Friday Flyer: Fiscal space - this time is different
Worrying developments in Italy and elsewhere in the Euro Area underline the implications arising from poor management of fiscal risks. Fiscal policy can be a great way of sharing risks faced by households but there is an ever-present tension between acting now in the face of known shocks and retaining some space for future action in response to as yet unknown shocks. In the European monetary union, successive governments would like to have responded more actively to national economic performance with more active fiscal policy, but the initial lack of fiscal space has meant that relatively little has been done, particularly since 2011.
In the UK, the Office for Budget Responsibility published a report last year assessing the fiscal risks faced by HM Treasury. It was an important and path breaking analysis of the risks to the path of government debt. Sterling service was done by highlighting and quantifying the quantity of debt that would need to be issued in an ageing population with increasingly stark demands on health services under low levels of productivity. In the worst case scenarios public debt could rise to multiples of national income not seen since the end of the Napoleonic wars.
The natural response to projections of high levels of indebtedness is to think of ways of cutting expenditures and turn to policies that seek to reduce the size of state. But to portray fiscal risks as simply expenditure-determined misses misunderstands the purpose of fiscal policy. It is not the size of the debt or surprises in the deficits that represent risks – as these represent mostly the flow of economic events. Fundamentally fiscal risk is simply the weight we attach to the possibility that the government cannot issue debt instruments in order to share economic risks faced by the private sector with future generations. And those risks can often be mitigated by the development of public goods rather than their suppression.
Debt management, by which I mean the magnitude, composition and duration of public debt has evolved as the main instrument by which the state is able to offset the risks faced by the private sector. Debt issuance has many practical risk-mitigating elements. It can, for example, reduce the magnitude of an economic downturn, prevent a financial collapse, extend healthy and productive lives or help us get to work in time. There is an economic risk from issuing too much debt but also one from not building appropriate levels of human and physical capital. There are also opportunities from the nadir in current real rates to lock in borrowing at historically low levels.
The state thus has to make a choice between employing debt instruments and keeping them in reserve in anticipation of future risks. Whilst the one over-riding constraint is fiscal solvency, which is manifest as the continuous ability to issue or roll over debt in financial markets, the choice of whether to issue debt is not a simple function of the existing level of debt. There are times when debt stabilisation, which may guarantee access to debt markets in the future, dominates any immediate economic need to issue more debt and there may be times when it is necessary to build up public capital via debt issuance. Either priority may dominate at any given level of debt to income.
In the immediate aftermath of the financial crisis it was quite sensible to allow public debt to respond. In the UK debt to GDP rose by some 45% points from 2007 to 2017 but in the Euro Area it was only 24% points on average and in, for example, Italy some 32%. Subsequently, when it was not possible to know how vulnerable the economy was, it was sensible to act prudently on further debt issuance and since 2011 public debt in the UK has increased by just over 5% relative to GDP and in the Euro Area only by 2% on average.
The UK’s next big shock, leaving the European Union, has a clear identifiable impact on the traded sector as well as on in investment. The response this time should be to reduce economic risks by providing an insurance mechanism for the regions most affected. Some elements of new taxes and also relaxation of the fiscal rules to allow further investment in education and connectivity is probably required. Whilst fiscal policy since the financial crisis has done much to increase public sector efficiency, this time more active fiscal policy might be required to create the necessary fiscal space.