14 November 2008
Despite the abandonment of the fiscal rules, the UK remains prudent by European measures. Steve Wilcox argues that by adopting the EU's financial rules in the Pre-Budget Report on November 24, government and housing policy will benefit
The credit crunch has had both a direct and indirect impact on the government's public expenditure plans. Support for the financial sector – and the part-nationalisation of a number of banks have directly added to expenditure and debt levels. At the same time the indirect effects of the credit crunch – such as the recession, the reduction of tax revenues, and increased benefit spending due to much higher levels of unemployment – will further increase expenditure and debt levels.
While the detailed impact of the credit crunch on public finances will not be revealed until the publication of the 2008 Pre-Budget Report on November 24, the government's fiscal rules are clearly no longer sustainable.
The first rule is the 'golden rule' that borrowing for revenue and spending should balance over the economic cycle, with net borrowing permitted only to finance capital spending. The second 'sustainable investment rule' is that the total level of public sector net debt should not exceed 40% of gross domestic product.
Even at the time of the 2008 Budget, PSND was forecast to rise very close to the 40% limit – peaking at 39.8% of GDP in 2010/11, before easing back to 39.3% by 2012/13. Annual public sector current balances were forecast to be –0.6% of GDP in 2007/08 before easing back to 1.3% of GDP in 2012/13.
Amid some controversy, the government set 1997/98 as the start of the economic cycle, and suggested that it finished in the second half of 2006. It claims to have complied with the golden rule over the current cycle by a narrow margin.
Whatever the arguments about the timing of the cycles, and the way in which the balances are measured over the cycle – as average annual percentages of GDP rather than as a net cumulative cash balance – the margins are so narrow that the direct and indirect impacts of the credit crunch will breach the current rules.
This much was acknowledged by the chancellor in his recent Mais lecture, when he accepted that the rules would need to be revised; and it is anticipated that he will go far further in setting out a new fiscal framework in the PBR.
There are a number of options for the chancellor to follow. But perhaps the first thing to recognise is that, despite the imminent breach of the rules, the total level of government debt in the UK remains low by European standards, as can be seen in figure 1.
The standard European Union debt measure is the general government financial debt, rather than the UK-style PSND. On that measure, the UK deficit in 2007 stood at 43.8% of GDP, compared to an EU '15' average of 66.4%. Moreover, the GGFD limit set as the convergence target for the purposes of monetary union is 60% of GDP.
It is also notable that a number of EU Euro countries are not compliant with the monetary convergence rules set under the Maastricht Treaty. Both France and Germany have GGFD levels slightly over the convergence limit (at 64.2% and 65% respectively), while Greece has a debt level of 94.5%, and Italy a debt level of 104%.
The related Euro monetary rule is that general government financial deficits should not exceed 3% in any year. Earlier in the decade the Eurozone had its own crisis when France and Germany, as well as other EU countries, breached the 3% limit.
In theory, the excess borrowing by both France and Germany should have led to the imposition of financial penalties to exert pressure on the individual governments to return to compliance with the pact. In practice, EU ministers reviewed the rules in 2005 and effectively dropped the threat of financial penalties while retaining the underlying fiscal rules, albeit in a more flexible approach over the economic cycle.
At the time the Treasury published a pamphlet essentially advocating that the Eurozone should adopt similar financial rules to the UK's rules. The central merit of the UK golden rule is the greater formal flexibility it provides for levels of annual borrowing over the economic cycle, provided that the total level of government debt remains at prudent levels. In some respects, however, the UK approach is more restrictive than the Eurozone approach.
Moreover, while the UK fiscal measures relate to the public sector, the Eurozone rules relate only to 'general government', and do not impose any limitations on the debt levels of public corporations (ie, trading bodies owned or controlled by government). Rather extraordinarily, the 2004 Treasury document did not allude to this distinction once in its 40-page pamphlet.
This distinction has been a particularly important driver for housing policy, where borrowing for expenditure on council housing now formally counts as part of the 'public corporate sector' rather than as part of the local government sector. This is essentially because council housing is a trading activity. It does not need to be legally separate from the council for it to be accounted for as part of the public corporate sector, as indeed it is in the UK national accounts. In the jargon, council housing constitutes a 'quasi corporation', whether it is under the direct management of the council or has been established as an 'arm's-length management organisation'.
This contrasts with housing associations, which have been raising private finance since 1987 on the basis that they are in the private not-for-profit corporate sector, rather than the public corporate sector. However, questions hang over that designation given that housing associations have been declared to be public sector bodies both for purposes of EU procurement legislation and UK ombudsman services. It is a matter for the newly independent UK Statistics Authority, and not the Treasury, to determine whether or not housing associations are appropriately designated for national accounts purposes. To date, they have not had any reason to reconsider this.
Nonetheless, it should be noted that the relevant sections of the System of National Accounts refer to government control through the power to hire and fire board members as sufficient for a body to be considered a part of the public sector; it does not require direct day-to-day majority ownership or control. While the institutional and regulatory framework for housing associations in England has now been recast, the power to intervene and appoint and dismiss housing association board members remains intact.
There is consequently a risk that at some point housing associations might be redesignated as part of the public sector, bringing their £30bn-plus borrowing within the scope of PSND. However, that change would be of no consequence if the UK adopted fiscal rules based on general government rather than public sector debt. The case for such a change, with its particular implications for council housing, was set out in a Chartered Institute of Housing report in 1995. It was clear that had the new Labour government chosen to follow that route when it first came to power there would have been no concerns about making such a switch at that time.
These issues take on a new importance following the credit crunch and the government's part-nationalisation of a number of banks. The nationalised banks are public corporate bodies, as was the case with all the former nationalised industries and utilities prior to their privatisation.
It follows that while their acquisition fundamentally breaches the current 'sustainable investment' rule, the borrowing for their acquisition does not count at all in terms of general government financial deficits (see figure 2).
If the investment in the banks results in losses that have eventually to be funded by government then that support will count as government spending against GGFD; but not the initial borrowing to take over partial or total ownership of the banks.
The simplest way for the chancellor to revise the fiscal rules would be to switch to a general government-based approach and adopt the 60% GGFD limit from the Eurozone rules. This would require the rule for annual deficits also to be recast in terms of general government, rather than public sector, finances. But the aspiration of achieving a balanced revenue budget over the economic cycle could be retained.
It remains to be seen whether the chancellor will take this approach, or simply relax the rules and/or create a 'special category' of banking assets intended to be kept as part of the public sector only for a limited period of time.
Those options would, however, smack of sticking plaster. The switch to Eurozone style fiscal rules, on the other hand, would be both more coherent and would underline the fact that even now UK government debt remains well below EU average levels and that there is no fundamental fiscal crisis.
The UK fiscal rules always were excessively prudent and their demise should not be lamented. To cleave to them now would be as much a mistake and a disaster as Britain's return to the gold standard in 1925. That the chancellor has recognised the need to abandon the old rules is welcome. But much will hang on the way he constructs the new fiscal rules – especially for the future of housing policy.
Steve Wilcox is professor of housing at the University of York. This article is an edited version of a chapter in the UK Housing Review 2008/09, due to be published by the Building Societies Association and the Chartered Institute of Housing in December
PFnov2008
