Why austerity?
Osborne claimed that his rapid deficit reduction improved confidence across the economy, which caused demand to recover and growth to return.

Why a fiscal rule requiring an overall surplus in every year?

• Paying down debt in time of growth makes sense, so a surplus is required.
• Rules based on cyclically-adjusted measures and forecast targets—such as the present, five-year rolling structural current balance requirement—have huge measurement problems, which makes them a less effective constraint on Government policy.
• He felt that the debt targets, which were anchored to a particular year, were the harder constraint on his actions in the past Parliament. The new requirement for a surplus each year is a similarly hard constraint and is intended to be so to effectively constrain future Chancellors.
• The overall surplus is used instead of the current balance for two reasons: splitting current from capital expenditure allows gaming of the rules, and also leads to an undesirably negative framing of current expenditure.

Ring fences
Osborne was unapologetic about using ring-fences to protect particular areas of Government spending. He characterised them as simple heuristics that clearly set out the spending priorities of the Government.

The review considers whether a numerical fiscal rule might help and makes the point that

..it might weaken the Government’s ‘ownership’ of the debt target, and its preparedness to save revenue windfalls…  It might create incentives for governments to comply with the rule through policies that would weaken other parts of the balance sheet.

In other words, once there is a rule then the game is compliance with the letter, not the spirit, and that can actually weaken fiscal governance.

The review is also lukewarm on the idea of a NZ fiscal council, pointing to

…the operational independence of the Treasury in the preparation of the forecasts and other documents of its responsibility, its well-established non-partisan reputation, its increased openness to outside inputs, and its strong record of relatively (compared to other national forecasters) accurate and unbiased macroeconomic and fiscal forecasts.

How does HM Treasury stack up against that assessment and should we be thinking about its role in fiscal sustainability rather than allocating the entire burden to the OBR?

If the ideas about secular stagnation turn out to hold water then we may be hitting the ZLB far more often in the coming decades. Even if that doesn’t eventuate, real interest rates have been trending down for a long time, which has led some people to recommend a higher inflation target to avoid the ZLB in future. The upshot is that, unless there are changes to the standard monetary policy regime–flexible targeting of 2 per cent inflation–high fiscal multipliers and fiscal activism may become a regular occurrence. If it does then the government’s fiscal rule had better work during those times, too.

That has important consequences for the way surpluses and deficits are dealt with. It means that governments tend not to save surpluses beyond their term because they reap little benefit from it. They also attempt to close deficits within the term, which can be too rapid when the deficit is large. The recent recession in the UK is a textbook example of the latter problem. Faced with a deficit exceeding 10% of GDP, the Government sensibly altered their plans to reduce it. However, the five-year planning horizon of their term in office induced them to attempt to close it far more rapidly than would be ideal. The immediate cost was a reduction in aggregate demand just as monetary policy was losing steam. The chart shows two estimates of the cost that imposed on the UK’s output. Over the three years charted that probably amounts to a cumulative £3,500 per household.

The real costs of poor, short-term fiscal rules are twofold: they enable governments to avoid the challenge of long-term fiscal sustainability, and they encourage them to pursue damagingly rapid fiscal adjustments. An effective rule needs to solve both of these problems. It must bring the long-term challenges into focus for the current administration, but it must give the government the leeway to solve them over decades, not years.

Getting the debt to GDP ratio to fall at some stage is a good idea, but having a target for a specific year is silly. It is not optimal because if some shock hits the economy before 2016/7 which means debt tends to rise relative to GDP, it is crazy to try and counteract that to meet the target in such a short space of time. It is not effective because it can be gamed by the government fiddling the timing of expenditures.

…

Having a five year rolling target for the deficit allows fiscal policy plenty of time to adjust to shocks. We saw this in action over the last few years, as the Chancellor was able to reduce the pace of fiscal consolidation from 2012 when the economy failed to recover as quickly as he had hoped. Changing this mandate from five to three years gives any Chancellor less time to adjust, which is why it is a backward step.

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.[ref]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.[/ref]

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.

A few days ago I wrote about the lessons that can be drawn from the recent history of the UK’s fiscal rules. This post measures the Government’s new Charter for Fiscal Responsibility against them. The Charter sets out the Government’s fiscal rule and requires the Office for Budget Responsibility (OBR) to assess Budgets against it. The new Charter lightly updates the previous version in two ways:

1. It requires the Government to forecast a cyclically-adjusted, current account surplus within three years, rather than the previous five years.
2. Public sector net debt should fall as a percentage of GDP in 2016-17, a year later than in the previous Charter.

Now compare against the lessons from history.

Complex rules need genuinely independent monitoring and enforcement.

Satisfied by the Charter, which requires the independent OBR to assess compliance.

Durable rules must be resilient to changing economic conditions.

Failed, according to the OBR’s latest forecasts. The chart below shows relevant forecasts for three levels of productivity growth. It shows that, without a quadrupling of growth over the next three years, the fiscal rule is forecast to be broken. A forecast continuation of the current stagnation would immediately breach the first part of the new rule and would suggest that it is likely the second part will also be breached. A rule that will fail if current conditions persist is about as fragile as could be imagined.

Fiscal rules should have operational deficit targets, not debt targets.

This rule has both so it narrowly fails. Recent history suggests that the deficit target is of greater importance to the government. The previous rule was formulated in a similar fashion with slightly different parameters and the debt target was judged likely to be breached for two years, yet the government continued to stick to the deficit target. Even if the deficit target remains in force once the debt target falls by the wayside, the failure of one will ultimately require that the entire Charter be updated again. This clearly isn’t a rule designed to last.

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.