Aiming at a moving target: the problem with the structural deficit
I attended an interesting speech by Shadow Chief Secretary to the Treasury Rachel Reeves at the IPPR last week. I was especially intrigued by what she had to say about fiscal rules and in particular the Chancellor’s current rules.
The two rules are:
-to “achieve cyclically-adjusted current balance by the end of the rolling, five-year forecast period”
– and “for public sector net debt as a percentage of GDP to be falling at a fixed date of 2015-16”.
The first rule amounts to saying that the Government promises to promise to eliminate the structural deficit five years forward from any given point.
But because that five year horizon moves forward with every year, the delivery on that promise can advance ever further into the future. Indeed this has happened already, with George Osborne pushing his target for deficit elimination back by two years.
As the Institute of Fiscal Studies has said, “a government that continually promised to tighten in future, but never delivered on those promises, would not technically be judged to be breaking the rule”.
Or as another commentator has pointed out, it is rather like someone promising to give up smoking in five years’ time – a promise which can always be kept, without ever stopping smoking, because its fulfilment is always five years in the future.
So as Robert Chote, Director of the OBR has agreed, this rule does not guarantee “long-term sustainability”.
The second rule gives the Chancellor a target with a fixed date, but because it is not about the level or trajectory of public debt, but only about its immediate movement, it could be met in all kinds of ways, shifting borrowing from one year to another, far from relevant or sensible for ongoing fiscal stability.
The IFS, polite to the last, describes this rule as “curious”.
As they point out, “if debt were to fall as a share of national income in 2015-16, but increase in every year up to then and in every year after, the supplementary target would still be satisfied.”
The IFS view, then, is that the two rules in combination are insufficient “to ensure fiscal sustainability”.
So, even with the Government’s borrowing plans being thrown out of the window, the Chancellor continues to meet his rules, because it’s so easy to fudge them.
I think these are both fair criticisms – the fact that the Chancellor has now revised his borrowing targets up to in excess of what the last government proposed whilst still meeting his rules tells us that those rules were a lot more flexible than we were led to believe.
Now, I’m actually quite suspicious of ‘fiscal rules’ in general. I’m not sure how effective they ever really are – the Chancellor’s current rules, Gordon Brown’s ‘Golden rules’, the old European Stability & Growth Pact all eventually failed. What’s more, I think we start to get into serious questions about democratic legitimacy when we apply rules that might actually be effective in restraining government borrowing (e.g. the now dropped German proposal for an external overseer of the Greek public finances – economically credible yes, democratic no).
But leaving questions about the effectiveness or desirability of fiscal rules to one side, I think there is a third objection to Osborne’s rules that can be made, alongside the equally valid ones made by Rachel Reeves.
I worry he is targeting the wrong measure.
Osborne’s primary target is to achieve a ‘cyclically-adjusted current balance’, i.e. to remove the structural deficit. Over the past two years or so we’ve heard a lot about the structural deficit, the part of the deficit that will remain once the economy is back to growing at its trend rate of output – i.e. the bit that apparently can only be removed by spending cuts or tax rises. This is quite curious as, until June last year, we didn’t hear a great deal about this at all.
Go back to Osborne’s Mais lecture of February 2010 when the then-Shadow Chancellor made a major statement of his economic policy aims.
As I have made clear, our aim will be to eliminate the bulk of the structural current budget deficit over a Parliament.
Four months later, in mid June 2010, Osborne unveiled the new OBR’s first forecasts to Parliament, the ‘pre-Budget June forecast’. Osborne had spent the previous year arguing that an independent fiscal watchdog was needed to stop the Chancellor ‘fiddling the figures’. It’s quite easy to imagine what he expected the new OBR to report and how he expected to play the politics of it. Alistair Darling’s last budget (made only three months before) would be revealed to be based on optimistic assumptions – the deficit was surely higher than the public had been led to believe.
Except, it wasn’t. The table below summarises the projected deficits from Darling’s last Budget and the OBR’s first report.
If the Treasury had ‘fiddled the figures’, it had fiddled them in the wrong way… Its deficit forecasts were a cumulative £29bn lower than those of the new OBR. Interestingly enough Osborne chose not to highlight this in his Parliamentary statement on the OBR numbers, instead switching to talk about the structural deficit, now the ‘most important figure’.
The reason for that is that the cyclically adjusted current balance – commonly known as the structural deficit – is forecast to be higher in every single year than what this House was told in March.
This is the most important figure in this report, because the structural deficit is the borrowing that remains even when growth in the economy returns.
And it is the structural deficit that is a key determinant of whether the public finances are sustainable.
This year the structural deficit is forecast to reach 5.2 per cent of GDP, that’s £9bn higher than we were told in March.
Next year, the structural deficit will be £12bn higher than we were told.
The Budget speech came two weeks later and by now the structural deficit was the central issue ion Osborne’s rhetoric.
The formal mandate we set is that the structural current deficit should be in balance in the final year of the five-year forecast period, which is 2015-16 in this Budget.
We now know, thanks to last week’s Office for Budget Responsibility forecast, that the structural current deficit is significantly larger than we were told – 0.8 per cent of GDP or £12 billion next year.
Because the structural deficit is worse than we were told, my Budget today implies further reductions in departmental spending of £17 billion by 2014-15.
In February 2010 Osborne pledged to eliminate the ‘bulk’ of the structural deficit, by June eliminating it all had become the key target for his fiscal mandate.
But, the OBR are always keen to point out, the structural deficit is difficult to calculate. As they said in their very first report:
As set out previously, forecasts of cyclically-adjusted aggregates are subject to particular uncertainty.
This is because the size of the structural deficit is more determined by the size of the output gap and trend growth than by other factors.
After the Autumn Statement, Henderson Global Investors’ Simon Ward wrote that:
It should be stressed that the OBR’s negative reassessment of the fiscal position reflects a downgrade to its estimates of current and future potential output rather than worse-than-expected recent borrowing outturns. This downgrade may or may not be warranted but it is troubling that the fiscal framework pivots on a concept subject to huge empirical uncertainty.
I agree, it is ‘troubling’ indeed that £30bn of additional spending cuts were announced on the back of a ‘concept subject to huge empirical uncertainty’.
I’m not arguing at all that the concept of a structural deficit is meaningless, but I do think it is subject to huge uncertainty and highly liable to revision. Does it really make sense to be planning fiscal policy 4 to 5 years out on the basis of something like this? Does the Chancellor not risk aiming at a moving target?