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A Labour of liabilities, by George Osborne

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30 September 2005

Gordon Brown's fiscal rules were invented to win his party credibility, but he has changed their definitions so often that unless they are independently scrutinised we face a borrowing disaster

At a routine meeting of the Treasury select committee on July 19, the fiscal framework that had underpinned the government's economic credibility fell apart.

At that meeting, Gordon Brown announced that he was unilaterally changing the date of the start point of the economic cycle from 1999 to 1997, thus allowing another £13bn of deficit within this cycle. He knew, as we know now, that the very next day he would have gone into deficit on his cherished 'golden rule', and he decided that he would rather cheat than break it.

How did we get into this position? To understand the significance of the fiscal rules, it is useful to look at some history. In the 1970s, the public finances played second fiddle to attempts at demand management. Tax rates soared, as did the deficit. This meant higher interest rates, as lenders required a 'risk premium' on their loans to safeguard against default and inflation. Higher interest rates made debt financing even harder, increasing the deficit further. Britain had to be bailed out by the International Monetary Fund in order to pay the interest on its debt.

The last Conservative government recognised in its 1980 medium-term financial strategy that Britain must not spend beyond its means. The strategy set a fiscal policy framework that helped to put government finances on a secure and stable footing. Further reforms followed in the 1990s: three-year spending targets were introduced, putting government finances on a longer-term footing and, from 1992, a clear set of rules were used to guide fiscal policy. The 1993 Budget, though deeply unpopular, tightened fiscal policy, and put the public finances on their strongest footing in a generation.

The incoming Labour government recognised the importance of maintaining the strength of the public finances. Gordon Brown set two fiscal policy rules. The golden rule was that over the economic cycle, the government should borrow only to invest and not to fund current spending. The sustainable investment rule was that public sector net debt should be maintained below 40% of GDP.

For Labour, the rules were crucial to persuade investors and the public that they had some economic credibility. But they were never watertight. Because the chancellor was his own judge and jury, he was able to change subtle definitions of the rules to fit his needs. This meant he could run an unsustainable fiscal policy, and spend more than he could afford, but still stay within his definition of the rule.

In 2001, the chancellor predicted he would have to borrow just £12bn in the years to 2005/06. Instead, he has borrowed £112bn. For the second year running, Britain has broken the 3% budget deficit limit set out in the Maastricht Treaty. Respected international organisations like the IMF and the Organisation for Economic Co-operation and Development state that Britain now has a structural deficit, which domestic commentators such as the Institute for Fiscal Studies believe is at least £10bn. There is little point in having a golden rule if it can be tarnished so easily.

Only last week, the IMF World Economic Outlook reported that it expects the sustainable investment rule to be broken in 2006 — even on the current, narrow definition. That means that government debt will be above the ceiling that Brown admits is necessary to ensure the sustainability of the public finances, putting economic stability at risk.

There are two steps that the chancellor must take in this November's Pre-Budget Report to bring credibility back to the fiscal rules. The golden rule should be judged by an independent panel, which should estimate the length of the cycle and decide what counts as investment expenditure. The panel should also make a statement on the overall sustainability of the public finances and assess whether the deficit is cyclical or structural.

The sustainable investment rule should be calculated on the basis of independent decisions on what should, and should not, count as government debt. Proper recognition should be given to liabilities that taxpayers will have to pay for in the future. In this way, genuine fairness between generations can be secured, and Britain will not borrow more than it can afford.

Therefore, the Office for National Statistics should be given responsibility for compiling the balance sheet for the whole of government, and deciding which debts are government liabilities. The ONS should be made independent, so that the decisions it takes are free of political interference.

Through these reforms, the fiscal rules will be properly implemented once again. This can help to restore the health of the public finances, which is vitally important to the UK economy. It is crucial that the rules governing the economy are properly and independently assessed, or the fiscal rules will get very well known, for all the wrong reasons.

l George Osborne is shadow chancellor of the exchequer

Gordon Brown's fiscal rules were invented to win his party credibility, but he has changed their definitions so often that unless they are independently scrutinised we face a borrowing disaster

At a routine meeting of the Treasury select committee on July 19, the fiscal framework that had underpinned the government's economic credibility fell apart.

At that meeting, Gordon Brown announced that he was unilaterally changing the date of the start point of the economic cycle from 1999 to 1997, thus allowing another £13bn of deficit within this cycle. He knew, as we know now, that the very next day he would have gone into deficit on his cherished 'golden rule', and he decided that he would rather cheat than break it.

How did we get into this position? To understand the significance of the fiscal rules, it is useful to look at some history. In the 1970s, the public finances played second fiddle to attempts at demand management. Tax rates soared, as did the deficit. This meant higher interest rates, as lenders required a 'risk premium' on their loans to safeguard against default and inflation. Higher interest rates made debt financing even harder, increasing the deficit further. Britain had to be bailed out by the International Monetary Fund in order to pay the interest on its debt.

The last Conservative government recognised in its 1980 medium-term financial strategy that Britain must not spend beyond its means. The strategy set a fiscal policy framework that helped to put government finances on a secure and stable footing. Further reforms followed in the 1990s: three-year spending targets were introduced, putting government finances on a longer-term footing and, from 1992, a clear set of rules were used to guide fiscal policy. The 1993 Budget, though deeply unpopular, tightened fiscal policy, and put the public finances on their strongest footing in a generation.

The incoming Labour government recognised the importance of maintaining the strength of the public finances. Gordon Brown set two fiscal policy rules. The golden rule was that over the economic cycle, the government should borrow only to invest and not to fund current spending. The sustainable investment rule was that public sector net debt should be maintained below 40% of GDP.

For Labour, the rules were crucial to persuade investors and the public that they had some economic credibility. But they were never watertight. Because the chancellor was his own judge and jury, he was able to change subtle definitions of the rules to fit his needs. This meant he could run an unsustainable fiscal policy, and spend more than he could afford, but still stay within his definition of the rule.

In 2001, the chancellor predicted he would have to borrow just £12bn in the years to 2005/06. Instead, he has borrowed £112bn. For the second year running, Britain has broken the 3% budget deficit limit set out in the Maastricht Treaty. Respected international organisations like the IMF and the Organisation for Economic Co-operation and Development state that Britain now has a structural deficit, which domestic commentators such as the Institute for Fiscal Studies believe is at least £10bn. There is little point in having a golden rule if it can be tarnished so easily.

Only last week, the IMF World Economic Outlook reported that it expects the sustainable investment rule to be broken in 2006 — even on the current, narrow definition. That means that government debt will be above the ceiling that Brown admits is necessary to ensure the sustainability of the public finances, putting economic stability at risk.

There are two steps that the chancellor must take in this November's Pre-Budget Report to bring credibility back to the fiscal rules. The golden rule should be judged by an independent panel, which should estimate the length of the cycle and decide what counts as investment expenditure. The panel should also make a statement on the overall sustainability of the public finances and assess whether the deficit is cyclical or structural.

The sustainable investment rule should be calculated on the basis of independent decisions on what should, and should not, count as government debt. Proper recognition should be given to liabilities that taxpayers will have to pay for in the future. In this way, genuine fairness between generations can be secured, and Britain will not borrow more than it can afford.

Therefore, the Office for National Statistics should be given responsibility for compiling the balance sheet for the whole of government, and deciding which debts are government liabilities. The ONS should be made independent, so that the decisions it takes are free of political interference.

Through these reforms, the fiscal rules will be properly implemented once again. This can help to restore the health of the public finances, which is vitally important to the UK economy. It is crucial that the rules governing the economy are properly and independently assessed, or the fiscal rules will get very well known, for all the wrong reasons.

George Osborne is shadow chancellor of the exchequer

PFsep2005

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