When fiscal rules create a perverse political trade-off

The UK’s Budget, presented last Wednesday by chancellor Jeremy Hunt, followed the usual well-rehearsed choreography. The government sends its policy plans to the independent Office for Budget Responsibility, which forecasts how the resulting public finances measure up against a set of fiscal rules — established by the government itself.

The result becomes a political tool in the form of “headroom”: how much more public borrowing can rise without crossing a line that has come to define the limits of fiscal responsibility. Government and opposition alike must account for how to stay on the right side of the line while making good on their policy offering to voters.

This encourages opaque and erratic fiscal games (to “find money” for desired policies without reprioritising real resources). It also risks democratic stasis: it raises the political price of offering voters anything substantial and undermines serious debate about what the economy needs.

In a sensible economic system, (what passes for) fiscal responsibility should go hand-in-hand with strong, sustained growth. For fiscal rules to create a political trade-off between one and the other is perverse. This effect may be particularly strong in the UK, but it exists elsewhere, too. In the US, a convention of 10-year budget “scoring” can lead policy to be assessed on the assumption it will be reversed in the 10th year.

The EU’s now-reformed fiscal rules have, in the past, spurred countercyclical policy. This made downturns after the global financial crisis deeper, counterproductively worsening public debt burdens.

Germany’s entire green investment strategy was thrown into disarray in November when the constitutional court struck down a trick commonly used by German politicians: creating notional “funds”, when national deficit rules are suspended for emergency reasons, that can later borrow freely outside the main budget. The court rejected one particularly egregious example, but politicians have enshrined another (for defence spending) in the constitution. Others are in limbo.

All these are cases of fiscal rules encouraging deceptive or bad economic policy, or both. What can be said in their favour? They could serve three important functions: keeping politicians trustworthy by exposing the implications of their choices, encouraging better fiscal policy and making the process more rational by swapping political friction for cool calculation.

In practice, trying to impose probity on politicians already minded to be dishonest simply encourages them to game the rules, especially when badly designed. Take the UK’s public debt rule, defined on a “rolling” five-year basis. Fulfilling it depends only on what the government says today it will do in the future, not on what it actually does.

As for better fiscal policy, today’s rules emerged as the answer to an old problem: the generalised rise in public debt in the 1980s, blamed on politicians’ willingness to short-change future generations and pump-prime the economy before elections.

Is that still the biggest challenge? In the stagnant pre-Covid decade the problem was rather one of governments too afraid of stimulating their economies. Procyclical temptations remain: France’s finance minister explains new spending cuts by saying “when you earn less, you spend less” — glossing over the risk that if you spend less on important things, you could also earn less.

Today, the risk of too little public capital investment — in stronger growth, the green and digital transitions and in defence — is at least as great as that of high public debt. There is little sign that fiscal rules help avoid that mistake.

To its credit, the EU has tried to do better in the reformed rules it has just introduced. They will require four to seven-year spending plans that you stick with. That should reduce the incentive to game the system. And at least the EU’s multi-country set-up enjoys truly independent checks and balances that a purely national system cannot fully guarantee: governments can and do change their own fiscal rules.

On the third goal, perhaps trying to depoliticise the budgetary process was always misguided. There is only so much rules can do to fix a broken politics; conversely, they add little to countries blessed with honest politicians willing to seek the common interest.

The most promising aspect of the EU’s reform is the new political give-and-take they encourage between countries and EU institutions. The best we can hope for from fiscal rules is not to circumvent a dysfunctional budgetary politics but to help it evolve into something better.

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