by Mike Denham, former chairman
It wasn’t supposed to be like this. When taxpayers were first introduced to fiscal rules, we were told they would limit public sector debt to prudent and stable levels. Yet three decades later, we find ourselves on the hook for debts of almost £3 trillion (£3,000,000,000,000). That’s around 100 per cent of GDP, or a scary £100,000 for every single household in the country.
Worse, the debt is still growing, with another £128 billion added in the last year alone. And it’s no good imagining this is some remote problem we can leave for our unborn grandchildren to sort out. The annual debt interest bill is already over £100 billion, or nearly £4,000 per household.
Why have the fiscal rules turned out to be such a flop?
The first and obvious point is that successive chancellors have failed to comply with the rules as originally stated. Even the Chancellor who came up with them eventually broke his own rules.
Chancellor Gordon Brown launched his rules in 1997, with debt standing at £360 billion, or 37 per cent of GDP. He said that was too high, blaming it on the previous Conservative government. As he put it, “the Chancellor is first and foremost the guardian of the public finances—the people's money”, and he launched a deficit reduction plan, pledging to follow two explicit rules.
His first rule, the “golden rule”, held that over an economic cycle current spending would be financed entirely from taxation, with borrowing only for investment. His second rule was that debt as a proportion of national income would be held “at a prudent and stable level”. He imposed a debt limit of 40 per cent of GDP, broadly in line with best practice thinking at the time.
For the first five years, Brown stuck to his rules, bringing debt down to a prudent 28 per cent of GDP by 2001-02. But in Labour’s second term he ramped up public spending, breached his golden rule on borrowing, and pushed the debt/GDP ratio back up to 36 per cent on the eve of the 2008 financial crash. He’d broken one rule and was well on his way to breaking the second.
Of course, the crash itself made both the deficit and the debt much worse, and by 2010-11, debt had soared to 71 per cent of GDP. By then, Brown’s original rules had been abandoned, to be replaced by a much looser version.
In 2010, the new Conservative Chancellor George Osborne quite rightly blamed the mess on his Labour predecessors. He introduced two new rules, but unfortunately for taxpayers, his rules opened the door to further fiscal backsliding. Because whereas Brown’s original rules had set specific maximum levels for borrowing and debt, Osborne’s new rules only specified that future changes should be in the right general direction. And even that needn’t happen in the immediate future.
It was a far less demanding fiscal regime, which is why Osborne sought to bolster its credibility by establishing the independent Office for Budget Responsibility (OBR). It was charged with scrutinising the public finances and producing the official fiscal forecasts, the aim being to reassure taxpayers and the financial markets that at least the numbers could no longer be fiddled by HM Treasury.
Osborne did manage to cut borrowing from the catastrophic level he inherited, but despite being widely lambasted for supposedly imposing “austerity”, he never got even close to balancing the books. Instead, debt went on growing throughout his tenure, reaching 83 per cent of GDP in 2016-17.
Since then, the fiscal rules have been chopped and changed so often that it’s difficult to keep track. In total, we’ve now had ten different sets, and subsequent rules have all been much looser than Brown’s originals.
And that underlines another important reason for their failure, because whenever the existing rules have been breached, the response has been to relax the rules rather than tighten fiscal policy. To say the rules have been non-binding is a considerable understatement.
It is true that chancellors over the last 20 years have had to deal with two major economic crises – the financial crash and then the covid lock-down. Both led to huge increases in borrowing and debt. But once the immediate crises had passed there should have been a serious programme to get borrowing and debt back to the prudent and stable levels originally promised. And we’ve never seen it.
Consider the latest version of the rules, announced by Rachel Reeves last October. She’d inherited a debt/GDP ratio of 96 per cent, with borrowing running at 5 per cent of GDP – both far too high for fiscal sustainability, and demanding urgent and substantial fiscal retrenchment. Yet her first thought was to change the rules again.
For her first rule, she resurrected Brown’s original focus on the current budget balance. However, instead of targeting a zero aggregate balance over an economic cycle, as he’d done, she settled just for the current budget being in surplus in 2029-30, the final year of the OBR’s five-year forecast. Obviously, that places no meaningful limit on deficits in the years before then.
For her second rule, she threw out the traditional debt measure used by all previous chancellors, including Brown (Public Sector Net Debt – PSND). In its place, she chose Public Sector Net Liabilities (PSNL), a broader measure of liabilities net of various assets. Needless to say, PSNL is smaller than PSND, although at 83 per cent of GDP it’s still way above Brown’s original 40 per cent debt limit. Again, she targeted only 2029-30, requiring that PSNL be falling as a share of GDP in that specific year. Her rule does nothing to stop debt increasing in the intervening years.
Both of Reeves' new rules were weaker than what had gone before, which allowed her not only to avoid fiscal retrenchment but also to increase public spending even further. Over the years up to 2029-30, she increased spending by an astonishing £370 billion on top of an inherited baseline that was already far too high.
This is not at all how the fiscal rules were supposed to operate, and there are a host of other problems as well. For example, almost half of public spending comprises Departmental Expenditure Limits (DELs), which are not forecast in detail beyond the next couple of years. For later years, the chancellor just allocates an aggregate amount – the so-called spending envelope. So to make their fiscal numbers add up, successive chancellors have simply assumed a low figure for the envelope, even though they have not made the tough programme decisions required to deliver it.
In this and other ways, Chancellors have in effect learned to game the system. They have learned to deliver budgets that appear to be disciplined by fiscal rules, without actually having to make the tough decisions necessary to restore fiscal sustainability. And meanwhile, the debt mountain keeps growing.
At some point of course, the system will blow up. As we’ve consistently argued, a build-up of debt on this scale will sooner or later undermine market confidence, and we’ve already had a few warning shots. Government borrowing costs will shoot up, and just like in 1976, whoever is Chancellor at the time will be forced into emergency action, slashing expenditure and increasing taxes. The losers will be all of us.
So what could be done?
One suggested solution is to give the OBR more power, by for example, mandating them to over-rule a chancellor’s unrealistic assumptions on the future spending envelope. Or perhaps by requiring them to assess government plans against more meaningful fiscal rules targeted on reducing debt back to an OBR-judged sustainable level. Our here-today-gone-tomorrow politicians would then be forced to act responsibly “in the national interest”.
However, such a move would undermine still further the authority of our democratically elected governments, placing yet more power in the hands of unelected quangocrats whose idea of the national interest might not be ours.
Moreover, although the OBR does its best, its fiscal projections are based on economic forecasts that often turn out to be wrong, sometimes very wrong. For, as the eminent economist JK Galbraith put it, “the only function of economic forecasting is to make astrology look respectable”. We’d all be wise to remember that. Fine-tuning policy decisions on the basis of shaky OBR projections five years out – as Reeves is reported to have done in March – is not a sound foundation for fiscal sustainability.
From a taxpayer’s perspective, a much more appealing approach would be to reorient the fiscal rules towards a focus on public spending.
For one thing, as we’ve long maintained, the fundamental driver of our looming fiscal crisis is that public spending is far too high. At the turn of the millennium, it was a sustainable 35 per cent of GDP, whereas it is now 45 per cent, with little sign of coming back down. And while successive chancellors have sought to fund the increase through higher taxes, that has proved a recipe for undermining economic growth, as we’re seeing right now with Reeves’ own disastrous tax increases.
Second, while it’s essential to get borrowing and debt back under control, we should understand that governments have little direct control over either. To state the obvious, borrowing is the difference between two very large numbers, both of which can move around in ways that are difficult to predict accurately. The OBR’s fiscal projections are subject to substantial error margins, especially in the later years of its forecasts.
Third, while total spending may be difficult to predict accurately, getting on for half is directly controlled by central government through Departmental Expenditure Limits (RDELs and CDELs). And a further quarter goes on welfare payments, which are subject to government-controlled rates and eligibility criteria. That’s much more control than there is over borrowing and debt five years out.
We’ve never had a spending rule, but switching to a medium-term target for public spending would focus attention squarely on things the government can and must control.
The financial markets and others would obviously still take a strong interest in the prospects for borrowing and debt, even if they were no longer the principal fiscal targets. But government fiscal policy would no longer be driven by the twists and turns of economic forecasts five years out. The OBR would continue with its forecasting work, but the policy emphasis would be on a medium-term strategy to deliver an affordable and sustainable level of public spending.