Hidden dangers are lurking in Reeves’s £50bn fiscal rules rejig
You could be forgiven for feeling a bit confused about the state of our public finances. The Chancellor doesn’t miss an opportunity to bang on about the awful mess that the Government has inherited and in particular about the so-called £22bn fiscal black hole. Yet in the last week, there have been suggestions that she is considering a rejig of the fiscal rules which would supply a £50bn escape hatch, at least for investment spending.
What on earth is going on?
It is perfectly reasonable that Rachel Reeves should be considering rejigging the fiscal rules. They are arbitrary and don’t make a lot of sense. Indeed, there have been 10 versions of them since they were first introduced in 1997. The average lifespan of fiscal rules in the UK is about the lowest of any country in the OECD. And the Chancellor is rightly concerned that the current formulation unduly squeezes investment spending.
We don’t know exactly how the fiscal rules might be rejigged but there are a few ideas circulating.
Under the last government, public sector borrowing was supposed not to exceed 3pc of GDP in five years’ time. That balance includes both day-to-day spending and investment spending. The Chancellor could reasonably decide to reformulate this rule to require a target balance, of perhaps zero, on only the current budget. This would then allow her to increase government spending on investment.
Nevertheless, there would have to be some limit on overall government debt. Under the previous government, a second fiscal rule laid down that the ratio of underlying debt to GDP should be falling in five years’ time. A suggestion has recently emerged that this rule could be rejigged to include an allowance for public sector assets.
It may seem financially bizarre to be locked in by arbitrary targets for public liabilities without having any regard to what lies on the other side of the balance sheet. It has been suggested, for instance, that one possibility would be to include such assets as the Government’s book of student loans.
This is a very dangerous path to go down. It is going to be extremely difficult to value public sector assets, including student loans – a high proportion of which are not repaid.
And if the ambition is to have a fiscal rule that takes proper account of the true state of the public sector balance sheet, then surely allowance should be included for unfunded public sector pensions. The size of this item has been growing like topsy and will have been driven up still further by recent generous pay settlements.
The history of British governments’ behaviour on these issues is mixed. On the one hand, there has been a long-standing tendency for the Treasury to squeeze investment spending unduly as a way of keeping overall borrowing in check. This has been a significant factor holding back Britain’s overall level of investment, which has for ages been among the lowest in the developed world.
On the other hand, under Gordon Brown, when the government wanted to spend more money, there was a tendency to classify all sorts of dubious spending as investment. The devil is in the details. It is the quality of investment spending that really matters. Bad investment is really just consumption – but without the enjoyment.
If the Chancellor does manage to rejig the rules in such a way as to allow significantly more Government spending on investment, there would be wider financial consequences. The Government has said that there is to be no more austerity. Accordingly, it looks as though the intention is to have no further cuts to the Government’s current spending and to try to keep borrowing on track by increasing taxes.
But if there is extra investment spending – although this might be a good thing – it will take quite some time for the benefits of this investment to come through in the form of increased productive potential. By contrast, the effects on demand would be pretty much immediate.
The result is that an increase in investment spending, unless it was offset by reductions in current spending or an equivalent increase in taxes, would increase overall aggregate demand and thereby, other things being equal, put upward pressure on inflation. The result would surely be that interest rates would need to stay higher for longer. Indeed depending upon the amount of extra spending, short-term interest rates might even need to go up.
How would the financial markets react to a rejigging of the fiscal rules?
As it happens, the Office for Budget Responsibility (OBR) may give the Government more fiscal headroom as it increases its forecast level of tax revenue.
But in any case, the markets have always taken the fiscal rules with a pinch of salt. They have realised that the rules are not sacrosanct and are familiar with the black arts of fiscal presentation. They are not easily bamboozled by governments fiddling about with definitions of debt or borrowing.
What matters for the financial markets is that the Government is believed to be fiscally responsible. If they cease to believe that then, as we saw with the unfortunate Truss/Kwarteng episode, they can give a sharply adverse reaction very quickly.
It has been noteworthy that over the last week, the pound has been quite perky on the exchanges, not only against the dollar but also against other major currencies. This has probably been due to the perception that the Bank of England will continue to cut interest rates quite slowly, in contrast to the Federal Reserve which will cut more quickly.
If the Chancellor goes ahead with a major increase in investment spending with the interest rate consequences described above, then there might well be a further bout of sterling strength. That might sound like good news but I don’t think it is. A stronger pound reduces our competitiveness in world markets. In current circumstances, that is the last thing we need.
Roger Bootle is senior independent adviser to Capital Economics. He can be reached at roger.bootle@capitaleconomics.com