to do so, the equity markets might welcome signs that the UK is taking a more sensible approach to supporting growth.
Finally, the Chancellor could argue that there are good reasons for a significant loosening in fiscal policy in the face of dwindling scope to loosen monetary policy. That might eventually allow monetary policy to return to some semblance of “normal” and reduce any distortionary effects of very low interest rates.
Valid though these arguments are, we suspect that when it comes down to it the more palatable option will be to modify the fiscal rules rather than ditch them altogether. By retaining some fiscal rules, this might help to ensure that the UK continues to be viewed as a safe haven through further squalls ahead. And having no rules whatsoever would leave the government unnecessarily open to political attack. Note that the IMF estimates that over 90 countries use fiscal rules. And while those rules have been altered over time, few countries have abandoned them altogether. Presumably, then, the Government will judge that it is far better to set a fiscal rule demonstrating (at least some semblance of) fiscal prudence!
Altering the rules
Equally, though, with both the government and the Labour Party falling over themselves to propose bigger tax cuts and spending rises, the new set of fiscal rules are unlikely to be too binding.
A full list of the possibilities are in Table 2 on page 7. Below we discuss the most plausible. The simplest option would be to tweak the existing fiscal mandate for cyclically-adjusted public sector borrowing to be no more than 2% of GDP in 2020/21.
This makes some sense. Raising the borrowing limit from 2.0% to 2.6% of GDP would account for the reclassification of student loans – which is a definitional change and so has arguably not changed the appropriate underlying fiscal stance – and afford the Chancellor about £8bn (or 0.3% of GDP) of extra fiscal leeway in 2020/21. This would also have the advantage that it would allow the government to claim that the debt to GDP ratio doesn’t rise over the next five years. (See Chart 4.)
Chart 4: Public Sector Net Debt (As a % of GDP)
Sources: OBR, Capital Economics
But while £8bn sounds like a large sum, it isn’t really that big. Admittedly, Javid has ruled out immediately implementing at least some of Boris Johnson’s pledges on the campaign trail – to raise the 40% income tax threshold and increase the NICs threshold – which would have cost £20bn. But he has promised an “infrastructure revolution”, which will presumably cost more than £8bn.
Even increasing the deficit limit further to bring it in line with the 3% of GDP target for euro-zone countries – would only give the Chancellor about £17bn (or 0.7% of GDP) in 2020/21 to play with. And that would not be compatible with a flat or falling debt to GDP ratio.
Another option would be to set a limit for the debt ratio. After all, there is perhaps some rationale for letting the debt to GDP ratio rise a bit further in the near term. The UK’s debt ratio is still lower than in many other major developed economies. On the IMF’s comparable figures, the UK’s 77% in 2018 was lower than the US (80%), France (90%), Italy (120%) and of course Japan (153%).
And the government’s interest bill should remain at manageable levels provided that interest rates do not rise significantly as we (and most others) expect. Even if a Brexit deal is agreed, we think that interest rates will only rise gradually from 0.75% now to 1.50% by the end of 2021.
The problem with setting a debt ceiling, of course, is that there is no definitive answer of what might constitute a prudent level and at what point debt becomes unsustainable. Gordon Brown’s 1997 “Sustainable Investment” rule stated that public sector net debt should not exceed 40% of GDP at any time. But there was little obvious reason why a debt ceiling of 40% was necessarily preferable to one of 50% or 30%.
And while it used to be considered conventional wisdom that debt ratios above 90% of GDP compromised the medium-term growth prospects of an economy, the evidence on which this was largely based has now been questioned. What’s more, even if there were a prudent level of debt, there is no rationale for it to remain the same over time.
Meanwhile, public sector net debt includes all government liabilities but just liquid assets, such as cash. In contrast public sector net worth, which includes liabilities and all assets, is what arguably matters more for the longer-term sustainability of the public finances. If, for example, the value of the road network declined due to poor maintenance that might suggest expensive repairs would be required sometime in the future.
But while public sector net wealth might in theory provide a better overall measure of the health of the public finances than public sector net debt, in practice it would be difficult to target. After all, it is notoriously difficult to value public sector assets and the relevant figures have not been published since 2012 due to quality concerns. And if the government needed to meet its liabilities it couldn’t quickly and easily sell its assets such as roads and buildings. So while the government might express a desire to target public sector net worth eventually, a move in this direction seems unlikely soon.
A carve out for investment spending
So none of the options set out so far may prove entirely satisfactory for the government. Our best guess is that the government will opt for a fiscal rule that allows it to borrow as much as it wishes, so long as that borrowing is to finance investment spending. This would be consistent with Javid’s campaign to invest in an “infrastructure revolution”. And it could allow the Chancellor to argue that he is operating fiscal policy in a way that would not be damaging for the economy in the medium term, as investment would generate more productive assets and a future income stream.
What’s more, investment is the part of government spending with the biggest so-called “multiplier” and so would give the Chancellor maximum bang for his buck. Indeed, the OBR assumes that a change in government investment spending feeds through one for one to GDP. Moreover, with interest rates exceptionally low, the government has more scope to undertake investments that will make the economy more productive and that offer a better return than the cost of borrowing.
Moreover, it would allow the government to borrow only to finance investment spending, rather than to borrow to fund day-to-day spending. This would mean that the current generation pays for all its own (non-investment) expenses. But the costs of investment spending – which would lead to economic benefits over time – is borne by both the current and the future generation.
Most likely, then, is that the Chancellor chooses to target a balanced cyclically-adjusted “current budget” (i.e. the difference between government day-to-day spending and government revenues, which excludes investment spending), with some guidance on the level of debt. A balanced current budget rule was previously adopted by George Osborne between 2010 and 2015 and has been proposed by the Labour Party in its 2017 manifesto.
This would probably not be too restrictive. Cyclically-adjusted current borrowing has already fallen below zero in the last fiscal year. And the Government is unlikely to commit to a balanced budget in every year. Rather than setting an arbitrary date for the fiscal rule (such as 2020/21 currently), he could instead choose a rolling five-year ahead target. According to the OBR’s spring 2019 forecast the surplus was forecast to increase to 1.6% of GDP (or about £40.4bn) by 2023/24. (See Chart 5.)
Admittedly, that headroom is likely to be reduced as a result of the £13.4bn boost to spending in 2020/21 announced in the Spending Round and the recent deterioration in the public finances. But that might still provide the Chancellor with enough room to announce a net giveaway in the Budget (outside of investment spending) of about £8bn (or 0.4% of GDP).
Chart 5: Cyclically-Adjusted Current Borrowing (As a % of GDP)
On its own, that’s not much. But such a target would in theory allow unlimited investment spending. The limit would, of course, be the viable number of projects. At the very least, though, we see no reason why the Government shouldn’t raise investment spending by 1% of GDP (or around £20bn) from 2% now to about 3% of GDP, as it did most recently in the years after the financial crisis (See Chart 6.)
Chart 6: Public Sector Net Investment (As a % of GDP)
The Chancellor could tie this in with some guidance on the debt limit. Most simply he could set a limit on the debt ratio, perhaps of 90%. Or sticking with the excluding investment theme, another option would be to target a falling debt to GDP ratio excluding investment spending. This is conceivable but given that these figures are not currently published, the Chancellor may be inclined to shy away from it. An alternative, might be to impose a limit on the cost of servicing debt, which would encourage borrowing when interest rates are low and provide a disincentive when interest rates are high. Or there could be some combination of the above.
Overall, there are many options and we do not know for sure what the Chancellor will choose. But a target of a “cyclically-adjusted balanced current budget” (excluding investment spending) seems most plausible, with some guidance on the level of debt. That in theory could allow a fiscal stimulus worth up to 1.5% of GDP (or £32bn or so) in the Budget on 6th November, focused mainly on investment.
Whatever self-imposed fiscal rule the Chancellor opts for, the Budget will probably mark the beginning of the biggest fiscal boost seen since the financial crisis. This will act as a prop to the economy over the next few years whether there is a Brexit deal or a no deal and may help to alleviate the need for very loose monetary policy.
Table 1: Evolution of the Main Fiscal Rules
Sources: HM Treasury, Capital Economics. Excludes fiscal rules on welfare cap, first introduced in 2014
Table 2: Possible New Fiscal Rules
Sources: IFS, FT, Capital Economics, Labour Manifesto
Ruth Gregory, Senior UK Economist, +44 20 7811 3913, firstname.lastname@example.org