Why it is now the time to set out strict fiscal rules to stop over-spending for ever

Kwasi Kwarteng
IN HIS speech at the Labour party conference last week shadow chancellor Ed Balls made an interesting suggestion. He argued that Britain should introduce a new set of fiscal rules to be independently monitored by the Office for Budgetary Responsibility (OBR). We should not reject the idea just because of the messenger.

The economic downturn will not last forever. The current target of fiscal policy is the elimination of the structural deficit by the end of this parliament. But what will happen after this? We should put in place credible fiscal rules so that the gains from today’s sacrifices are not squandered by future governments. The government should run a balanced budget over the course of the economic cycle. By saving in the good times, we can afford the higher bills and lower tax revenues when the economy falters. Fiscal rules are far from perfect, but the evidence from around the world is that they work.

This is most important when an economy is growing. The incentives in our political system always tempt governments to spend more. Governments begin to believe their own overoptimistic forecasts, and fail to save for a rainy day. New Labour failed to restrain spending, precisely when the economy looked best, at the beginning of the decade. The result was a steady growth of government. In 2000, government spending was around 36.8 per cent of GDP, according to the Treasury’s figures. In 2010, it was 47.1 per cent. The coalition government is now making drastic savings because Labour spent so unwisely.

Fiscal rules are increasingly popular around the world. In 1990, only 10 countries had fiscal rules. Now, 80 countries have adopted them. Germany, for example, recently introduced its own balanced budget amendment, the Schuldenbremse. The German government is committed to run a deficit of no more than 0.35 per cent of GDP from 2016, unless there is a natural disaster or economic crisis. Switzerland’s 2001 balanced budget rule helped it run surpluses in the early years of the millennium.

According to the IMF, countries with fiscal rules are more likely to return to pay down their debt. Since Sweden introduced its own fiscal rules in 1989, its total debt has nearly halved, falling from around 70 per cent of GDP in 1998 to around 35 per cent now.

Britain’s own former fiscal rule lacked both transparency and credibility. The golden rule was announced in 1998, but abandoned just ten years later. It stated that “over the economic cycle, the government will borrow only to invest and not to fund current spending.” After running surpluses for his first few years, Brown clearly failed to meet this target. Rather than cut spending, the government simply changed its definition of when the economic cycle was supposed to have begun to make its numbers work. The result was persistent deficits.

The most important reform to this flawed system was made by the coalition government with the creation of the independent OBR. An independent fiscal council can work well with fiscal rules. Indeed, the OBR already judges the government on whether it has more than a 50 per cent chance of meeting two fiscal targets: essentially that in five years time the current account budget will be in balance and that net debt will be falling.

We should strengthen these targets to make them both more transparent and more credible. For example, we could specify that whenever an economy is growing faster than trend – around 2 per cent – that the government should be heading towards, or running, a surplus. Even independent forecasts tend to be more likely to be over-optimistic than pessimistic. To counter this, we could aim for a structural surplus of 1 per cent of GDP over the course of the economic cycle.

The politics of any rule is more important than the economics. Experience has taught us that poorly designed rules end up being simply ignored. This year, the US Congress voted to raise its debt cap for the 75th time. The Eurozone’s Stability and Growth Pact didn’t succeed in turning Greece into Germany.

Whether the government looks set to meet these targets shouldn’t be an arcane technical issue, but a subject of national debate. It is worth looking again at how best to achieve this. The OBR currently gives the chancellor advice, which he is then free to ignore. While the chancellor should retain the final say, he should have to defend, in a public forum, any failure to comply with the rules. If his numbers fail to add up, he should be forced to come back and give a separate statement to the House on how he plans to bring the budget back into balance.

The government is rightly focused now on the challenging task of reducing the deficit. We cannot eliminate economic and world instability, but we can make Britain’s economy more secure. It would be a shame if the rewards from today’s sacrifices were thrown away by future indulgence. We should introduce new fiscal rules to make sure that doesn’t happen.

Kwasi Kwarteng was elected as Conservative Member of Parliament for Spelthorne in 2010. He worked in the City, and holds a PhD in Economic History from Cambridge University.