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Posts Tagged ‘Fiscal mandate’

A more active fiscal policy? Changing the rule book

In his 2016 Autumn Statement, the new Chancellor of the Exchequer, Philip Hammond, announced that he was abandoning his predecessor’s target of achieving a budget surplus in 2019/20 and beyond. This was partly in recognition that tax revenues were likely to be down as economic growth forecasts were downgraded by the Office for Budget Responsibility. But it was partly to give himself more room to boost the economy in response to lower economic growth. In other words, he was moving from a strictly rules-based fiscal policy to one that is more interventionist.

Although he still has the broad target of reducing government borrowing over the longer term, this new flexibility allowed him to announce increased government spending on infrastructure.

The new approach is outlined in the updated version of the Charter for Budget
Responsibility
, published alongside the Autumn Statement. The government’s fiscal mandate would now include the following:

 •  a target to reduce cyclically-adjusted public-sector net borrowing to below 2% of GDP by 2020/21;
 •  a target for public-sector net debt as a percentage of GDP to be falling in 2020/21.

It also states that:

In the event of a significant negative shock to the UK economy, the Treasury will review the appropriateness of the fiscal mandate and supplementary targets as a means of returning the public finances to balance as early as possible in the next Parliament.

In the Autumn Statement, the new approach to fiscal policy is summarised as follows:

This new fiscal framework ensures the public finances continue on the path to sustainability, while providing the flexibility needed to support the economy in the near term.

With his new found freedom, the Chancellor was able to announce spending increases, despite deteriorating public finances, of £36bn by 2021/22 (see Table 1 in the Autumn Statement).

Most of the additional expenditure will be on infrastructure. To facilitate this, the government will set up a new National Productivity Investment Fund (NPIF) to channel government spending to various infrastructure projects in the fields of housing, transport, telecoms and research and development. The NPIF will provide £23bn to such projects between 2017/18 and 2021/22.

But much of the additional flexibility in the new Fiscal Mandate will be to allow automatic fiscal stabilisers to operate. The OBR forecasts an increase in borrowing of £122bn over the 2017/18 to 2021/22 period compared with its forecasts made in March this year. Apart from the additional £23bn spending on infrastructure, most of the rest will be as a result of lower tax receipts from lower economic growth. This, in turn, is forecast to be the result of lower investment caused by Brexit uncertainties and lower real consumer spending because of the fall in the pound and the consequent rise in prices.

But rather than having to tighten fiscal policy to meet the previous borrowing target, the new Fiscal Mandate will permit this rise in borrowing. The lower tax payments will help to reduce the dampening effect on the economy.

So are we entering a new era of fiscal policy? Is the government now using discretionary fiscal policy to boost aggregate demand, while also attempting to increase productivity? Or is the relaxation of the Fiscal Mandate just a redrawing of the rules to give a bit more flexibility over the level of stimulus the government can give the economy?

Videos
Autumn Statement 2016: Philip Hammond’s speech (in full) GOV.UK (23/11/16)
Philip Hammond’s autumn statement – video highlights The Guardian (23/11/16)
Key points from the chancellor’s first Autumn Statement BBC News, Andrew Neil (23/11/16)
Autumn Statement: higher borrowing, lower growth Channel 4 News, Helia Ebrahimi (23/11/16)
Autumn Statement: Chancellor’s growth and borrowing figures BBC News (23/11/16)
Markets react to Autumn Statement Financial Times on YouTube, Roger Blitz (23/11/16)
Hammond’s Autumn Statement unpicked Financial Times on YouTube, Gemma Tetlow (23/11/16)
Autumn Statement 2016: The charts that show the cost of Brexit Sjy News, Ed Conway (24/11/16)
BBC economics editor Kamal Ahmed on the Autumn Statement. BBC News (23/11/16)
Autumn statement: debate Channel 4 News, Financial Secretary to the Treasury, Jane Ellison, and Labour’s Shadow Business Secretary, Clive Lewis (23/11/16)
Autumn Statement: Workers’ pay growth prospects dreadful, says IFS BBC News, Kevin Peachey and Paul Johnson (24/11/16)

Articles
Autumn Statement 2016: Expert comment on fiscal policy Grant Thornton, Adam Jackson (23/11/16)
Philip Hammond loosens George Osborne’s fiscal rules to give himself more elbow room as Brexit unfolds CityA.M., Jasper Jolly (23/11/16)
Britain’s New Fiscal Mandate Opens Way To Invest For Economic Growth Forbes, Linda Yueh (23/11/16)
Autumn Statement 2016: experts respond The Conversation (23/11/16)
Chancellor’s ‘Reset’ Leaves UK Economy Exposed And Vulnerable Huffington Post, Alfie Stirling (23/11/16)
Britain’s Autumn Statement hints at how painful Brexit is going to be The Economist (26/11/16)
Chancellor’s looser finance targets highlight weaker UK economy The Guardian, Phillip Inman (24/11/16)
Hammond’s less-than-meets-the-eye plan that hints at the future Financial Times, Martin Sandbu (23/11/16)
Economists’ views on Philip Hammond’s debut Financial Times, Paul Johnson, Bronwyn Curtis and Gerard Lyons (24/11/16)

Government Publications
Autumn Statement 2016 HM Treasury (23/11/16)
Charter for Budget Responsibility: autumn 2016 update HM Treasury

Reports, forecasts and analysis
Economic and fiscal outlook – November 2016 Office for Budget Responsibility (23/11/16)
Autumn Statement 2016 analysis Institute for Fiscal Studies (November 2016)

Questions

  1. Distinguish between discretionary fiscal policy and rules-based fiscal policy.
  2. Why have forecasts of the public finances worsened since last March?
  3. What is meant by automatic fiscal stabilisers? How do they work when the economic growth slows?
  4. What determines the size of the multiplier from public-sector infrastructure projects?
  5. What dangers are there in relaxing the borrowing rules in the Fiscal Mandate?
  6. Examine the arguments for relaxing the borrowing rules more than they have been?
  7. If the economy slows more than has been forecast and public-sector borrowing rises faster, does the Chancellor have any more discretion in giving a further fiscal boost to the economy?
  8. Does the adjustment of borrowing targets as the economic situation changes make such a policy a discretionary one rather than a rules-based one?
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Monetary and fiscal policies – a U-turn or keeping the economy on track?

What have been, and will be, the monetary and fiscal responses to the Brexit vote in the referendum of 23 June 2016? This question has been addressed in speeches by Mark Carney, Governor of the Bank of England, and by George Osborne, Chancellor the Exchequer. Both recognise that the vote will cause a negative shock to the economy, which will require some stimulus to aggregate demand to avoid a recession, or at least minimise its depth.

Mark Carney stated that:

The Bank of England stands ready to provide more than £250bn of additional funds through its normal facilities. The Bank of England is also able to provide substantial liquidity in foreign currency, if required.

In the coming weeks, the Bank will assess economic conditions and will consider any additional policy responses.

This could mean that at its the next meeting, scheduled for 13/14 July, the Monetary Policy Committee will consider reducing Bank Rate from its current level of 0.5% and introducing further quantitative easing.

In a speech on 30 June, he went further:

I can assure you that in the coming months the Bank can be expected to take whatever action is needed to support growth subject to inflation being projected to return to the target over an appropriate horizon, and inflation expectations remaining well anchored.

Then in a speech on 5 July, introducing the latest Financial Stability Report, he said that the Bank of England’s Financial Policy Committee is lowering the required capital ratio of banks, thereby freeing up capital for lending to customers. The part being lowered is the ‘countercyclical capital buffer’ – the element that can be varied according to the state of the economy. Mark Carney said:

The FPC is today reducing the countercyclical capital buffer on banks’ UK exposures from 0.5% to 0% with immediate effect. This is a major change. It means that three quarters of UK banks, accounting for 90% of the stock of UK lending, will immediately have greater flexibility to supply credit to UK households and firms.

Specifically, the FPC’s action immediately reduces regulatory capital buffers by £5.7 billion and therefore raises banks’ capacity to lend to UK businesses and households by up to £150 billion. For comparison, last year with a fully functioning banking system and one of the fastest growing economies in the G7, total net lending in the UK was £60 billion.

Thus although there may be changes to interest rates and narrow money in response to economic reactions to the Brexit vote, the monetary policy framework remains unchanged. This is to achieve a target rate of CPI inflation of 2% at the 24-month time horizon.

But what of fiscal policy?

In its Charter for Budget Responsibility, updated in the Summer 2015 Budget, the government states its Fiscal Mandate:

3.2 In normal times, once a headline surplus has been achieved, the Treasury’s mandate for fiscal policy is:
   a target for a surplus on public-sector net borrowing in each subsequent year.

3.3 For the period outside normal times from 2015-16, the Treasury’s mandate for fiscal policy is:
   a target for a surplus on public-sector net borrowing by the end of 2019-20.

3.4 For this period until 2019-20, the Treasury’s mandate for fiscal policy is supplemented by:
   a target for public-sector net debt as a percentage of GDP to be falling in each year.

The target of a PSNB surplus by 2019-20 has been the cornerstone of recent fiscal policy. In order to stick to it, the Chancellor warned before the referendum that a slowdown in the economy as a result of a Brexit vote would force him to introduce an emergency Budget, which would involve cuts in government expenditure and increases in taxes.

However, since the vote he is now saying that the slowdown would force him to extend the time for reaching a surplus beyond 2019-20 to avoid dampening the economy further. But does this mean he is abandoning his fiscal target and resorting to discretionary expansionary fiscal policy?

George Osborne’s answer to this question is no. He argues that extending the deadline for a surplus is consistent with paragraph 3.5 of the Charter, which reads:

3.5 These targets apply unless and until the Office for Budget Responsibility (OBR) assess, as part of their economic and fiscal forecast, that there is a significant negative shock to the UK. A significant negative shock is defined as real GDP growth of less than 1% on a rolling 4 quarter-on-4 quarter basis. If the OBR assess that a significant negative shock:

occurred in the most recent 4 quarter period;
is occurring at the time the assessment is being made; or
will occur during the forecast period

then:

  if the normal times surplus rule in 3.2 is in force, the target for a surplus each year is suspended (regardless of future data revisions). The Treasury must set out a plan to return to surplus. This plan must include appropriate fiscal targets, which will be assessed by the OBR. The plan, including fiscal targets, must be presented by the Chancellor of the Exchequer to Parliament at or before the first financial report after the shock. The new fiscal targets must be approved by a vote in the House of Commons.
  if the shock occurs outside normal times, the Treasury will review the appropriateness of its fiscal targets for the period until the public finances return to surplus. Any changes to the targets must be approved by a vote in the House of Commons.
  once the budget is in surplus, the target set out in 3.2 above applies.

In other words, if the OBR forecasts that the Brexit vote will result in GDP growing by less than 1%, the Chancellor can delay reaching the surplus and thus not have to introduce tougher austerity measures. This, in effect, is what he is now saying and maintaining that, because of paragraph 3.5, it does not break the Fiscal Mandate. The nature of the next Budget, probably in the autumn, will depend on OBR forecasts.

A few days later, George Osborne announced that he plans to cut corporation tax from the current 20% to less than 15% – below the rate of 17% previously scheduled for 2019-20. His aim is not just to stimulate the economy, but to attract inward investment, as the rate would below that of any major economy and close the rate of 12.5% in Ireland. His hope would also be to halt the outflow of investment as companies seek to relocate in the EU.

Videos and podcasts
Statement from the Governor of the Bank of England following the EU referendum result Bank of England (24/6/16)
Uncertainty, the economy and policy – speech by Mark Carney Bank of England (30/6/16)
Introduction to Financial Stability Report, July 2016 Bank of England (5/7/16)
Osborne: Life will not be ‘economically rosy’ outside EU BBC News (28/6/16)
Osborne takes ‘realistic’ view over surplus target BBC News (1/7/16)
Why has George Osborne abandoned a key economic target? BBC News (1/7/16)

Articles
Mark Carney says Bank of England ready to inject £250bn into economy to keep UK afloat after EU referendum Independent, Zlata Rodionova (24/6/16)
Carney Signals Rate Cuts as Brexit Chaos Engulfs Political Class Bloomberg, Scott Hamilton (30/6/16)
Bank of England hints at UK interest rate cuts over coming months to ease Brexit woes International Business Times, Gaurav Sharma (30/6/16)
Carney prepares for ‘economic post-traumatic stress’ Financial Times, Emily Cadman (30/6/16)
Bank of England warns Brexit risks beginning to crystallise BBC News (5/7/16)
Bank of England tells banks to cut buffer to boost lending Financial Times, Caroline Binham and Chris Giles (5/7/16)
George Osborne puts corporation tax cut at heart of Brexit recovery plan Financial Times (3/7/16)
George Osborne corporation tax cut is the wrong way to start EU negotiations, former WTO boss says Independent, Hazel Sheffield (5/7/16)
George Osborne abandons 2020 UK surplus target Financial Times, Emily Cadman and Gemma Tetlow (1/7/16)
George Osborne scraps 2020 budget surplus plan The Guardian, Jill Treanor and Katie Allen (1/7/16)
Osborne abandons 2020 budget surplus target BBC News (1/7/16)
Brexit and the easing of austerity BBC News, Kamal Ahmed (1/7/16)
Osborne Follows Carney in Signaling Stimulus After Brexit Bloomberg, Simon Kennedy (1/7/16)

Questions

  1. Explain the measures taken by the Bank of England directly after the Brexit vote.
  2. What will determine whether the Bank of England engages in further quantitative easing beyond the current £385bn of asset purchases?
  3. How does monetary policy easing (or the expectation of it) affect the exchange rate? Explain.
  4. How effective is monetary policy for expanding aggregate demand? Is it more or less effective than using monetary policy to reduce aggregate demand?
  5. Explain what is meant by (a) capital adequacy ratios (tier 1 and tier 2); (b) countercyclical buffers. (See, for example, Economics 9th edition, page 533–7 and Figure 16.2))
  6. To what extent does increasing the supply of credit result in that credit being taken up by businesses and consumers?
  7. Distinguish between rules-based and discretionary fiscal policy. How would you describe paragraph 3.5 in the Charter for Budget Responsibility?
  8. Would you describe George Osborne’s proposed fiscal measures as expansionary or merely as less contractionary?
  9. Why is the WTO unhappy with George Osborne’s proposals about corporation tax?
  10. What is the Nash equilibrium of countries seeking to undercut each other’s corporation tax rates?
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Brexit: the economic consequences

The UK has voted to leave the EU by 17 410 742 votes (51.9% or 37.4% of the electorate) to 16 141 241 votes (48.1% or 34.7% of the electorate). But what will be the economic consequences of the vote?

To leave the EU, Article 50 must be invoked, which starts the process of negotiating the new relationship with the EU. This, according to David Cameron, will happen when a new Conservative Prime Minister is chosen. Once Article 50 has been invoked, negotiations must be completed within two years and then the remaining 27 countries will decide on the new terms on which the UK can trade with the EU. As explained in the blog, The UK’s EU referendum: the economic arguments, there are various forms the new arrangements could take. These include:

‘The Norwegian model’, where Britain leaves the EU, but joins the European Economic Area, giving access to the single market, but removing regulation in some key areas, such as fisheries and home affairs. Another possibility is ‘the Swiss model’, where the UK would negotiate trade deals on an individual basis. Another would be ‘the Turkish model’ where the UK forms a customs union with the EU. At the extreme, the UK could make a complete break from the EU and simply use its membership of the WTO to make trade agreements.

The long-term economic effects would thus depend on which model is adopted. In the Norwegian model, the UK would remain in the single market, which would involve free trade with the EU, the free movement of labour between the UK and member states and contributions to the EU budget. The UK would no longer have a vote in the EU on its future direction. Such an outcome is unlikely, however, given that a central argument of the Leave camp has been for the UK to be able to control migration and not to have to pay contributions to the EU budget.

It is quite likely, then, that the UK would trade with the EU on the basis of individual trade deals. This could involve tariffs on exports to the EU and would involve being subject to EU regulations. Such negotiations could be protracted and potentially extend beyond the two-year deadline under Article 50. But for this to happen, there would have to be agreement by the remaining 27 EU countries. At the end of the two-year process, when the UK exits the EU, any unresolved negotiations would default to the terms for other countries outside the EU. EU treaties would cease to apply to the UK.

It is quite likely, then, that the UK would face trade restrictions on its exports to the EU, which would adversely affect firms for whom the EU is a significant market. Where practical, some firms may thus choose to relocate from the UK to the EU or move business and staff from UK offices to offices within the EU. This is particularly relevant to the financial services sector. As the second Economist article explains:

In the longer run … Britain’s financial industry could face severe difficulties. It thrives on the EU’s ‘passport’ rules, under which banks, asset managers and other financial firms in one member state may serve customers in the other 27 without setting up local operations. …

Unless passports are renewed or replaced, they will lapse when Britain leaves. A deal is imaginable: the EU may deem Britain’s regulations as ‘equivalent’ to its own. But agreement may not come easily. French and German politicians, keen to bolster their own financial centres and facing elections next year, may drive a hard bargain. No other non-member has full passport rights.

But if long-term economic effects are hard to predict, short-term effects are happening already.

The pound fell sharply as soon as the results of the referendum became clear. By the end of the day it had depreciated by 7.7% against the dollar and 5.7% against the euro. A lower pound will make imports more expensive and hence will drive up prices and reduce the real value of sterling. On the other had, it will make exports cheaper and act as a boost to exports.

If inflation rises, then the Bank of England may raise interest rates. This could have a dampening effect on the economy, which in turn would reduce tax revenues. The government, if it sticks to its fiscal target of achieving a public-sector net surplus by 2020 (the Fiscal Mandate), may then feel the need to cut government expenditure and/or raise taxes. Indeed, the Chancellor argued before the vote that such an austerity budget may be necessary following a vote to leave.

Higher interest rates could also dampen house prices as mortgages became more expensive or harder to obtain. The exception could be the top end of the market where a large proportion are buyers from outside the UK whose demand would be boosted by the depreciation of sterling.

But given that the Bank of England’s remit is to target inflation in 24 month’s time, it is possible that any spike in inflation is temporary and this may give the Bank of England leeway to cut Bank Rate from 0.5% to 0.25% or even 0% and/or to engage in further quantitative easing.

One major worry is that uncertainty may discourage investment by domestic companies. It could also discourage inward investment, and international companies many divert investment to the EU. Already some multinationals have indicated that they will do just this. Shares in banks plummeted when the results of the vote were announced.

Uncertainty is also likely to discourage consumption of durables and other big-ticket items. The fall in aggregate demand could result in recession, again necessitating an austerity budget if the Fiscal Mandate is to be adhered to.

We live in ‘interesting’ times. Uncertainty is rarely good for an economy. But that uncertainty could persist for some time.

Articles
Why Brexit is grim news for the world economy The Economist (24/6/16)
International banking in a London outside the European Union The Economist (24/6/16)
What happens now that Britain has voted for Brexit The Economist (24/6/16)
Britain and the EU: A tragic split The Economist (24/6/16)
Brexit in seven charts — the economic impact Financial Times, Chris Giles (21/6/16)
How will Brexit result affect France, Germany and the rest of Europe? Financial Times, Anne-Sylvaine Chassany, Stefan Wagstyl, Duncan Robinson and Richard Milne (24/6/16)
How global markets are reacting to UK’s Brexit vote Financial Times, Michael Mackenzie and Eric Platt (24/6/16)
Brexit: What happens now? BBC News (24/6/16)
How will Brexit affect your finances? BBC News, Brian Milligan (24/6/16)
Brexit: what happens when Britain leaves the EU Vox, Timothy B. Lee (25/6/16)
An expert sums up the economic consensus about Brexit. It’s bad. Vox, John Van Reenen (24/6/16)
How will the world’s policymakers respond to Brexit? The Telegraph, Peter Spence (24/6/16)
City of London could be cut off from Europe, says ECB official The Guardian, Katie Allen (25/6/16)
Multinationals warn of job cuts and lower profits after Brexit vot The Guardian, Graham Ruddick (24/6/16)
How will Brexit affect Britain’s trade with Europe? The Guardian, Dan Milmo (26/6/16)
Britain’s financial sector reels after Brexit bombshell Reuters, Sinead Cruise, Andrew MacAskill and Lawrence White (24/6/16)
How ‘Brexit’ Will Affect the Global Economy, Now and Later New York Times, Neil Irwin (24/6/16)
Brexit results: Spurned Europe wants Britain gone Sydney Morning Herald, Nick Miller (25/6/16)
Economists React to ‘Brexit’: ‘A Wave of Economic and Political Uncertainty’ The Wall Street Journal, Jeffrey Sparshott (24/6/16)
Brexit wound: UK vote makes EU decline ‘practically irreversible’, Soros says CNBC, Javier E. David (25/6/16)
One month on, what has been the impact of the Brexit vote so far? The Guardian (23/7/16)

Questions

  1. What are the main elements of a balance of payments account? Changes in which elements caused the depreciation of the pound following the Brexit vote? What elements of the account, in turn, are likely to be affected by the depreciation?
  2. What determines the size of the effect on the current account of the balance of payments of a depreciation? How might long-term effects differ from short-term ones?
  3. Is it possible for firms to have access to the single market without allowing free movement of labour?
  4. What assumptions were made by the Leave side about the economic effects of Brexit?
  5. Would it be beneficial to go for a ‘free trade’ option of abolishing all import tariffs if the UK left the EU? Would it mean that UK exports would face no tariffs from other countries?
  6. What factors are likely to drive the level of investment in the UK (a) by domestic companies trading within the UK and (b) by multinational companies over the coming months?
  7. What will determine the course of monetary policy over the coming months?
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The political business cycle – mark II

During the 1970s, commentators often referred to the ‘political business cycle’. As William Nordhaus stated in a 1989 paper. “The theory of the political business cycle, which analyzes the interaction of political and economic systems, arose from the obvious facts of life that voters care about the economy while politicians care about power.”

In the past, politicians would use fiscal, and sometimes monetary, policies to manipulate aggregate demand so that the economy was growing strongly at the time of the next election. This often meant doing unpopular things in the first couple of years of office to allow for popular things, such as tax cuts and increased government transfers, as the next election approached. This tended to align the business cycle with the election cycle. The economy would slow in the early years of a parliament and expand rapidly towards the end.

To some extent, this has been the approach since 2010 of first the Coalition and now the Conservative governments. Cuts to government expenditure were made ‘in order to clear up the mess left by the previous government’. At the time it was hoped that, by the next election, the economy would be growing strongly again.

But in adopting a fiscal mandate, the current government could be doing the reverse of previous governments. George Osborne has set the target of a budget surplus by the final year of this parliament (2019–20) and has staked his reputation on achieving it.

The problem, as we saw in the blog, Hitting – or missing – the government’s self-imposed fiscal targets is that growth in the economy has slowed and this makes it more difficult to achieve the target of a budget surplus by 2019–20. Given that achieving this target is seen to be more important for his reputation for ‘sound management’ of the public finances than that the economy should be rapidly growing, it is likely that the Chancellor will be dampening aggregate demand in the run-up to the next election. Indeed, in the latest Budget, he announced that specific measures would be taken in 2019–20 to meet the target, including a further £3.5 billion of savings from departmental spending in 2019–20. In the meantime, however, taxes would be cut (such as increasing personal allowances and cutting business rates) and government spending in certain areas would be increased. As the OBR states:

Despite a weaker outlook for the economy and tax revenues, the Chancellor has announced a net tax cut and new spending commitments. But he remains on course for a £10 billion surplus in 2019–20, by rescheduling capital investment, promising other cuts in public services spending and shifting a one-off boost to corporation tax receipts into that year.

But many commentators have doubted that this will be enough to bring a surplus. Indeed Paul Johnson, Director of the Institute for Fiscal Studies, stated on BBC Radio 4′s Today Programme said that “there’s only about a 50:50 shot that he’s going to get there. If things change again, if the OBR downgrades its forecasts again, I don’t think he will be able to get away with anything like this. I think he will be forced to put some proper tax increases in or possibly find yet further proper spending cuts”.

If that is the case, he will be further dampening the economy as the next election approaches. In other words, the government may be doing the reverse of what governments did in the past. Instead of boosting the economy to increase growth at election time, the government may feel forced to make further cuts in government expenditure and/or to raise taxes to meet the fiscal target of a budget surplus.

Articles
Budget 2016: George Osborne hits back at deficit critics BBC News (17/3/16)
George Osborne will have to break his own rules to win the next election Business Insider, Ben Moshinsky (17/3/16)
Osborne Accused of Accounting Tricks to Meet Budget Surplus Goal Bloomberg, Svenja O’Donnell and Robert Hutton (16/3/16)
George Osborne warns more cuts may be needed to hit surplus target Financial Times, Jim Pickard (17/3/16)
6 charts that explain why George Osborne is about to make austerity even worse Independent, Hazel Sheffield (16/3/16)
Budget 2016: Osborne ‘has only 50-50 chance’ of hitting surplus target The Guardian, Heather Stewart and Larry Elliott (17/3/16)
How will Chancellor George Osborne reach his surplus? BBC News, Howard Mustoe (16/3/16)
Osborne’s fiscal illusion exposed as a house of credit cards The Guardian, Larry Elliott (17/3/16)
The Budget’s bottom line: taxes will rise and rise again The Telegraph, Allister Heath (17/3/16)

Reports, analysis and documents
Economic and fiscal outlook – March 2016 Office for Budget Responsibility (16/3/16)
Budget 2016: documents HM Treasury (16/3/16)
Budget 2016 Institute for Fiscal Studies (17/3/16)

Questions

  1. Explain the fiscal mandate of the Conservative government.
  2. Does sticking to targets for public-sector deficits and debt necessarily involve dampening aggregate demand as an election approaches? Explain.
  3. For what reasons may the Chancellor not hit his target of a public-sector surplus by 2019–20?
  4. Compare the advantages and disadvantages of a rules-based fiscal policy and one based on discretion.
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Hitting – or missing – the government’s self-imposed fiscal targets

On election to office in May 2015, the UK’s Conservative government set new fiscal targets. These were set out in an updated Charter for Budget Responsibility. As Box 12.3 in Essentials of Economics (7th edition) states:

The new fiscal mandate set a target for achieving a surplus on public-sector net borrowing by the end of 2019/20. More controversially, government should then target a surplus in each subsequent year unless real GDP growth falls below 1 per cent … Meanwhile, the revised supplementary target for public-sector debt was for the net debt-to-GDP ratio to fall each year from 2015/16 to 2019/20.

What is more, the Charter requires the government to set a cap on welfare spending over a five-year period. Such spending includes spending on pensions, tax credits, child benefit and unemployment benefit. In July 2015 the Chancellor set this cap at £115bn for 2016/17, a reduction of £12bn.

Whether or not such a tight fiscal target is desirable, the government has been missing the target. In November last year, the Chancellor had to backtrack on his plans to make substantial reductions in tax credits and as a result the welfare cap has been breached, as the following table from page 5 of the December 2015 House of Commons briefing paper shows.

Also, with the slowing of economic growth, the Chancellor has stated that he will miss the requirement for a fall in the net debt-to-GDP ratio unless further cuts in government spending are made, equivalent to 50p in every £100.

But, if the economy is slowing, is it right to cut government expenditure? In other words, should there be some discretion in fiscal policy to respond to economic circumstances? There are two issues here. The first is whether the resulting cut in aggregate demand will be detrimental to growth. The second is who will bear the cost of such cuts. Critics of the government claim that it will largely the poor who will lose if the cuts are made mainly from benefits.

The articles below examine the public finances, the difficulties George Osborne has been facing in sticking to his fiscal mandate and the options open to him.

Articles
Budget 2016: Osborne’s economic fitness regime BBC News, Andy Verity (14/3/16)
Budget 2016: George Osborne fuels speculation of nasty shocks The Guardian, Larry Elliott and Anushka Asthana (14/3/16)

Official publications
Charter for Budget Responsibility: Summer Budget 2015 update HM Treasury (July 2015)
OBR publications, including ‘Economic and fiscal outlook’ and ‘Fiscal sustainability report’ Office for Budget Responsibility

Questions

  1. Outline the main points of the Charter for Budget Responsibility (CBR).
  2. What are the arguments for sticking to fiscal rules, such as those in the CBR?
  3. What are the arguments for using discretion to adjust fiscal policy as economic circumstances change?
  4. Compare the Conservative government’s fiscal mandate with the newly announced approach to fiscal policy of the Labour opposition?
  5. How does the Labour Party’s new approach differ from the Golden Rule followed by Gordon Brown as Chancellor in the Labour government from 1997 to 2007?
  6. What factors will determine whether or not the government will return to meeting the rules set out in the Charter for Budget Responsibility?
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Imposing a new fiscal straitjacket

In his annual Mansion House speech to business leaders on 10 June 2015, George Osborne announced a new fiscal framework. This would require governments in ‘normal times’ to run a budget surplus. Details of the new framework would be spelt out in the extraordinary Budget, due on 8 July.

If by ‘normal times’ is meant years when the economy is growing, then this new fiscal rule would mean that in most years governments would be require to run a surplus. This would reduce general government debt.

And it would eventually reduce the debt from the forecast ratio of 89% of GDP for 2015 to the target of no more than 60% set for member states under the EU’s Stability and Growth Pact. Currently, many countries are in breach of this target, although the Pact permits countries to have a ratio above 60% provided it is falling towards 60% at an acceptable rate. The chart shows in pink those countries that were in breach in 2014. They include the UK.

Sweden and Canada have similar rules to that proposed by George Osborne, and he sees them as having been more able to use expansionary fiscal policy in emergency times, such as in the aftermath of the financial crisis of 2007/8, without running excessive deficits.

Critics have argued, however, that running a surplus whenever there is economic growth would dampen recovery if growth is sluggish. This makes the rule very different from merely requiring that, over the course of the business cycle, there is a budget balance. Under that rule, years of deficit are counterbalanced by years of surplus, making fiscal policy neutral over the cycle. With a requirement for a surplus in most years, however, fiscal policy would have a net dampening effect over the cycle. The chancellor hopes that this would be countered by increased demand in the private sector and from exports.

The rule is even more different from the Coalition government’s previous ‘fiscal mandate‘, which was for a ‘a forward-looking target to achieve cyclically-adjusted current balance by the end of the rolling, five-year forecast period’. The current budget excludes investment expenditure on items such as transport infrastructure, hospitals and schools. The fiscal mandate was very similar to the former Labour government’s ‘Golden rule’, which was to achieve a current budget balance over the course of the cycle.

By excluding public-sector investment from the target, as was previously done, it can allow borrowing to continue for such investment, even when there is a substantial deficit. This, in turn, can help to increase aggregate supply by improving infrastructure and has less of a dampening effect on aggregate demand. A worry about the new rule is that it could lead to further erosion of public-sector investment, which can be seen as vital to long-term growth and development of the economy. Indeed, Sweden decided in March this year to abandon its surplus rule to allow government borrowing to fund investment.

The podcasts and articles below consider the implications of the new rule for both aggregate demand and aggregate supply and whether adherence to the rule will help to increase or decrease economic growth over the longer term.

Video and audio podcasts
George Osborne confirms budget surplus law Channel 4 News, Gary Gibbon (10/6/15)
Osborne To Push Through Budget Surplus Rules Sky News (10/6/15)
OECD On Osborne’s Fiscal Plans Sky News, Catherine Mann (10/6/15)
‘Outright fiscal madness’ Osborne’s Mansion House Speech RT UK on YouTube, Harry Fear (11/6/15)
A “straightjacket” [sic] on future government spending? BBC Today Programme, Robert Peston; Nigel Lawson (11/6/15)
Thursday’s business with Simon Jack BBC Today Programme, Gerard Lyons (12/6/15)

Articles
Osborne seeks to bind successors to budget surplus goal Reuters, David Milliken (10/6/15)
George Osborne to push ahead with budget surplus law The Telegraph, Peter Dominiczak (10/6/15)
Osborne Wants U.K. to Build Treasure Chest During Good Times Bloomberg, Svenja O’Donnell (10/6/15)
Questions over Osborne’s Victorian-era budget plans BBC News (10/6/15)
Years more spending cuts to come, says OBR BBC News (11/6/15)
Is Chancellor right to want surplus in normal times? BBC News, Robert Peston (10/6/15)
George Osborne Unveils New Budget Surplus Law, But Critics Warn It Means Needless Cuts Huffington Post, Paul Waugh (10/6/15)
George Osborne’s fiscal handcuffs are political, but he does have a point Independent, Hamish McRae (11/6/15)
Osborne’s budget surplus law follows UK tradition of moving goalposts Financial Times, Chris Giles (10/6/15)
George Osborne’s budget surplus rule is nonsense and it could haunt Britain for decades Business Insider, Malaysia, Mike Bird (10/6/15)
To cut a way out of recession we need growth, not austerity economics Herald Scotland, Iain Macwhirter (11/6/15)
George Osborne moves to peg public finances to Victorian values The Guardian, Larry Elliott and Frances Perraudin (10/6/15)
The Guardian view on George Osborne’s fiscal surplus law: the Micawber delusion The Guardian, Editorial (10/6/15)
Academics attack George Osborne budget surplus proposal The Guardian, Phillip Inman (12/6/15)
Osborne plan has no basis in economics Guardian letters, multiple signatories (12/6/15)
Is there an optimal debt-to-GDP ratio? Vox EU, Anis Chowdhury and Iyanatul Islam
No basis in economics Mainly Macro, Simon Wren-Lewis (16/6/15)

Questions

  1. Explain what is meant by a ‘cyclically adjusted current budget balance’.
  2. How does the speed with which the government reduces the public-sector debt affect aggregate demand and aggregate supply?
  3. What are the arguments for and against running a budget surplus: (a) when there is currently a large budget deficit; (b) when there is already a budget surplus? How do the arguments depend on the stage of the business cycle?
  4. Do you agree with the statement that ‘the biggest issue with the UK economy right now is not the government deficit’. If so, what bigger issues are there?
  5. How could public-sector debt as a proportion of GDP decline without the government running a budget surplus?
  6. How might the term ‘normal times’ be defined? How does the definition used by the Chancellor affect the rate at which the public-sector debt is reduced?
  7. How sustainable is the current level of public-sector debt? How does its sustainability relate to the interest rate on long-term government bonds?
  8. If there is a budget surplus, such that GT is negative, what can we say about the balance betwen (I + X) and (S + M)? What good and adverse consequences could follow?
  9. Why do George Osborne’s plans for budget surpluses ‘risk a liquidity crisis that could also trigger banking problems, a fall in GDP, a crash, or all three’?
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Confused about deficits and debt? Try taking a bath!

In its report A Distorted Debate: the need for clarity on Debt, Deficit and Coalition Aims, the Centre for Policy Studies claims that the public is confused by economic terminology surrounding the government’s finances. We try and understand this confusion and offer a bath-time solution!

In a survey conducted for the Centre for Policy Studies only 10 per cent of Britons knew that despite cuts to parts of the government’s spending plans, the stock of public sector debt (also known as the national debt) is expected to rise by a further £60 billion by 2015. Rather, 47 per cent of respondents thought that debt would have fallen by this amount.

The confusion is not terribly surprising because there are two important core economic concepts that can confuse: stocks and flows. To try to help we will show how reference to a bath tub can hopefully eliminate the confusion. However, first, let us considerthe Coalition government’s principal fiscal objective. Its so-called fiscal mandate is for the cyclically-adjusted current budget to be in balance by 2015/16. In simple terms, the government wants to be able afford its day-to-day expenditures by this date, after taking into account where the economy is in the business cycle. In other words, if the economy’s output was at its sustainable or potential level in 2015-16 the government should be able to raise sufficient taxes to meet what it refers to as current expenditures. This would still allow the government to borrow to fund investment expenditure, e.g. infrastructural projects, which are enjoyed or consumed over a period of time.

An important thing to note about the fiscal mandate is that the government can expect to need to borrow money in order to afford its current expenditures up to 2015/16. Even beyond this date, assuming that the mandate can be met, it is likely to need money to afford capital expenditures. This is where we introduce the bath tub. Think of government spending as water coming through the bath taps while the taxes that government collect are water leaving through the plug hole. Therefore, spending and tax receipts are flows. If the water pouring into the bath (spending) is greater than the water leaving the bath (tax receipts), the level of water in the bath will rise. You can think of the water level in the bath as the stock of national debt. Therefore, if government is spending more than it receives it needs to borrow money. Borrowing is therefore a flow concept too. As it borrows, the stock of debt (the amount of water in our bath tub) rises.

So we know that government will continue to borrow in the near future. What it is hoping to be able to do, year by year, is begin to borrow less. It wants the deficit to fall. Then, if it can meet its target, it will at least be able to afford current expenditure (after adjustment for where the economy is in the cycle) by 2015/16. As the deficit begins to decline then the stock of debt will rise less quickly. But, the bath tub will continue to fill because more is flowing through the taps than is leaving through the plug hole. However, it will fill less quickly.

What our use of the bath tub analogy demonstrates is the confusion that can be caused when economic terminology is misused. It is important that the terms debt and deficit be used carefully and correctly. Therefore, the next time you are sitting in bath see if you can be the next Chancellor by understanding these key economic concepts.

Don’t know your debts from your deficit? You’re not alone Independent, Andrew Johnson (27/8/12)
Government unlikely to meet deficit targets, warns CPS Telegraph (27/8/12)
Coalition ‘most unlikely’ to meet key economic goals by next election Guardian, Andrew Sparrow (27/8/12)
Public ‘don’t know their debt from their deficit’ Public Finance, Vivienne Russell (28/8/12)
George Osborne ‘still failing to stop rising deficit’ Daily Express (28/8/12)

Questions

  1. Explain the difference between the concepts of government deficits and government debt?
  2. Explain what will happen to both the size of the government’s deficit and to its stock of debt if borrowing begins to decline.
  3. Can the stock of government debt fall if the government continues to borrow? Can the ratio of the stock of government debt fall relative to GDP (i.e. Debt/GDP), if government continues to borrow?
  4. With examples, explain the differences between the government’s current and investment (capital) expenditures.
  5. What are the economic arguments for trying to cut the deficit quickly or more slowly?
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