Why fiscal rules matter: sustainability

Before Christmas I wrote a couple of posts on fiscal rules and you might very well be asking why it really matters.

The first reason is that the current trajectory of public spending is unsustainable, but not in the sense that the Government means it. Sustainability in public spending should be measured over decades, not a single Parliament. The question is whether the current policy settings can be maintained indefinitely.

This is a chart of the UK’s debt-to-GDP over the past three centuries combined with the Office for Budget Responsibility’s latest long-run projections through to 2063-64. 1

The chart demonstrates that the rise in debt we’re presently seeing is not extreme by historical standards. However, the increase that would occur over the next fifty years with the current policy settings would see debt increase to levels not seen since World War 2. In fact, it is worse than that because the Napoleonic Wars and World War 2, which caused the two previous episodes of debt exceeding 200% of GDP, had one-off effects on debt. The increase projected by the OBR is largely caused by the rising cost of healthcare and pension spending as the UK population ages. That is an ongoing cost and avoiding it will require a dramatic change in government policy.

The problem with the current fiscal rules is that they do not force the government to look ahead more than three years so these long-run challenges remain politically distant. The OBR, in each year since it was created in 2010, has judged the public finances to be unsustainable. For example, in 2011, it said

In the absence of offsetting tax increases or spending cuts [these pressures] would eventually put public sector net debt on an unsustainable upward trajectory. It is likely that such a path would lead to lower long-term economic growth and higher interest rates, exacerbating the fiscal problem. The UK, it should be said, is far from unique in facing such pressures.

Unfortunately, the Government has set itself targets that extend only a few years into the future, which allows it to ignore these annual warnings. A truly effective fiscal rule would change that.

Notes:

  1. I have not used the OBR’s central projections here, which assume that health productivity more than doubles for the next fifty years. Instead, I have used the scenario that assumes productivity remains at historical levels.