Tag: interest rates

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The Chancellor’s fiscal dilemma

The UK Chancellor of the Exchequer, Rachel Reeves, will present her annual Budget in late autumn. It will involve some hard economic and political choices. The government would like to spend more money on improving public services but has pledged not to raise taxes ‘on working people’, which is interpreted as not raising the rates of income tax, national insurance for employees and the self-employed, and VAT. What is more, government borrowing is forecast by the OBR to be £118 billion, or nearly 4.0% of GDP, for the the year 2025/26. This is a fall from the 5.1% in 2024/25 and is well below the 15.0% in 2020/21 during the pandemic. But it is significantly above the 2.1% in 2018/19.

The government has pledged to stick to its two fiscal rules. The first is that the day-to-day, or ‘current’, budget (i.e. excluding investment) should be in surplus or in deficit of no more than 0.5 per cent of GDP by 2029/30 (or the third year of the rolling forecast period from the 2026/27 Budget). This allows investment to be funded by borrowing. The second rule is that public-sector net debt, which includes public-sector debt plus pension liabilities minus equity, loans and other financial assets, should be falling by 2029/30 (or the third year of the rolling forecast period from the 2026/27 Budget). The current budget deficit (i.e. excluding borrowing for investment) was forecast by the OBR in March to be 1.2% of GDP for 2025/26 (see Chart 1) and to be a surplus of 0.3% in 2029/30 (£9.9 billion). (Click here for a PowerPoint of the chart.)

The OBR’s March forecasts, therefore, were that the rules would be met with current policies and that the average rate of economic growth would be 1.8% over the next four years.

However, there would be very little room for manoeuvre, and with global political and economic uncertainty, including the effects of tariffs, climate change on harvests and the continuing war in Ukraine, the rate of economic growth might be well below 1.8%.

The March forecasts were based on the assumption that inflation would fall and hence that the Bank of England would reduce interest rates. Global pressure on inflation, however, might result in inflation continuing to be above the Bank of England’s target of 2%. This would mean that interest rates would be slow to fall – if at all. This would dampen growth and make it more expensive for the government to service the public-sector debt, thus making it harder to reduce the public-sector deficit.

A forecast earlier this month by the National Institute for Economic and Social Research (NIESR) (see link below and Chart 2) reflects these problems and paints a gloomier picture than the OBR’s March forecast. The NIESR forecasts that GDP will grow by only 1.3 per cent in 2025, 1.2 per cent in 2026, 1.1% in 2027 and 1.0% in 2028, with the average for 2025 to 2023 being 1.13%. This is the result of high levels of business uncertainty and the effects of tariffs on exports. With no change in policy, the current deficit would be £41.2 billion in the 2029/30 financial year. Inflation would fall somewhat, but would stick at around 2.7% from 2028 to 2030. Net debt would be rising in 2029/30 &ndash but only slightly, from 98.7% to 99.0%. (Click here for a PowerPoint of the chart.)

So what are the policy options open to the government for dealing with a forecast current budget deficit of £41.2 billion (1.17% of GDP)? There are only three broad options.

Increase borrowing

One approach would be to scrap the fiscal rules and accept increased borrowing – at least temporarily. This would avoid tax increases or expenditure cuts. By running a larger budget deficit, this Keynesian approach would also have the effect of increasing aggregate demand and, other things being equal, could lead to a multiplied rise in national income. This in turn would lead to higher tax revenues and thereby result in a smaller increase in borrowing.

There are two big problems with this approach, however.

The first is that it would, over time, increase the public-sector debt and would involve having to spend more each year on servicing that debt. This would leave less tax revenue for current spending or investment. It would also involve having to pay higher interest rates to encourage people to buy the additional new government bonds necessary to finance the increased deficit.

The second problem is that the Chancellor has said that she will stick to the fiscal rules. If she scraps them, if only temporarily, she runs the risk of losing the confidence of investors. This could lead to a run on the pound and even higher interest rates. This was a problem under the short-lived Liz Truss government when the ‘mini’ Budget of September 2022 made unfunded pledges to cut taxes. There was a run on the pound and the Bank of England had to make emergency gilt purchases.

One possibility that might be more acceptable to markets would be to rewrite the investment rule. There could be a requirement on government to invest a certain proportion of GDP (say, 3%) and fund it by borrowing. The supply-side benefits could be faster growth in potential output and higher tax revenue over the longer term, allowing the current deficit rule to be met.

Cut government expenditure

Politicians, especially in opposition, frequently claim that the solution is to cut out public-sector waste. This would allow public expenditure to be cut without cutting services. This, however, is harder than it might seem. There have been frequent efficiency drives in the public sector, but from 1919 to 2023 public-sector productivity fell by an average of 0.97% per year.

Causes include: chronic underinvestment in capital, resulting in outdated equipment and IT systems and crumbling estates; decades of underfunding that have left public services with crumbling estates, outdated equipment and insufficient IT systems; inconsistent, short-term government policy, with frequent changes in government priorities; bureaucratic systems relying on multiple legacy IT systems; workforce challenges, especially in health and social care, with high staff turnover, recruitment difficulties, and a lack of experienced staff.

The current government has launched a Public Sector Productivity Programme. This is a a cross-government initiative to improve productivity across public services. Departments are required to develop productivity plans to invest in schemes designed to achieve cost savings and improve outcomes in areas such as the NHS, police, and justice system. A £1.8 billion fund was announced in March 2024, to support public-sector productivity improvements and digital transformation. Part of this is to be invested in digital services and AI to improve efficiency. According to the ONS, total public-service productivity in the UK grew by 1.0% in the year to Q1 2025; healthcare productivity grew 2.7% over the same period. It remains to be seen whether this growth in productivity will be maintained. Pressure from the public, however, will mean that any gains are likely to be in terms of improved services rather than reduced government expenditure.

Increase taxes

This is always a controversial area. People want better public services but also reduced taxes – at least for themselves! Nevertheless, it is an option seriously being considered by the government. However, if it wants to avoid raising the rates of income tax, national insurance for employees and the self-employed, and VAT, its options are limited. It has also to consider the political ramifications of taking unpopular tax-raising measures. The following are possibilities:

Continue the freeze on income tax bands. They are currently frozen until April 2028. The extra revenue from extending the freeze until April 2030 would be around £7 billion. Although this may be politically more palatable than raising the rate of income tax, the revenue raised will be well short of the amount required and thus other measures will be required. Although some £40 billion will have been raised up to 2028 (which has already been factored in), as inflation falls, so the fiscal drag effect will fall: nominal incomes will need to rise less to achieve any given rise in real incomes.

Cutting tax relief for pensions. Currently, people get income tax relief at their marginal rate on pension contributions made by themselves and their employer up to £60 000 per year or 100% of their earnings, whichever is smaller. When people draw on their pension savings, they pay income tax at their marginal rate, even if the size of their savings has grown from capital gains, interest or dividends. Reducing the limits or restricting relief to the basic rate of tax could make a substantial contribution to increasing government revenue. In 2023/24, pension contribution relief cost the government £52 billion. Restricting relief to the basic rate or cutting the annual limit would make the relief less regressive. In such a case, when people draw on their pension savings, the income tax rate could be limited to the basic rate to avoid double taxation.

Raising the rate of inheritance tax (IHT) or reducing the threshold. Currently, estates worth more than £325 000 are taxed at a marginal rate of 40%. The threshold is frozen until 2029/30 and thus additional revenue will be received by the government as asset prices increase. If the rate is raised above 40%, perhaps in bands, or the threshold were lowered, then this will earn additional revenue. However, the amount will be relatively small compared to the predicted current deficit in 2029/30 of £41 billion. Total IHT revenue in 2022/23 was only 6.7 billion. Also, it is politically dangerous as people could claim that the government was penalising people who had saved in order to help the next generation, who are struggling with high rents or mortgages.

Increased taxes on business. The main rate of corporation tax was raised from 19% to 25% in April 2023 and the employers’ national insurance rate was raised from 13.8% to 15% and the threshold reduced from £9100 to £5000 per year in April 2025. There is little or no scope for raising business taxes without having significant disincentive effects on investment and employment. Also, there is the danger that raising rates might prompt companies to relocate abroad.

Raise fuel and/or other duties. Fuel duties raise approximately £24 billion. They are set to decline gradually with the shift to EVs and more fuel-efficient internal combustion engines. Fuel duty remained unchanged at 57.95p per litre from 2011 to 2022 and then was ‘temporarily’ cut to 52.95p. The rate of 52.95p is set to remain until at least 2026. There is clearly scope here to raise it, if only by the rate of inflation each year. Again, the main problem is a political one that drivers and the motor lobby generally will complain. Other duties include alcohol, tobacco/cigarettes/vaping, high-sugar beverages and gambling. Again, there is scope for raising these. There are two problems here. The first is that these duties are regressive, falling more heavily on poorer people. The second is that high duties can encourage illegal trade in these products.

Raising one of the three major taxes: income tax, employees’ national insurance and VAT. This will involve reneging on the government’s election promises. But perhaps it’s better to bite the bullet and do it sooner rather than later. Six European countries have VAT rates of 21%, three of 22%, three of 23%, two of 24%, four of 25%, one of 25.5% and one of 27%. Each one percentage point rise would raise about 9 billion. A one percentage point rise across all UK income tax rates would raise around £5.8 billion. As far as employees’ national insurance rates are concerned, the Conservative government reduced the main rate twice from 12% to 10% in January 2024 and from 10% to 8% in April 2024. The government could argue that raising it back to, say, 10% would still leave it lower than previously. A rise to 10% would raise around £11 billion.

Conclusion

The choices for the Chancellor are not easy. As the NIESR’s Economic Outlook puts it:

Simply put, the Chancellor cannot simultaneously meet her fiscal rules, fulfil spending commitments, and uphold manifesto promises to avoid tax rises for working people. At least one of these will need to be dropped – she faces an impossible trilemma.

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Questions

  1. Which of the options would you choose and why?
  2. Should the government introduce a wealth tax on people with wealth above, say, £2 million? If so, should it be a once-only tax or an annual tax?
  3. Research another country’s fiscal position and assess the choices their finance minister took.
  4. Look at a previous UK Budget from a few years ago and the forecasts on which the Budget decisions were made (search Budget [year] on the GOV.UK website). How accurate did the forecasts turn out to be? If the Chancellor then had known what would actually happen in the future, would their decisions have been any different and, if so, in what ways?
  5. Should fiscal decisions be based on forecasts for three of four years hence when those forecasts are likely to be unreliable?
  6. Should fiscal and monetary policy decisions be made totally separately from each other?
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Investment set to fall as business is baffled by Trump

Economic growth is closely linked to investment. In the short term, there is a demand-side effect: higher investment, by increasing aggregate demand, creates a multiplier effect. GDP rises and unemployment falls. Over the longer term, higher net investment causes a supply-side effect: industrial capacity and potential output rise. This will be from both the greater quantity of capital and, if new investment incorporates superior technology, from a greater productivity of capital.

One of the biggest determinants of investment is certainty about the future: certainty allows businesses to plan investment. Uncertainty, by contrast, is likely to dampen investment. Investment is for future output and if the future is unknown, why undertake costly investment? After all, the cost of investment is generally recouped over several months or year, not immediately. Uncertainty thus increases the risks of investment.

There is currently great uncertainty in the USA and its trading partners. The frequent changes in policy by President Trump are causing a fall in confidence and consequently a fall in investment. The past few weeks have seen large cuts in US government expenditure as his administration seeks to dismantle the current structure of government. The businesses supplying federal agencies thus face great uncertainty about future contracts. Laid-off workers will be forced to cut their spending, which will have knock-on effect on business, who will cut employment and investment as the multiplier and accelerator work through.

There are also worries that the economic chaos caused by President Trump’s frequent policy changes will cause inflation to rise. Higher inflation will prompt the Federal Reserve to raise interest rates. This, in turn, will increase the cost of borrowing for investment.

Tariff uncertainty

Perhaps the biggest uncertainty for business concerns the imposition of tariffs. Many US businesses rely on imports of raw materials, components, equipment, etc. Imposing tariffs on imports raises business costs. But this will vary from firm to firm, depending on the proportion of their inputs that are imported. And even when the inputs are from other US companies, those companies may rely on imports and thus be forced to raise prices to their customers. And if, in retaliation, other countries impose tariffs on US goods, this will affect US exporters and discourage them from investing.

For many multinational companies, whether based in the USA or elsewhere, supply chains involve many countries. New tariffs will force them to rethink which suppliers to use and where to locate production. The resulting uncertainty can cause them to delay or cancel investments.

Uncertainty has also been caused by the frequent changes in the planned level of tariffs. With the Trump administration using tariffs as a threat to get trading partners to change policy, the threatened tariff rates have varied depending on how trading partners have responded. There has also been uncertainty on just how the tariff policy will be implemented, making it more difficult for businesses to estimate the effect on them.

Then there are serious issues for the longer term. Other countries will be less willing to sign trade deals with the USA if they will not be honoured. Countries may increasingly look to diverting trade from the USA to other countries.

Video

Articles

Data

Questions

  1. Find out what tariffs have been proposed, imposed and changed since Donald Trump came to office on 20 January 2025.
  2. In what scenario might US investment be stimulated by Donald Trump’s policies?
  3. What countries’ economies have gained or are set to gain from Donald Trump’s policies?
  4. What is the USMCA agreement? Do Donald Trump’s policies break this agreement?
  5. Find out and explain what has happened to the US stock market since January 2025. How do share prices affect business investment?
  6. Which sector’s shares have risen and which have fallen?
  7. Using the Data link above, find out what has been happening to the US Policy Uncertainty Index since Donald Trump was elected and explain particular spikes in the index. Is this mirrored in the global Policy Uncertainty Index?
  8. Are changes in the Policy Uncertainty Index mirrored in the World Uncertainty Index (WUI) and the CBOE Volatility Index: VIX?
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Getting real with house prices

When I worked as a professional economist at HM Treasury and later the Council of Mortgage Lenders (now part of UK Finance), I would regularly brief on the state of the affordability of housing, with a particular focus on the owner-occupied market. That was back in the late 1990s. Fast forward a quarter of a century and I recognise not only how much I have aged but also how deep-rooted and long-standing the affordability problem is.

It is perhaps not surprising that in her first speech as the new Chancellor of the Exchequer, Rachel Reeves, referenced directly the housing market and the need to address supply-side issues. She has set a target of one and a half million new homes built over the next five years.

It is therefore timely to revisit the trends in house prices across the UK. By applying the distinction between nominal and real values we get a very clear sense of the deteriorating affordability of housing.

Nominal house price patterns

The average UK actual or nominal house price in April 2024 was £281 000. As Chart 1 shows, this masks considerable differences across the UK. In England the average price was £298 000 (105 per cent of the UK average), though this is heavily skewed by London where the average price was £502 000 (178 per cent of the UK average). Meanwhile, in Scotland it was £190 000 (68 per cent of the UK average), in Wales £208 000 (74 per cent of the UK average) and in Northern Ireland it was £178 000 (74 per cent of the UK average). (Click here to download a PowerPoint copy of the chart.)

A simple comparison of the average house price in April 2024 with January 1970 reveals a 72-fold increase in the UK, an 80-fold increase in England, including a 101-fold increase in London, a 65-fold increase in Wales, a 59-fold increase in Scotland and a 45-fold increase in Northern Ireland. Whilst these figures are sensitive to the particular period over which we choose to measure, there is little doubting that upward long-term trend in house prices.

Whilst nominal prices trend upwards over time, the short-term rates of increase are highly volatile. This can be seen from an inspection of Chart 2, which shows the annual rates of increase across the four nations of the UK, as well as for London. This is evidence of frequent imbalances between the flows of property on to the market to sell (instructions to sell) and the number of people looking to buy (instructions to buy). An increase in instructions to buy (housing demand) relative to those to sell (housing supply) puts upward pressure on prices; an increase in the number of instructions to sell (housing supply) relative to those to buy (housing demand) puts downward pressure on prices. (Click here to download a PowerPoint copy of the chart.)

Chart 2 nicely captures the recent slowdown in the housing market. The inflationary shock that began to take hold in 2021 led the Bank of England to raise Bank Rate on 15 occasions – from 0.25 per cent in December 2021 to 5.25 per cent in August 2023 (which remains the rate at the time of writing, but could be cut at the next Bank of England meeting on 1 August 2024). Higher Bank Rate has pushed up mortgage rates, which has contributed to an easing of housing demand. Demand has also been dampened by weak growth in the economy, higher costs of living and fragile consumer confidence. The result has been a sharp fall in the rate of house price inflation, with many parts of the UK experiencing house price deflation. As the chart shows, the rate of deflation has been particularly pronounced and protracted in London, with house prices in January 2024 falling at an annual rate of 5.1 per cent.

Real house price patterns

Despite the volatility in house prices, such as those of recent times, the longer-term trend in house prices is nonetheless upwards. To understand just how rapidly UK house prices have grown over time, we now consider their growth relative to consumer prices. This allows us to analyse the degree to which there has been an increase in real house prices.

To calculate real or inflation-adjusted house prices, we deflate nominal house prices by the Consumer Prices Index (CPI). Chart 3 shows the resulting real house prices series across the UK as if consumer prices were fixed at 2015 levels.

The key message here is that over the longer-term we cannot fully explain the growth in actual (nominal) house prices by the growth in consumer prices. Rather, we see real increases in house prices. Inflation-adjusted UK house prices were 5.3 times higher in April 2024 compared to January 1970. For England the figure was 5.9 times, Wales 4.8 times, Scotland 4.3 times and for Northern Ireland 3.3 times. In London, inflation-adjusted house prices were 7.4 times higher. (Click here to download a PowerPoint copy of the chart.)

As we saw with nominal house prices, the estimated long-term increase in real house prices is naturally sensitive to the period over which we measure. For example, the average real UK house price in August 2022 was 5.8 times higher than in January 1970, while in London they were 8.7 times higher. But the message is clear – the long-term increase is not merely nominal, reflecting increasing prices generally, but is real, reflecting pressures that are increasing house prices relative to general price levels.

Chart 4 shows how the volatility in house prices continues to be evident when house prices are adjusted for changes in consumer prices. The UK’s annual rate of real house price inflation was as high as 40 per in January 1973; on the other hand, in June 1975 inflation-adjusted house prices were 15 per cent lower than a year earlier. (Click here to download a PowerPoint copy of the chart.)

Over the period from January 1970 to April 2024, the average annual rate of real house price inflation in the UK was 3.2 per cent. Hence house prices have, on average, grown at an annual rate of consumer price inflation plus 3.2 per cent. For the four nations, real house price inflation has averaged 3.8 per cent in England, 3.4 per cent in Wales, 3.0 per cent in Scotland and 2.9 per cent in Northern Ireland. Further, the average rate of real house price inflation in London since January 1970 has been 4.5 per cent. By contrast, that for the East and West Midlands has been 3.7 and 3.5 per cent respectively. The important point here is that the pace with which inflation-adjusted house prices have risen helps to contextualise the extent of the problem of housing affordability – a problem that only worsens over time when real incomes do not keep pace.

House building

The newly elected Labour government has made the argument that it needs to prioritise planning reform as an engine for economic growth. While this ambition extends beyond housing, the scale of the supply-side problem facing the housing market can be seen in Chart 5. The chart shows the number of housing completions in the UK since 1950 by type of tenure. (Click here to download a PowerPoint copy of the chart.)

The chart shows the extent of the growth in house building in the UK that occurred from the 1950s and into the 1970s. Over these three decades the typical number of new properties completed each year was around 320 000 or 6 per thousand of the population. The peak of house building was in the late 1960s when completions exceeded 400 000 per year or over 7.5 per thousand of the population. It is also noticeable how new local authority housing (‘council houses’) played a much larger role in the overall housing mix.

Since 1980, the average number of housing completions each year has dropped to 191 000 or 3.2 per thousand of the population. If we consider the period since 2000, the number of completions has averaged only 181 000 per year or 2.9 per thousand of the population. While it is important to understand the pressures on housing demand in any assessment of the growth in real house prices, the lack of growth in supply is also a key factor. The fact that less than half the number of properties per thousand people are now being built compared with half a century or so ago is an incredibly stark statistic. It is a major determinant of the deterioration of housing affordability.

However, there are important considerations around the protection of the natural environment that need to be considered too. It will therefore be interesting to see how the reforms to planning develop and what their impact will be on house prices and their affordability.

Articles

Statistics

Questions

  1. Explain the difference between a rise in the rate of house price inflation a rise in the level of house prices.
  2. Explain the difference between nominal and real house prices.
  3. If nominal house prices rise can real house price fall? Explain your answer.
  4. What do you understand by the terms instructions to buy and instructions to sell?
  5. What factors are likely to affect the levels of instructions to buy and instructions to sell?
  6. How does the balance between instructions to buy and instructions to sell affect house prices?
  7. How can we differentiate between different housing markets? Illustrate your answer with examples.
  8. What metrics could be used to measure the affordability of housing?
  9. Discuss the argument that the deterioration of housing affordability is the result of market failure.
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The approach to monetary and fiscal policy

The following blog is inspired by my teaching of macroeconomic issues to my final year students at Aston University. In the classes we’ve been discussing important aspects of monetary and fiscal policy design. What has become clear to me and my students is that the trade-offs which characterise the discipline of economics are certainly alive and well in the current environment in which monetary and fiscal policy choices are being made.

To demonstrate this we consider here some of the discussions we’ve had in class around central bank independence and monetary policy mandates. We’ve also looked at fiscal policy. Here we’ve examined the state of the public finances and the importance that seems to be attached to debt stabilisation and the imposition of debt rules.

Delegation and central bank mandates

My teaching this term began by introducing my students to one of the most important and influential monetary policy models. This is the model of Kydland and Prescott. Their model, published in the Journal of Political Economy in 1977 has become the theoretical bedrock for the modern-day operational independence of central banks.1

The model explores how systemically high inflation can become established in economies when policymakers have the political incentive to lower unemployment or increase output above its long-run equilibrium value. This may be the case if governments operate monetary policy rather than the central bank (of if the central bank operates monetary policy but follows government objectives). By adopting expansionary monetary policy, governments can increase their popularity.

But this is likely to be short-lived, as any increased economic activity will only be temporary (assuming that the natural-rate hypothesis holds). Soon, inflation will rise.

But, if an election is on the horizon, there may be enough time to boost output and employment before inflation rises. In other words, an expectations-augmented Phillips curve may present governments with an incentive to loosen monetary policy and worry about the inflation consequences after the election.

However, the resulting ‘inflation surprise’ through the loosening of monetary policy means a fall in real pay and therefore in purchasing power. If people suspect that governments will be tempted to loosen policy, they will keep their expectations of inflation higher than the socially optimal inflation rate. Consequently, low-inflation targets lack credibility when governments have the temptation to loosen monetary policy. Such targets are time-inconsistent because governments have an incentive to renege and deliver higher inflation through a looser monetary policy. The result is an inflation bias.

Central bank independence
To prevent this inflationary bias arising, many central banks around the world have been given some form of operational independence with a mandate centred around an inflation-rate target. By delegating monetary policy to a more conservative central bank, the problem of inflationary bias can be addressed.

Yet central bank independence is not without its own issues and this has been an important part of the discussions with my students. Today, many economies are continuing to experience the effects of the inflationary shocks that began in 2021 (see Chart 1 for the UK CPI inflation rate: click here for a PowerPoint). The question is whether the appointment of a conservative or hard-nosed hawkish central banker trades off the stabilisation of inflation for greater volatility in output or unemployment.

The inflation–output stabilisation trade-off is closely associated with the works of Kenneth Rogoff2 and John Taylor3. The latter is known for his monetary policy rule, which has become known as the ‘Taylor rule’. This advocates that a rules-based central bank ought to place weight on both inflation and output stabilisation.

This is not without its own issues, however, since, by also placing weight on output stabilisation, we are again introducing the possibility of greater inflationary bias in policy making. Hence, while the act of delegation and a rules- or target-based approach may mitigate the extent of the bias relative to that in the Kydland and Prescott model, there nonetheless still remain issues around the design of the optimal framework for the conduct of monetary policy.

Indeed, the announcement that the UK had moved into recession in the last two quarters of 2023 can be seen as evidence that an otherwise abstract theoretical trade-off between inflation and output stabilisation is actually very real.

My classroom discussions have also shown how economic theory struggles to identify an optimal inflation-rate target. Beyond accepting that a low and stable inflation rate is desirable, it is difficult to address fully the student who asks what is so special about a 2% inflation target. Would not a 3% target, for example, be preferable, they might ask?

Whilst this may sound somewhat trivial, it has real-world consequences. In a world that now seems to be characterised by greater supply-side volatility and by more frequent inflation shocks than we were used to in recent history, might a higher inflation rate target be preferable? Certainly, one could argue that, with an inflation–output stabilisation trade-off, there is the possibility that monetary policy could be unduly restrictive in our potential new macroeconomic reality. Hence, we might come to see governments and central banks in the near future revisiting the mandates that frame the operation of their monetary policy. Time will tell.

Fiscal policy and debt stabilisation

The second topic area that I have been discussing in my final-year macroeconomics classes has centred around fiscal policy and the state of the public finances. The context for this is that we have seen a significant increase in public debt-to-GDP ratios over the past couple of decades as the public sector has attempted to absorb significant economic shocks. These include the global financial crisis of 2007–8, the COVID-19 pandemic and the cost-of-living crisis. These interventions in the case of the UK have seen its public debt-to-GDP ratio more than triple since the early 2000s to close to 100% (see Chart 2: click here for a PowerPoint).

Understandably, given the stresses placed on the public finances, economists have increasingly debated issues around debt sustainability. These debates have been mirrored by politicians and policymakers. A key question is whether to have a public debt rule. The UK has in recent years adopted such a rule. The arguments for a rule centre on ensuring sound public finances and maintaining the confidence of investors to purchases public debt. A debt rule therefore places a discipline on fiscal policy, with implications for taxation and spending.

How easy it is to stick to a debt rule depends on three key factors. It will be harder to stick to the rule:

  • The higher the current debt-to-GDP ratio and hence the more it needs to be reduced to meet the rule.
  • The higher the rate of interest and hence the greater the cost of servicing the public debt.
  • The lower the rate of economic growth and hence the less quickly will tax revenues rise.

With a given debt-to-GDP ratio, a given average interest rate payable on its debt, and a given rate of economic growth, we can determine the primary fiscal balance relative to GDP a government would need to meet for the debt-to-GDP ratio to remain stable. This is known as the ‘debt-stabilising primary balance’. The primary balance is the difference between a government’s receipts and its expenditures less the interest payments on its debt.

This fiscal arithmetic is important in determining a government’s fiscal choices. It shows the implications for spending and taxation. These implications become ever more important and impactful on people, businesses, and society when the fiscal arithmetic becomes less favourable. This is a situation that appears to be increasingly the case for many countries, including the UK, as the rate of interest on public debt rises relative to a country’s rate of economic growth. As this happens, governments are increasingly required to run healthier primary balances. This of course implies a tightening of their fiscal stance.

Hence, the fiscal conversations with my students have focused on both the benefits and the costs of debt-stabilisation. In respect of the costs, a few issues have arisen.

First, as with the inflation-rate target, it is hard to identify an optimal public debt-to-GDP ratio number. While the fiscal arithmetic may offer some clue, it is not straightforward to address the question as to whether a debt-to-GDP ratio of say 100% or 120% would be excessive for the UK.

Second, it is possible that the debt stabilisation itself can make the fiscal arithmetic of debt stabilisation more difficult. This occurs if fiscal consolidation itself hinders long-term economic growth, which then makes the fiscal arithmetic more difficult. This again points to the difficulties in designing policy frameworks, whether they be for monetary or fiscal policy.

Third, a focus on debt stabilisation alone ignores the fact that there are two sides to any sector’s balance sheet. It would be very unusual when assessing the well-being of businesses or households if we were to ignore the asset side of their balance sheet. Yet, this is precisely the danger of focusing on public debt at the exclusion of what fiscal choices can mean for public-sector assets, from which we all can potentially benefit. Hence, some would suggest a more balanced approach to assessing the soundness of the public finances might involve a net worth (assets less liabilities) measure. This has parallels with the debates around whether mandates of central banks should be broader.

Applications in macroeconomics

What my teaching of a topics-based macroeconomics module this term has vividly demonstrated is that concepts, theories, and models come alive, and are capable of being understood better, when they are used to shine a light on real-world issues. The light being shone on monetary and fiscal policy in today’s turbulent macroeconomic environment is perhaps understandably very bright.

Indeed, the light being shone on fiscal policy in the UK and some other countries facing an upcoming election, is intensified further with the state of the public finances shaping much of the public discourse on fiscal choices. Hopefully, my students will continue to debate these important issues beyond their graduation, stressing their importance for people’s lives and, in doing so, going beyond the abstract.

References

  1. Rules rather than discretion: The inconsistency of optimal plans
    The Journal of Political Economy, Finn E Kydland and Edward C. Prescott (1977, 85(3), pp 473–92)

  2. The optimal degree of commitment to an intermediate monetary target
    Quarterly Journal of Economics, Kenneth Rogoff (November 1985, 100(4), pp 1169–89)

  3. Discretion versus policy rules in practice
    Carnegie-Rochester Conference Series on Public Policy, John B Taylor (December 1993, 39, pp 195–214)

Articles

Questions

  1. What is meant by time-inconsistent monetary policy announcements? How has this concept been important for the way in which many central banks now conduct monetary policy?
  2. What is meant by a ‘conservative’ central banker? Why is the appointment of this type of central banker thought to be important in affecting inflation?
  3. What is the contemporary macroeconomic relevance of the inflation–output (or inflation–unemployment) stabilisation trade-off?
  4. How is the primary balance different from the actual budget balance?
  5. What do you understand by the concept of ‘the fiscal arithmetic’. Explain how each element of the fiscal arithmetic affects the debt-stabilising primary balance?
  6. Analyse the costs of benefits of a debt-based fiscal rule.