We need a new fiscal rule to rid the UK of its unsustainable debt levels

 
James Zuccollo
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IN A month’s time, millions of Britons will make a New Year’s resolution to lose weight. Over the next year, nearly 80 per cent of them will find this commitment too difficult and abandon it. UK governments of all colours have found it just as difficult to keep their fiscal promises over the last decade.

In 2010, George Osborne made a commitment to have the burden of government debt falling by 2015-16. He has all but acknowledged that he will break that commitment in tomorrow’s Autumn Statement. History will repeat itself: the previous government also ditched its fiscal rules in 2008 when the going got tough. When it comes to fiscal discipline, recent chancellors have lived by the maxim that “rules are made to be broken”. However, the real problem is that the rules themselves have been designed to fail.

The UK’s gross debt recently broke 80 per cent of GDP, after averaging only 40 per cent in the pre-crisis years from 2000 to 2007. Under the chancellor’s current plans, the Office of Budget Responsibility (OBR) forecasts gross debt to exceed 90 per cent of GDP by 2013-14. This is likely to be revised upward in the Autumn Statement.

Debt levels exceeding 85 to 90 per cent of GDP are bad for a number of reasons. They reduce the government’s flexibility to respond to contingencies, and also tend to encourage policies that amplify recessionary pain. More worryingly, there is research suggesting that debt levels over 90 per cent of GDP can lead to a reduction in economic growth of up to 1 percentage point per year. While that claim has been the subject of dispute among economists, it is prudent to stay out of any potential danger zone if possible.

Unfortunately, successive UK governments have only had surpluses large enough to reduce the country’s debt in six of the past 28 years. This is despite long periods of steady economic growth: between 2002 and 2008, debt rose from 37 to 44 per cent of GDP, even as the economy boomed.

We need to revise our current fiscal rules to lift the UK out of the danger zone and put public debt on a downward trajectory. The rules of the past decade have been easy to break because they have been so arbitrary. Gordon Brown’s golden rule required debt to stay below 40 per cent of GDP. It was a target with no good justification; as such it was relatively easy to abandon. Similarly, Osborne’s goal is to have debt falling as a percentage of GDP in 2015-16. That target will also be sacrificed in the face of, in the chancellor’s words, a Eurozone “crisis”, an oil price “shock” and “problems” in emerging markets.

The UK needs a new fiscal rule that achieves long-run debt reduction, while still allowing governments the flexibility to respond to contingencies. Switzerland, for example, uses a rule that mandates a small surplus over the course of the business cycle. It has caused government debt to fall from 70 per cent of GDP in 2005 to 47 per cent in 2012, despite the financial crisis.

Brown’s golden rule was similar in that it required budget balance over the business cycle. Its flaw was that it excluded investment spending. That gave an opportunity for creative accounting, which kept deficits high and debt rising. A spending rule needs to be comprehensive and include all government expenditure to avoid that sort of gaming.

Essential to the success of a new rule will be the strength of the supporting institutions. This government has already recognised the importance of external oversight to fiscal discipline by setting up the OBR. This body has a role in monitoring the current fiscal targets, but those targets are Osborne’s to discard and change as he sees fit. The chancellor needs a new fiscal framework to set achievable, medium-run rules with the OBR. The present, short-term targets provide little constraint as they are so easily changed, while achieving long-run debt reduction requires an enduring commitment. With independent monitoring and enforcement, fiscal sustainability can be the OBR’s to enforce, and not the chancellor’s to abandon.

A long-run strategy is needed to ensure that the UK escapes from the present situation and avoids escalating debt in the future. Appropriate fiscal rules, supported and monitored by the right institutions, can achieve that.

James Zuccollo is an economist at the independent think tank Reform. Its research paper Long-term fiscal sustainability is available at www.reform.co.uk