Everyone, including
the IFS, is agreed that the Chancellor should in the budget create
more fiscal headroom than she did previously. Rather than match
forecasts for taxes to expected current spending (plus or minus ten
billion, say), she should aim for forecast taxes to be significantly
more above expected current spending, to allow for headroom against
unforeseen negative shocks. This seems very reasonable, doesn’t it?
Well consider some analogies.
I have the
thermostat set at 20 degrees centigrade, because I find that a
comfortable temperature. But sometimes if there is a cold wind
outside the temperature inside can dip below that before the boiler
and the radiators can respond to put it back up to 20. I feel cold as
a result. So I should set the thermostat to 22 degrees, to provide
headroom in case a cold wind blows.
Hopefully you can
see the fallacy in that strategy. Or take the Bank of England’s
inflation target of 2%. Now, as we have seen, shocks to inflation
like wars can happen that will take inflation well above that target.
We cannot have that, can we. So the Bank should in practice aim for
zero inflation, to provide headroom so that it doesn’t get caught
out with above target inflation following inflationary shocks.
Now fortunately
those who designed the UK’s inflation targeting regime were
sensible enough to emphasise that the 2% target was not short for ‘2%
or less’, and that inflation falling short of 2% was just as bad as
inflation exceeding the target. So allowing headroom for the 2%
target would make no sense. So why does it seem to make sense in
achieving a fiscal rule but not an inflation target?
Why
does everyone seem to be calling for greater fiscal headroom in the budget? I think it is because the taxes=current spending fiscal rule is not seen as a symmetrical
target. If shocks turn out to be positive for the public finances so
borrowing is less than expected that is not seen as a problem, but if
negative shocks occur such that current spending exceeds taxes then
that is seen as a problem that the government has to fix immediately.
That is why we had the nonsense of welfare cuts in the Spring.
The analogy that
comes straight from the term ‘headroom’ is making sure you design
doors such that hardly any people hit their head on when they walk
through them. If you make your door too small many people will hit
their head, which is bad. If you make your doors too tall then there
is no equivalent injury suffered. The costs and benefits are not
remotely symmetric.
The financial
analogy might be a bank current account. I keep a positive balance in
my account because I cannot predict precisely every payment going in
and out of the account, and I don’t want the balance to go below
zero and incur overdraft charges. But is a bank account an
appropriate analogy for a government? Who is going to slap an
overdraft charge on the government?
One answer might be
the markets, in the form of higher interest rates on government debt.
But that should already be in the forecast. Borrowing moderately in
excess of the fiscal rules might lead to a small increase in interest
rates on government debt, not because of supply and demand for
government debt but because it would signal higher aggregate demand
and therefore higher interest rates set by the Bank of England. On
the other hand higher borrowing caused by weaker aggregate demand
(leading to lower tax receipts|) could have the opposite effect,
leading to lower interest rates on government debt. All this is quite
different from overdraft charges.
In my view fiscal
rules should be like the inflation target. They are and should be
symmetrical: it is just as bad to miss the rule by borrowing too
little as it is by borrowing too much. If you borrow too little you
are taxing people too much or not giving people enough public
services, or the economy is in a downturn. Those are all bad things
that should be rectified. If this is the case, then you don’t need
any headroom at all, just as the Bank of England doesn’t allow
headroom for its inflation target.
But this is not how
the media and the current government see things, and for that we
probably have the reaction to Liz Truss’s fiscal event partly to thank. In the Spring the government
did not take the
“grown up” decision (to quote Charlie Bean, ex
LSE, Bank of England and OBR) to allow the OBR’s forecast to show
the fiscal rule not holding with a promise to fix it in November.
Instead it decided it had to act immediately, cutting welfare spending
to meet the rule. Presumably it thought being ‘grown up’ and not
doing this would cause the markets to panic, or more likely the media
would generate lots of bad publicity.
Given this view held
by the Chancellor, then it does make sense to create lots of headroom
against borrowing more than the fiscal rule allows. But that in turn
inevitably means that fiscal policy is going to be tighter than the
fiscal rule implies it should be. If in practice you always plan for
forecast taxes to be £20 billion or more above expected current
spending, then given forecasting errors can go both ways the
government is enacting a tighter policy than the fiscal rule on paper
suggests. Furthermore in practice how much tighter will depend on the
whim of the Chancellor at the time in setting the amount of headroom,
which in turn will depend on the circumstances they find themselves
in.
Now I admit neither
of these problems (moderately tighter policy on an inconsistent
basis) is that great in the overall scheme of things, but I think
someone should at least recognise these issues. If you think government debt should fall faster than is implied by the golden rule, then it is better to get that rule to target a small surplus than mess around with headroom. But the headroom issue is a symptom of a bigger and more serious problem.
As a result
of a combination of mediamacro’s reading of the Truss debacle, and
the constant stories in the press about bond vigilantes and impending
doom from the imagined actions of these imaginary people, we are
returning to a world where policymakers see deficits and debt as
always a problem, rather than as something that allows better fiscal
policy making.
The government’s
debt and deficits are
meant to go up as well as down, because they allow
smoother taxes and spending and can also allow both to support the
economy when needed. Government borrowing is therefore a very useful
tool, and not some problem that needs to be eliminated as much as
possible. If, in contrast, the media and governments start seeing
government borrowing as a problem rather than a useful tool, then
this can interfere with good fiscal policy making. At its very worst,
it can lead governments to start trying to reduce deficits during
economic downturns or recessions, as it did from 2010 onwards. As I
have noted
elsewhere, that is a possibility that is more likely
to happen as a result of recent change to fiscal rules.
Exaggerated claims about market reactions to debt and deficits infantilize fiscal
policy, and that infantilisation can be very dangerous. Talking about the UK as part of some impending advanced economy debt crisis is almost as silly as talk about a possible IMF bailout. Such talk is only magnified by a right wing press desperate to
replace the memory of a recent crisis that was the result of a fiscal
event they lavished ecstatic praise upon. The main reason we have a fiscal problem in the US is not because politicians are being irresponsible about debt but because a populist dictator is denying economic reality at every turn. One pretty foolproof way of encouraging right wing populism in the UK is to pretend the market requires public spending cuts when public spending levels are already weak.
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