Why Fiscal Rules are Redundant and How Public Debt acts as a shock absorber and an enabler for public policy
The big issue government's need to confront is how much and on what they are spending, how this is financed by debt and taxation is a secondary issue in the context of the deadweight of expenditure.
This is written evidence that Warwick Lightfoot gave to the House of Lords Economics Affairs Committee inquiry into the sustainability of public debt. The gravemen of the analysis and policy advice is that governments are well placed to mobilise resources from public debt markets for crises, such as war and as a shock absorber when demand collapses in economic shocks. The big issues that governments have to confront is how much they are spending and what they are spending it on. How spending is financed between spending and taxation is a secondary question in the context of the deadweight costs of expenditure. The full economic cost of spending is greater than its cash cost. Whether spending is financed from taxation or borrowing makes little difference to its full cost and the question that needs to be interrogated is whether the returns from spending exceed the full deadweight. costs involved.
National Debt and Fiscal Rules
Government debt plays a central role in modern economies and their money and capital markets. Government borrowing plays a significant role in fiscal policy as part of macro-economic management particularly in the event of adverse shocks to demand. Artificial rules directed at maintaining public sector solvency are irrelevant when they are not an impediment that hinder good policy. Rules limiting annual borrowing and the stock of public debt if implemented methodically would prevent policy makers from using debt in wartime emergencies, managing social and economic shocks, undertaking public sector capital accumulation and structural policies to improve incentives and the supply performance of the economy. The more sophisticated and nuanced the rules become to address their inherent clumsy properties, the more likely that the complexity involved, will make policy opaque and will create perverse features in public finance policy that will yield malign distortions. Fiscal rules directed at controlling borrowing and debt, moreover, fail to address the principal issue in public finance, which is the overall level of public expenditure.
The political economy of government debt generates a culture of naïve political debate where borrowing invites disapproval and debt is condemned. The analogy is made with a private individual and household. This leads to calls for balanced budget rules, paying down the debt, fiscal rules that limit annual borrowing and caps on the stock of public debt in relation to national income. This anxiety about the economics of public debt has a long and erroneous political pedigree. Lord Macaulay in his History of England ridiculed anxiety about the growth of national debt in the 18th century. It was a corner stone of Gladstonian fiscal orthodoxy and contributed to aggravating the economic costs that arose from the radical shocks that affected the British economy after the First World War and the constrained finance contributed to Britian’s tack of military preparations for war in the 1930s.
The origins of modern public debt in the Netherlands in the 16th century, England in the17th and the United States in the 18th century illustrate the use and function of public debt in countries with representative institutions. What distinguished each of the pioneers of public debt were a political process based on legislative assemblies that agreed to levy taxes to fund debt service charges on publicly issued debt. This enabled governments to mobilise huge resources to fight wars and offered smaller powers fighting much greater powers an asymmetric advantage in terms of finance. The Netherlands in the 17th century successfully defeated the Spanish Empire and along with Britian in the 18th century defeated the French absolute monarchy and Britian used public debt to wage war and defeat Napoleonic France. The United States used public debt to fund its new federal constitution after 1789 and to pay the debts that it had incurred in the revolutionary war against Britain.
Funded public debt does not simply enable governments to mobilise huge resources for a political emergency, such as war, but provides other economic agents with great benefits and opportunities. A key benefit is the creation of a public debt that can be traded that is in credit terms is risk free. It gives savers and investors a convenient instrument to hold savings in and opportunities for speculation, as well as the mitigation and insurance against risk. In the 18th century ‘to be in funds’ was a safe and reliable investment that transformed the savings environment for private individuals, charitable trusts, in the 19th century it became the cornerstone of insurance and the annuity market and in the 20th century the principal instrument used by pension funds to match their maturity liabilities. A risk free, in credit risk terms, financial instrument that could be easily traded, in a highly liquid and efficient market is a great amenity. In the later decades of the 20th century a frequent compliant from the luncheon tables of the City of London was not too many gilts, but a lack of enough long dated gilts and too little liquidity in the market.
As well as yielding huge convenience to private economic agents, liquid public debt is at the heart of central bank open market operations to stabilise money markets and capital markets and the flows of credit that shape them. Modern economies need money and capital markets with efficient, liquid markets where transactions can be carried out at scale for efficient and realistic price discovery. The bed rock of this is liquid publicly traded risk-free government debt. That requires a large stock of debt refreshed by a significant flow of new bonds.
Fiscal rules fail to focus on the central issue in public finance: overall expenditure
Fiscal rules framed around controls on borrowing and the stock of government debt focus on a secondary dimension of UK public finance. The first order question is how much the government spends. How it finances its spending between taxation and borrowing is a second order question. All government spending involves a real resource cost. That real resource economic cost moreover is greater than the cash cost of the spending given that it involves a deadweight economic cost. How the government finances its total spending is a secondary question. Choice between taxation and borrowing in financing expenditure is an expression of preference about the timing of taxation. Fiscal rules framed at limiting borrowing focus on a subordinate matter rather than the principal issue in public finance. They can provide an asymmetric bias that raises government spending because they only place limits on borrowing but not on the tax burden or on spending.
Fiscal rules as a presentational device to reassure to financial markets
It has become fashionable to suggest that a framework of rules limiting annual borrowing and constraining total debt in relation to national income reassures financial markets. Bond prices and interest rates are determined by the fundamentals of economic growth, inflation and the interaction of supply and demand for credit. A set of finessed fiscal targets have little traction compared the fundamental influences that drive bond prices. The idea that a finance ministry can get lower cost of borrowing in the long term by some cleverly presented fiscal rules is whimsical.
Fiscal Rules that make economic policy more opaque, complex and less credible
Given the role of fiscal policy in managing modern economies, fiscal rules tend to be qualified and hedged in a manner that insurance companies caveat their policies with small print. Economists have explored a modern-day version of a balanced budget rule and sometime expressed it as ‘the golden rule’. It is framed so that governments pursue a balanced budget for current or ‘day to day’ spending but may borrow for investment of capital spending. This enables borrowing to be used to finance the accumulation of capital assets that will have a long-life and will benefit taxpayers over a generation or more, which a simple balanced budget rule would not accommodate. Yet a cast iron commitment not to borrow for current expenditure would lead to a pro rather than an anti-cyclical government balance over economic cycle and prevent active fiscal policy from being used in the event of an adverse economic shock. These concerns lead to a modified commitment to a balanced current budget rule but applied over the economic cycle, which further weakens the rule. Then the rules are applied over a certain yet elastic time period, averages are applied and an exercise that was intended to be a tough discipline dissolves into a comic set of abstractions worthy of Alice through the looking glass. You start out with something called a golden rule and a balanced budget and end up with this a set of opaque coda and caveats that vitiate any rule as normally and grammatically understood, because fiscal policy should not be constrained by a set of rules that prevent the state stabilising the economy as part of effective macro-economic management.
Golden Rule: Borrowing only for Investment and not Current spending
The golden rule has a superficial attraction combining bromides of the Gladstonian balanced budget with the scope to borrow for capital investment. How strict the rule is in practice turns on what items of public spending are scored as ‘investment’ and what is scored as current spending. Since iterations of this approach have appeared in UK fiscal policy since the 1990s it has contributed a policy making discussion where large chunks of public expenditure are described as ‘investment’. On that basis whole chunks of spending could be reclassified as ‘investment and not day to day’ and the discipline of the rule is vitiated. Yet a hard artificial separation between capital investment and current spending, where in financial planning terms capital spending is scored as desirable and current spending as bad, makes little sense. Capital assets acquired by the health service or education, such as a hospital operating theatre or a school physics laboratory are of little use without surgeons, anaesthetists and nurses or physics teachers paid for by current spending. A framework of fiscal rules with real bite that systematically promoted capital investment over current spending would yield disappointing results in terms of effective delivery of public services.
It is sometimes argued that using public debt to finance capital spending is prudent because it involves the creation of a public asset that is the counter party to the liability represented by the debt. While there are persuasive arguments for spreading the cost of public sector capital assets when properly scored over time, the notion that a public sector asset can match a public sector debt liability in the manner of a private sector balance sheet is misleading. The public sector debt liability will carry a cost that has to be serviced whereas a public sector asset would not necessarily yield a cash return to cover its cost and may well involve additional public spending if efficient use is to be made of it.
GDP as a benchmark for assessing public debt policy?
Benchmarking the government’s annual budget balance in relation to GDP makes sense when considering fiscal policy as part of macro-economic management and stabilising the economy over the cycle, given that it offers an illustration of the scale of the fiscal impulse involved. Yet constructing a fiscal rule intended to ensure the stability or affordability of public debt in relation to national income, serves little or no purpose. It is not at all clear what merit one ratio of debt to GDP ratio has compared to another. Not least because it involves comparing a stock – the level of debt – with a flow - which is what GDP is. In themselves modern national accounts constructed using the UN guidance on conventions for national accounts for market economies are not helpful in a mechanical financial manner of narrowly exemplifying an economy’s capacity to service its public debt, given that much of the information is estimated from surveys and involves complex estimates of deflators to estimate output and transaction in certain sectors, such as public sector output. These estimates of output do not yield a numeraire that neatly matches cash financial transactions that can be taxed for the purposes of debt service management.
What determines the cost of UK public debt in a world of integrated international capital markets?
Three things determine a government’s cost of borrowing: its credit risk, can it pay the debt back; the markets’ expectations of UK inflation in the medium and longer term and the international real rate of interest. There is little or no credit risk attaching to the UK government when it borrows in sterling in the domestic gilt market. Market expectations of UK inflation are a function of market practitioner’s perception of monetary policy and the effectiveness of the central bank. The real rate of interest is internationally determined by integrated international capital markets where the debt of advanced economies is freely traded without capital controls. This is the big difference between the 1970s and early 1980s and contemporary capital markets. Before 1980 the British Government as a very large borrower could crowd out private sector borrowing and investment, in a world of integrated capital markets UK government borrowing has very limited influence on the overall supply of public risk-free debt relative to demand in a market that is over $50 trillion dollars where the stock of British public debt barely accounts for around 5 per cent of the amount outstanding. In terms of the long-term real rate of interest at which it borrows Britain is a price taker rather than a price maker.
Fiscal policy, monetary policy and debt management need to be co-ordinated by a finance ministry
Fiscal, monetary and debt management policy need to be co-ordinated. They cannot be neatly separated out in a highly stylised fashion. The conceit that monetary policy could be conducted wholly separately from fiscal policy was broken in between 2008 and 2009 when they became fused as fiscal measures were used to support the banking system and the central bank’s unorthodox open market operations that became Quantitative Easing. In the eye of the Great Financial Crisis in 2008 monetary policy lost the capacity to stabilise the banking system and financial markets without the support of taxpayers’ money. In the decade after 2009 despite the protracted use of audacious unconventional monetary tools such as QE and forward guidance, monetary policy lost the capacity to stimulate the economy when interest rates were close to the zero rate, active use should have been made of fiscal policy as a source of stimulus. When fiscal policy was fully used in the covid public health emergency its capacity to stimulate was amply demonstrated. While monetary policy has again demonstrated that as a tool of disinflation it remains potent and effective, once it was used by central banks after a delay.
During the period when fiscal stimulus measures could have been helpfully used between 2009 and 2020 interest rates were extraordinarily low. The Government could have borrowed at very long maturities and locked into those low rates. It could have explored reviving the traditional irredeemable ‘consols’. These accounted for around a half the British debt stock issued before 1939. An important innovation in British debt management has been inflation linked gilts, first issued in 1981. From representing around 7 to 9 per cent of the stock of UK public debt thirty they now account for something closer to a quarter. The Treasury should have been exploring how wise it is to have such a high ratio of index linked debt within national debt, in the event of an unexpected episode of inflation, in terms of public expenditure control and debt management costs.
When commodity and other international prices were rising in 2021 the Treasury should have explored with the Debt Management Office and the Bank of England how the central bank could have taken immediate monetary measures to limit the extent and speed of the pass through of the increase in the international price level to limit the public expenditure costs of higher recorded inflation. Consideration should have been given to the scope for a monetary policy directed at raising the exchange rate. The Treasury should also have considered whether a temporary reduction in VAT that would have lowered the UK price level. These are all difficult and big questions that the finance ministry should use its political authority to adjudicate on. They involve complex technical questions, but ultimately turn on big, important, and politically contentious policy issues that only a political authority can decide.
Policy making emasculated by process and a granular focus on the unknowable
Too much of contemporary British official economic policy appears emasculated in process. It is, moreover, a series of processes that have become highly technically framed in a manner that myopically focuses on the details of questions that are inherently unknowable such as the size of the output gap in the British economy and the evolution of its trend rate of growth in granular detail over relatively short time periods.
A myopic focus fiscal sustainability, assessed on unknowable criterion that distracts from the central issues in public finance
The focus of present fiscal policy is a set of fiscal rules directed to addressing a gouch anxiety about the solvency of UK public debt. These result in supposed rules to ensure sustainability that are assessed by detailed consideration of a huge range of variables that are unknowable. The rules themselves are rightly laid aside at the first sign of crisis or circumstances when a ‘proper’ or strict application of them would have been damaging.
Fiscal rules can yield an asymmetric bias that ratchets up public spending
In practice they accommodate an asymmetric upward drift in public expenditure. Higher spending accompanied by higher borrowing results in a discretionary increase in taxation, in order, to meet the fiscal rules. It sets up a dynamic that raises public spending. The new higher tax burden accommodates additional borrowing and a higher level of public expenditure, given that rules about borrowing and debt do not constrain taxation or expenditure.
The rules themselves at the time of budgets and other fiscal events invite an irrelevant debate that focuses on debt affordability and whether there is head room for higher spending or lower taxes instead of the substantial debate that needs to be had about the level of public expenditure, its benefits, and full costs, including its deadweight cost. Instead of a debate about the overall level of spending, what spending priorities should be, how they should be scored and reordered, along an assessment of the efficiency, economy and effectiveness of public services and an attempt to interrogate the unit costs and the social and economic return yielded from different categories of public spending.
Warwick Lightfoot
15 May 2024
Warwick Lightfoot is an economist and was Special Adviser to the Chancellor of the Exchequer between 1989 and 1992