Fiscal rules - time for a rethink?

 The case for rethinking fiscal rules is overwhelming 

Rather than exerting useful discipline, they are constraining government investment

ANDY HALDANE.  The writer, an FT contributing editor, is chief executive of the Royal Society of Arts 

 Last month, I discussed the negative feedback loop between stalling economic growth and expanding safety nets. How do countries break free from this “doom loop”? One important element is to rethink the fiscal rules shaping government investment decisions. 

 The idea of fiscal rules, which place limits on governments’ borrowing, is a sound one. Governments should abide by a “good ancestor” principle, endowing future generations with assets and income, not encumbering them with debt and taxes. In this way, fiscal rules can help ensure intergenerational equity — they are the everyday equivalent of aiming to leave your children the house rather than the mortgage. 

 After a sequence of pandemic-related splurges in government spending, fiscal rules are now at serious risk of being breached. The US is facing a cliff-edge next month due to the debt limits imposed by Congress. In the EU, calibration of the Stability and Growth Pact’s limits on countries’ debt is proving acrimonious. And in the UK, fiscal rules requiring a falling debt ratio within five years are restricting the government’s ability to put in place long-term growth-enhancing policies. 

 Are these rules exerting useful fiscal discipline or constraining investment and growth? I believe the latter. They are typically based on the stock of government debt relative to income. We would expect this ratio to vary over time. The greater the challenges facing a nation state, the stronger the case for debt-financed investment in the public goods needed to rise to them. 

 Take the UK. Since the industrial revolution, ratios of debt to gross domestic product in the UK have, on average, doubled every century. This was an explicit societal choice to invest in the new sets of public goods necessary to support economic and social progress — from schools to housing to health. 

Other countries’ debt ratios have also tended to trend higher over time. We should not necessarily expect this pattern to repeat itself in the 21st century. But nor should we expect debt ratios to flatline or fall. 

Many advanced economies are facing challenges no less severe than those our ancestors faced. And the case for a new set of public goods to meet them is just as compelling. This highlights a second defect with existing fiscal rules: they are typically based on net financial debt. They do not recognise the non-financial assets created by public investment, whether tangible (roads, hospitals, schools) or intangible (intellectual property, data, code). 

Nor do they recognise investment in natural assets, such as clean water, air and a thriving biosphere. Recognising those assets would give us a measure of the true net worth of the government. Just as a company or household would look at their net worth when making investment choices, so too should government. 

Countries with high net assets have been found to have lower borrowing costs. Bond market vigilantes target poor ancestors, not borrowers. That’s why real government borrowing costs have trended downwards over the centuries, despite government debt ratios trending upwards. 

Financial markets know it is the value of the house, not the mortgage, that matters. Countries with higher net worth also tend to exhibit greater macroeconomic resilience. This then reduces the burden on the state when adverse shocks strike. 

Our current debt-based fiscal rules, by constraining public investment, have contributed to a reduction in macroeconomic resilience and a bulging of the safety net following shocks. That has been the story of the past few decades when public investment by G7 countries has been flat or falling, despite global real rates of interest being close to zero. 

Here was an opportunity to invest in economic and environmental regeneration and boost growth and macroeconomic resilience. Misguided fiscal rules meant it was wasted and the doom loop perpetuated. 

 Global real yields have since risen across the world. But with real rates still under 1 per cent globally, the cost/benefit calculus would overwhelmingly favour public investment today to support growth and resilience tomorrow. Recent skirmishes over debt limits in advanced economies mean this opportunity is at risk, once again, of being squandered. Adhering to existing fiscal rules risks underinvesting today in tomorrow’s economic and environmental health. 

As the evidence of the past few decades demonstrates, debt-based fiscal rules dent growth, weaken macroeconomic resilience and amplify the doom loop. Future generations will rightly consider us bad ancestors if we stick with them.