A (very) short history of UK fiscal rules

Earlier this week the UK Government announced its new fiscal rule, which defines the fiscal envelope. For those of you who aren’t British, the deficit exceeded 10% of GDP during the recession and fiscal sustainability has become an important political issue, even for people who aren’t econ junkies! Unfortunately, this new rule is unlikely to encourage the sort of sustainability that the Government is hoping for. To understand why, I’m going to write a short series of posts on fiscal rules. This first post will briefly review the history of fiscal rules in the UK. For people who love technical details, this paper by Simon Wren-Lewis and Jonathan Portes is a great review and I’ll be coming back to it later.

A fiscal rule is simply a set of objectives that guide and constrain the Government as it makes policy. The rule usually comprises targets for debt and the deficit, with many variations in the details. Rules were introduced to the UK in 1997 by the then-Chancellor, Gordon Brown. Since then they have had a rocky history, as the chart shows:

The first rule required the current budget to balance over the economic cycle and debt to remain below 40% of GDP. It was considered close to optimal because it excluded investment expenditure, which usually requires borrowing, and was measured over a cycle, which allows for counter-cyclical fiscal policy. Unfortunately, it turned out to be a perfect illustration of the trade-off between optimality and enforceability. The Government gamed the rules by re-classifying some spending as investment and re-dating the economic cycle to allow themselves the maximum amount of borrowing. The result was rising net debt even as the economy experienced a long period of strong growth.

Lesson 1: Complex rules need genuinely independent monitoring and enforcement.

When the financial crisis hit in 2007 debt rocketed through the 40% boundary and the rules were abandoned. The new Government set itself a new rule in 2010 but poor economic performance led to that being sidelined within two years. At the time the rule was created growth was picking up and most people thought that a recovery was imminent; that turned out to be a mirage. Unfortunately, the commitment to reduce debt as a percentage of GDP by 2015-16 relied on strong growth and it quickly became apparent that the goal would not be met.

Lesson 2: Durable rules must be resilient to changing economic conditions.

Both of the broken rules had two parts: a rolling deficit target and a fixed debt target. In both cases it is the debt target that was broken because of the change in economic circumstances. Intuitively, that makes sense. The rolling deficit target sets the trajectory of the public finances and that can be stuck to, irrespective of the starting point. But the debt target is a fixed end point and, when economic conditions shift, it can quickly fall out of reach. Consequently, it is usually the fixed, debt targets that turn out to be the most fragile element of fiscal rules.

It is worth mentioning that some countries, such as New Zealand, have long-run debt targets with no fixed date by which they must be achieved. The problem of fragility doesn’t arise because the government’s operational target remains the deficit. That deficit target is simply set such that the debt target will eventually be met.

Lesson 3: Fiscal rules should have operational deficit targets, not debt targets.