House of Commons - Pre-Budget Report 2008

Pre-Budget Report 2008 - Treasury Contents

3 The public finances

45. In its Code for Fiscal Stability, published in November 1998, the Government set out the principles by which it would conduct fiscal policy. These were:

a. transparency in the setting of fiscal policy objectives, the implementation of fiscal policy and in the publication of the public accounts;

b. stability in the fiscal policy-making process and in the way fiscal policy impacts on the economy;

c. responsibility in the management of the public finances;

d. fairness, including between generations; and

e. efficiency in the design and implementation of fiscal policy and in managing both sides of the public sector balance sheet.[144]

The Government has two fiscal policy objectives, which are:

over the medium term, to ensure sound public finances and that spending and taxation impact fairly within and between generations; and

over the short term, to support monetary policy and, in particular, to allow the automatic stabilisers to help smooth the path of the economy. [145]

To achieve these two objectives, the Government has established two fiscal rules. These are:

the golden rule: over the economic cycle, the Government will borrow only to invest and not to fund current spending; and

the sustainable investment rule: public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level. Other things being equal, net debt will be maintained below 40% of GDP over the economic cycle.[146]

DATING OF ECONOMIC CYCLE

46. In order to assess performance against the fiscal rules, an assessment is needed of when the economic cycle began and ended. The Treasury explained in Budget 2008 some of the difficulties it had faced in ascertaining the timing of the end of the last cycle and concluded at that time that it was too soon to make an assessment.[147] Alongside the 2008 Pre-Budget Report, the Treasury published Evidence on the economic cycle, which reached the following conclusion:

the evidence from the range of cyclical indicators supports the assessment that the economic cycle judged to have started in 1997H1 [first half of the year] ended during the second half of 2006. Uncertainties continue to surround this assessment, in particular those relating to further possible revisions to National Accounts data.[148]

PERFORMANCE AGAINST FISCAL RULES OVER THE LAST ECONOMIC CYCLE

47. According to the Government's Fiscal Framework, published alongside the 2008 Pre-Budget Report, the fiscal rules were met over the last economic cycle which the Treasury estimated finished in 2006-07:

the average current surplus over the economic cycle was 0.1 per cent of GDP, meeting the golden rule that the Government borrows only to invest and helping ensure sound public finances and fairness between generations; and

public sector net debt was reduced from 42.5 per cent of GDP in 1996-97 to 36.0 per cent in 2006-07, meeting the sustainable investment rule that net debt be held at a stable and prudent level over the economic cycle, and meeting the commitment that, other things being equal, net debt would be maintained below 40 per cent of GDP over the economic cycle.[149]

USEFULNESS OF FISCAL RULES OVER THE LAST ECONOMIC CYCLE

48. The Chancellor gave his opinion of the benefits of the fiscal rules over the last cycle:

I think they are a pretty good discipline. It has helped us since 1997 to have rules that governed how much you could borrow and which were a discipline on us to reduce debt. As you know, debt came down quite substantially during that ten-year period.[150]

According to the Chancellor, having a credible fiscal framework in turn led to further benefits:

If you look at the long term gilt yields in this country and where they are today I think people do have confidence in us, but confidence comes from two things. One is that people want to know what rules you are operating under and also whether you are prepared to do what is necessary in order to ensure that you do stick to the objectives you set out.[151]

In written evidence, Professor David Heald told us he did not share the same level of enthusiasm, asserting that the Treasury's action had "bred an air of cynicism about the fiscal rules".[152]

Departure from the fiscal rules

49. The Chancellor confirmed that "the fiscal rules were important and fiscal rules remain important and will always be important".[153] Mr Ramsden, for the Treasury, maintained that even if the rules themselves were coming under pressure, their underlying principles remained valid. He explained that the rules were "a means to an end":

We set the two rules, the Golden Rule and the Sustainable Investment Rule for the last cycle … We always made clear that those rules were set in the way they were set for that cycle. Since then we have been hit by these two global shocks and the credit shock is intensifying. Against that backdrop, … it would be perverse to stick to rules that were not a means to an end, that actually required you to tighten fiscal policy during a recession"^.[154]

50. The Chancellor, in his Mais Lecture in November 2008, indicated that the Government would temporarily depart from the fiscal rules, and set out the reasons why:

the fiscal rules we adopted over ten years ago—which target debt and promote investment—enabled us to triple public investment, at the same time as cutting debt to one of the lowest levels among the world's major economies. But to apply these rules rigidly in today's changed conditions would be perverse. We must respond to the challenges and uncertainty we face today—supporting the economy now and maintaining public investment—while at the same time ensuring that we live within our means in the medium term.[155]

51. Mr Chote agreed, saying "there is no question but that they had to depart from [the fiscal rules] given where we were starting and the size of the adjustment that the economy has faced".[156] Mr Ramsden argued that, although the Treasury had had to depart from the rules, the objectives framing fiscal policy had not changed and were as set out in the Code for Fiscal Stability.[157]

The Government's objectives for fiscal policy in the face of these shocks remain unchanged. The Government's immediate priority is to continue to support the economy, while setting a path now for ensuring fiscal sustainability over the medium term. In these circumstances, the role of the fiscal framework is to ensure fiscal policy has the flexibility to respond appropriately, while remaining committed to clear, transparent long-term goals. So, to achieve its objectives, and as provided for in the Code for Fiscal Stability, the Government will depart temporarily from the fiscal rules until the global shocks have worked their way through the economy in full.[158]

52. In place of the Golden Rule and Sustainable Investment Rule, the Government announced a Temporary Operating Rule in the Pre-Budget Report:

to set policies to improve the cyclically-adjusted current budget each year, once the economy emerges from the downturn, so it reaches balance and debt is falling as a proportion of GDP once the global shocks have worked their way through the economy in full.[159]

The Chancellor commented that:

The important thing is not just the rule but the way in which we would implement it, and, again, it is set out here, and that is that as we come through this from 2011 there is a tightening of about 0.5% until 2015/2016. So I think the rules are important but also seeing evidence that you are prepared to take the necessary steps to stick to those rules are important as well … What I have done is to set out a temporary operating rule, but also, importantly, the way in which I intend to deliver on that.[160]

53. Mr Chote contended that the Temporary Operating Rule did "not provide much of a constraint or anchor at all", but agreed with the Chancellor that the credibility of the public finances hinged on the actions to be taken by the Government in order to meet the Rule, not the actual Rule itself:

[The Treasury] have said that they want to see the cyclically adjusted position for borrowing improving year-by-year, which would be the case anyway as a result of fiscal drag if you had no policy measures, and they would like to see [the ratio of] debt to GDP falling at the end of a forecast horizon which if you are improving the current budget in that sort of way you would normally expect that to be the case anyway … Credibility at this stage relies crucially on the measures that have been announced on spending and taxation rather than on the fiscal targets per se. That is really what people are having to put their faith in.[161]

Mr Ramsden did not accept that the Rule offered no meaningful constraint on Treasury budgeting:

You would get some very small reductions relative to the reductions that we have judged appropriate from fiscal drag. Also, in the case of our forecast, because we expect the more tax-rich parts of the economy, which are taking a real hit through this recession … to recover, but over and above that, the reason that I think this is a credible consolidation plan and that over time, as we refresh it and as it is developed, I think it will give enhanced credibility to the framework, is because, in addition to just those automatic effects, or those effects that come from judgement, we are announcing from 2010-11, the last year of the CSR [Comprehensive Spending Review] period, additional VFM [value for money] savings of £5 billion. Then beyond the CSR period we have set out what I think are achievable assumptions for real spending growth falling in terms of totally managed expenditure, which is current and capital, to an average of 1.1% a year. That is a significant slowdown in spending growth which is the major part of the consolidation. Then, in addition to that, we have set out specific tax-raising measures in PBR documentation which we think will contribute to the consolidation. [162]

54. Mr Ramsden was confident that the Rule would enable the Treasury to "be judged over time on whether we achieve the kind of plans that we have set out. … That would be one way I would expect us to be held to account, just as we have been in the past on our track record, and we will be judged against whether these plans are achieved and if there are any departures from them".[163] He also pointed to the role of the market in providing a judgement on the Government's stewardship of the public finances.

For fiscal policy, it is quite hard to come up with a summary measure of credibility … We tend to look at the ten-year bond yield. Over time that has come down successively and, as I have said, at the moment it is down at about 3.6%. So we suggest that people want to buy government debt and consider the position credible and sustainable.[164]

A return to the fiscal rules?

55. The Pre-Budget Report announced that the temporary departure from the fiscal rules would last "until the global shocks have worked their way through the economy in full".[165] Mr Ramsden, given the uncertainties involved, did not consider it appropriate to constrain that period definitely.[166] Mr Chote commented that the Government was "unclear" about how long the fiscal rules would be temporarily departed from.[167]

56. Under the Code for Fiscal Sustainability, the Government could have chosen to change the fiscal rules, but instead chose to depart temporarily from them, implying that the original rules would, at some stage, be returned to.[168] Mr Chote considered that the Treasury was unclear on this issue, saying that it had "not really said … whether they still believe in their original long-term assessment of what is a prudent level of government debt." In the longer term, he argued, the Treasury "would need to think about whether the targets that they had originally set themselves were the right ones".[169] The Treasury did say that "in advance of the public finances reaching cyclically-adjusted current balance, the Government will set out how it will apply the fiscal framework in future to continue to deliver its objectives".[170] Mr Ramsden refused to be drawn on setting a debt limit for a possible future revised Sustainable Investment Rule.[171] The Chancellor confirmed that he did not have any immediate plans to consult on a future fiscal framework, but would "leave that option open".[172]

57. We accept the Chancellor's argument that a rigid application of the fiscal rules in the current circumstances would have been damaging to the UK economy. The fact that a temporary departure from the fiscal rules has been required serves to reinforce our view that a revised fiscal framework is needed. The forthcoming period during which the Temporary Operating Rule applies provides a good opportunity to re-evaluate the fiscal framework for the future. We recommend that the Treasury conduct a full public consultation on the design of such a framework. We remain of the view as expressed in our previous Reports, such as on the Budget 2008, that it is our desire to see a credible framework which is more forward-looking than the fiscal rules used over the last cycle, which have been beset by problems surrounding the dating of the economic cycle.

State of the public finances

CURRENT BUDGET

58. At the time of the 2008 Budget, the Treasury forecast that the current budget would move into surplus in 2010-11. In our Report arising from that document, we noted the risks to that forecast:

There has been a further weakening of the Treasury's forecasts of the current budget balance from 2008-09 onwards since last year and the latest forecasts for the fiscal position are based on forecasts for economic growth that are subject to considerable downside risks.

The Pre-Budget Report projected a significant further deterioration in the public finances, with the current budget in deficit throughout the forecast period, peaking at 5.3% of GDP in 2009-10, and then falling to 1.1% by 2013-14. The cyclically-adjusted deficit was forecast to fall from 4.4% of GDP in 2009-10 to 1.0% in 2013-14 "when the economy is projected to return to trend, driven by a recovery of tax receipts and lower spending growth". The Pre- Budget Report noted that "a further adjustment of ½ a per cent a year in 2014-15 and 2015-16 would eliminate the deficit on the current budget by 2015-16".[173] The Chancellor took the view that the appropriate response to the combined forces of the credit crunch, inflationary pressures in 2008, lower revenues from the financial services sector and the housing market downturn was to "support the economy at the moment", with the intention of reducing the borrowings required to fund such a strategy as the economy rebounds.[174]

PUBLIC SECTOR NET DEBT

59. The Pre-Budget Report projected public sector net debt would increase to well above the limit set by the Sustainable Investment Rule, of 40% of GDP over the course of the economic cycle. For 2008-09, the Treasury estimated that net debt would be 41.2%.[175] Net debt is then set to increase each and every year of the forecast period reaching 57.4% of GDP by 2013-14.[176] Most of this increasing debt burden results from rising public expenditure in recent years and from the operation of the automatic stabilisers; the contribution of measures in the Pre-Budget Report is relatively modest. We asked witnesses whether they were concerned about the sustainability of the public finances. Mr Chote defined sustainability as "the Government's ability to meet the obligations it has", explaining that the more debt taken on, the more future tax revenue would be needed to service that debt. In principle, the Government could reach the point at which the debt interest burden was so high that it would run out of economic resources to service its liabilities. Much earlier than that though, in Mr Chote's view, the Government would face "the political constraint of … finding it difficult to persuade taxpayers to accept that burden".[177] The Chancellor did not think there was "a particular number [for the public sector net debt] beyond which you cannot go".[178] He accepted that public debt was "higher than we would like it to be", but offered the following justification:

I had to reach a judgment at a time when we are being hit by the credit crunch by, earlier in the year, these very high inflationary prices. What did I do to support the economy? Firstly, and I think there is all-party agreement to this, you let the automatic stabilisers play their role. That is quite expensive actually in terms of rising benefits, but we have to do that. It does affect your borrowing. I also have to take account that our revenues, particularly from the financial services industry are going down quite dramatically: because we are such a big financial services centre we are being affected by it. We are being affected by the downturn in the housing market— that means that borrowing does rise. I had to allow that to rise, because if I had started to take money out of the economy now, or earlier than I am proposing to, I think it would make a difficult situation a lot worse. In addition to that, of course, we also have been maintaining investment, spending on transport and housing and capital projects, and so on, … of course, as we come out of this and we start to grow, then we need to be able to get that borrowing back down.[179]

60. Mr Chote did not believe that people thought that the Government was at risk of default, but said that "the question of the degree to which the increase in debt makes it more expensive for the Government to borrow is a live one and is likely to be more important as a constraint over the next few years than it has been in the past".[180] Mr Bootle accepted Mr Chote's explanation of the theoretical risks of unsustainable public debt, but pointed out that the actual reaction of sovereign debt markets to the Pre-Budget Report was very positive:

although there is this theoretical concern that the Government will find it more expensive to borrow actually what is happening in the markets with a vengeance is that the Government is finding it cheaper to borrow. The markets are falling over themselves to buy government debt.[181]

Mr Ramsden confirmed that the price paid by the Government for raising debt had "continued to fall across all maturities":

Short-dated gilts are currently at historically low levels and the 10 year benchmark is at 3.6%, so there is a lot of demand for government debt at the moment and in the economic conditions and credit conditions that we face we think it is appropriate to allow government borrowing and government debt to rise to compensate for the fact that private sector borrowing is being reined in sharply globally through the process of de-leveraging.[182]

61. It is encouraging that at the present time the markets are supporting the Government in its raising of debt. We note the Chancellor's acceptance that in due course the levels of public sector net debt need to be addressed.

144 HM Treasury, The Code for Fiscal Stability, November 1998, p 5 Back

145 Pre-Budget Report 2008, p 36, para 2.91 Back

146 Ibid., p 36, para 2.92 Back

147 Budget 2008, p 177, para C.12 Back

148 HM Treasury, Evidence on the economic cycle, November 2008, p 3, Summary Back

149 HM Treasury, Government's Fiscal Framework, November 2008, p 4, para 1.6 Back

150 Q 318 Back

151 Q 319 Back

152 Ev 67 Back

153 Q 315 Back

154 Q 156 Back

155 Speech by the Chancellor at the Cass Business School, London, 29 October 2008 [Mais lecture]. Back