Fiscal Frameworks & Spending Plans
Today’s political news is being dominated by a report in the Independent, claiming that Labour will pledge to go into the next election with higher spending plans than the Conservatives.
The report gives a preview of forthcoming research from the Fabians:
Arguing the cuts may be unnecessary, the study says that, if the economy is growing by about 2 per cent annually, public spending could rise by 1 per cent a year and Labour could achieve Mr Osborne’s target of seeing debt falling by 2016-17 two years later – or sooner than 2018-19 if taxes were increased.
Leaving aside today’s likely political brouhaha* over what this analysis means for the politics of 2015, this report is an important contribution to the economics of getting an appropriate fiscal framework in place.
The political debate on whether or not parties should sign up to the Coalition spending plans beyond 2015 is currently crowding out a much more important fact – the UK no longer has a fiscal framework that is fit for purpose.
In effect many are now arguing that policymakers should buy themselves ‘fiscal credibility’ by signing up to a fiscal framework which is failing to reduce the deficit. This seems to me an odd state of affairs.
The Government originally said it would have reduced borrowing to £37bn by 2014/15, the latest estimate is for annual borrowing of £108bn in that year. Cumulatively the Government is set to borrow around £250bn more than it intended. The current framework is not working, even on its own terms.
Partially this is because many seem to assume that reducing the deficit is simply a result of taking ‘tough choices’ and making spending cuts. But when the economy is weak then the multiplier on government spending is higher and making cuts now simply reduces growth, pushes up unemployment and makes ‘dealing with our debts’ harder, not easier. The story of UK fiscal policy from 2010 to 2013 is not ‘tough choices now but good times later’, it is ‘tough choices now and then even more tough choices later’. Austerity keeps being extended and yet some people continue to argue that setting unrealistic targets and then missing them is the best way to ensure that you are seen as credible.
George Osborne’s fiscal framework, adopted in June 2010, rested on two pillars. First a target to eliminate the structural deficit within 5 years and second a target that the government debt/GDP ratio would fall in 2015/16.
The IFS were fairly critical on these targets at the time. The first target was crucially governed by a rolling period 5 year period – the plan was never to eliminate the structural deficit by 2015, but to eliminate it in a rolling 5 year period. In effect this was like saying, ‘I’ll quit smoking in the next 7 days’ – as the 7 day period always rolls forward, one can say that every single day for a year and never stop smoking and yet always been ‘on track to the meet the target’. This is basically what has happened to the Government’s plan to eliminate the structural deficit, as 2010 rolled in 2011 and 2012 rolled into 2013, the end date for eliminating the structural deficit was continually pushed forward. Borrowing forecasts were revised up but the Government could continue to argue they were ‘on track’.
The second party of the mandate (the so-called supplementary target)was supposed to provide an anchor by noting that in the year 2015/16 debt/GDP would fall (as the IFS noted this plan was only ever for a single year so was always limited, if debt/GDP fell in 2015/16 but then began rising again the target would have been met).
The Government though announced in 2012 that they would no longer meet this target. In effect the current fiscal framework is to eliminate the structural deficit in a rolling five year period that never actually bites.
In many ways this is the worst of all worlds, the short period of the target forces the government into making cuts too quickly which damage growth but the fact that the policy is so-flexible means the tomorrow never actually comes and so the period of cuts are continually extended. This is a recipe for continual austerity.
But the problems with the current framework don’t stop here. I would go further and argue that the structural deficit itself is the wrong target. The structural deficit is not something that can be measured, it is only something that can be estimated and those estimates are highly uncertain.
We are basing fiscal policy, much of the political debate on the economy and the Government’s supposed ‘credibility with the markets’ on something ‘subject to huge empirical uncertainty’.
Let’s try a thought experiment – imagine that the OBR, in time for the Autumn Statement, decides to change its forecasting methodology for the output gap and becomes convinced that Capital Economics are correct and the gap is much larger. It will then say the structural deficit is much lower than it currently estimates and the additional fiscal tightening penciled for 2015-2017 will not be required. Once again the Government will be on ‘on course’ to eliminate the structural deficit ‘this parliament’. No doubt that would be celebrated by the Government’s supporters as a vindication of their fiscal policy. A vindication simply because of a change in an estimate.
Or, on the other hand, imagine that the OBR gets more pessimistic. It revises its view of the output gap in the other direction. It now says the structural deficit is even bigger then it thought and more cuts will be required (this is what happened last year and may happen again this year).
Of course, which ever way the OBR swings it may change its mind in the future. As the IPPR’s Tony Dolphin has observed it is perfectly possible that in, say, 2016 the OBR will decide it was wrong all along, that the structural deficit has already been eliminated and that austerity went beyond what was necessary.
Does anyone seriously think this is a sensible basis for a fiscal mandate?
As Ian Mulheirn argued after the Autumn Statement, the fact that the OBR changed its methodology for estimating the structural deficit was highly significant.
In other words, even with the extra year of austerity the Chancellor announced, he would have likely missed his fiscal mandate had the OBR not junked its models and adopted a more, how shall we say, sympathetic one.
Now as it happens, that’s probably a sensible judgement. But the point here is that everything about the scale of necessary future cuts and tax rises hangs on this judgement about an obscure economic concept. And that’s a judgement that just changed radically and without warning. If the last OBR models were so wrong, who’s to say that the new production function one isn’t also wrong?
Let’s look at the effect of that on the public finances. If we take a forecaster whose estimate of the output gap is higher, such as NIESR’s implied output gap of -4.3% (NIESR give a range of -4% to -4.5%), the OBR’s analysis suggests that this would put the current budget into a structural surplus of around £40bn in the target year 2017-18. In other words, on this analysis the Chancellor is making cuts way in excess of what’s needed to balance the books.
And NIESR is hardly an outlier here. Oxford Economics estimates the output gap at -5.2% while Capital Economics recently argued that it could be -6%. Think of all the unnecessary austerity if these people are right. By junking its models, the OBR has invited a very lively debate.
Those arguing that policymakers should sign up to the current fiscal plans are in effect arguing that policymakers should sign up to a fiscal framework that has failed to reduce the deficit anywhere as much as promised, that binds in tight austerity, that is targeting the wrong measure and that is subject to heavy revision.
The real question that should be asked of policymakers is not, “do you sign up to the Government’s current spending plans?” But instead, “what is your proposed framework?”
The forthcoming Fabian research is one proposed answer. Another, also published by the Fabian Society, proposed a new ‘golden rule’ that explicitly took account of sector savings balances.
One sensible suggestion comes from the IPPR’s Nick Pearce, who has argued that (FT paywall):
Alongside plans for structural reforms to the UK economy, it should commit to reduce the ratio of public debt to gross domestic product over a 10-year period; thereby lowering interest payments and preparing for any future economic shock.
Pearce suggest planning to cut the debt/GDP ratio to 60% by 2025 (from an estimated 85% in 2015). Such a target has the attractions of being suitably long term to allow for early growth boosting measures and explicitly taking account of growth (the debt/GDP ratio can be reduced by growing the economy), as well as being transparent and easily measurable.
These are sensible directions in which to take the current long-term fiscal debate and we would all do better to ask about fiscal frameworks rather than focusing on the much more narrow question of ‘committing to existing plans’.
*I continue to be amazed at much of the UK media’s capacity for collective cognitive dissonance – “Thursday: IMF warns UK should spend more in blow for Osborne”, “Friday: Labour have risky plan to spend more”.