Debt, deficits and the fiscal framework
It has been widely reported that the government is considering abandoning the second half of its fiscal mandate - that debt should be falling as a percentage of GDP in 2015-16. My view is that the short term economic impacts of this are limited. It's not really news; NIESR has been saying for well over a year that this target was unlikely to be met. What deficit reduction we've seen so far - largely achieved through cutting investment - hasn't exactly gone according to plan. Nor should we worry about the markets - they certainly haven't reacted yet and I doubt they will. As for the ratings agencies, any policymaker who pays them the slightest attention shouldn't be allowed near economic decision-making.
More importantly, in policy terms, somewhat looser fiscal policy in the short term is entirely sensible and affordable. As Vince Cable said on Sunday, the main problem facing the UK economy in the short term is a lack of demand, which is in large part the result of the government's decision to pursue over-rapid fiscal consolidation. To the extent that any change is an overdue recognition and reversal of this mistake, it is to be welcomed.
However, and this is the main point of this post - dropping the debt target raises wider questions about the government's fiscal framework. Without the debt target, the central element of the fiscal framework - the deficit reduction target - is no longer credible. It is worth reproducing the description of the framework set out in the 2010 Emergency Budget
"The Budget announces the Government’s forward-looking fiscal mandate to achieve cyclically-adjusted current balance by the end of the rolling, five-year forecast period. At this Budget, the end of the forecast period is 2015-16. At this time of rapidly rising debt, the fiscal mandate will be supplemented by a target for public sector net debt as a percentage of GDP to be falling at a fixed date of 2015-16, ensuring that the public finances are restored to a sustainable path. This fiscal mandate, supplemented by the target for debt, will guide fiscal policy decisions over the medium term, ensuring that the Government sets plans consistent with accelerating the reduction in the structural deficit so that debt as a percentage of GDP is restored to a sustainable, downward path."
What's the logic here? The Treasury argued, correctly, that having a forward-looking deficit target eliminated one of the key weaknesses of the previous, backward-looking regime, the "Golden Rule", that the government could count past surpluses against future deficits. But correcting this weakness introduced another one: read literally, eliminating the deficit (however defined) by the end of the five-year forecast period is not a constraint at all. As we pointed out in our evidence to the Treasury Committee last November, the forward-looking deficit target on its own is no more credible than saying "I'll give up drinking next month"; and, when you ask me next month how it's going, telling you the same thing:
"It is important to note that the fiscal mandate - " to achieve cyclically-adjusted current balance by the end of the rolling, five-year forecast period" - does not ensure long run sustainability. It would be consistent with the fiscal mandate for the Government to plan, this year, on a cyclically adjusted current deficit of 10 per cent of GDP for the first year of the forecast period (2012-13), 8 per cent for the second, and so on, achieving balance by the fifth year (2016-17), setting out the necessary tax rises and spending cuts to achieve this plan; and then, next year, even if economic circumstances are entirely unchanged, to delay all the tax rises and spending cuts by one year, so again planning on a deficit of 10 per cent of GDP for the first year of the forecast period and balance by the fifth year (now 2017-18)."
So that is why the supplementary debt target is there. On its own, it doesn't make much sense either; why target falling debt in one specific year? That has little necessary connection with the long-term sustainability of the public finances, since debt could be rising the year before and the year after. But it does stop the government behaving in the way described above. The point is that, as the Treasury quote above makes quite clear, on its own the primary target does not "ensure that the public finances are restored to a sustainable path." The supplementary target is required as well. They are not separable, but part of a package. Abandoning the debt target will mean, as a matter of economic logic, rethinking the primary target if it is has to have any economic credibility at all.
The government's fiscal strategy always had two flaws; first, a failure to understand the short--term macroeconomic impacts of fiscal consolidation; and second, a misunderstanding of the vital but complex and often misused concept of "credibility". Most of the debate has focused on the former. But the latter is at least as important. The focus needs to be less on second-guessing financial markets in the short-term (still less the ratings agencies) and much more on ensuring that we have a sensible framework that will ensure long-run fiscal sustainability. Dropping or modifying the "supplementary" target, without re-examining the framework itself, will be a short-term fix at best, when what we need is something that will last.