Sunday, November 21, 2004
A black hole in the golden rule
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

Listening to Gordon Brown being interviewed on the Today programme last week, there were two moments when even across the airwaves you could sense the temperature rising and the steam escaping from the chancellor’s ears.

One was when Peter Mandelson’s name was mentioned, which was understandable in any circumstances but particularly after our new EU commissioner had the temerity to say that the Treasury has been gloating that Britain’s economic performance is much better than Europe’s.

The other was when he was asked about the “black hole” in the public finances. Nothing is more guaranteed to raise the ire of a chancellor with deep Presbyterian roots than saying he has been playing fast and loose with taxpayers’ money.

So out came the familiar mantra. The government’s spending plans were fully affordable, the fiscal rules would be met, and everybody who suggested that they would not would be proved wrong. There will be a lot more of that on December 2, when Brown presents his pre-budget report, his eighth.

There will also be another batch of responses, from analysts, who will say that the chancellor will not meet the rule most under pressure, the golden rule, and that he will need to raise taxes (or cut spending) by about £10 billion to do so. With spending already fixed for the next three years, that puts the onus firmly on higher taxation.

But let us stand back a little. What is the golden rule? It is, in laymen’s terms, the notion that governments should borrow only to invest (in roads, new schools, hospitals and so on), and not for the purposes of current spending (wages, salaries, medicines, exercise books etc). Defined by the Treasury, it is that the current budget should balance — at minimum — over the economic cycle.

There are, as an aside, as many golden rules in economics as in life. From the Christian golden rule — do unto others as you would have them do unto you — to the golden rule of economic growth, which sets out the optimal path of savings and investment, there are many to choose from. Milton Friedman said his golden rule was setting a path for the money supply and sticking to it. The version Brown adopted has the virtue of being straightforward.

The chancellor’s second rule, the sustainable investment rule, is even simpler, committing the government to keeping the national debt below 40% of gross domestic product. It gets less attention because it is not under pressure. At present debt is 34% of GDP.

There are two questions that should concern us about the golden rule. The most pressing is whether it will be met over the present cycle. The Treasury believes the cycle began in 1999-2000 and will end next year, 2005-6. That does not mean, by the way, that growth will come to an end, merely that the economy will have completed the four phases of the economic cycle — peak, downswing, trough, upswing, and back to another peak.

Even the Treasury admits that meeting the rule over the present cycle will be a close-run thing. Its most recent forecasts, in the March budget, suggested that the average current budget surplus over the cycle would be 0.1% of GDP. That is a mere £1.2 billion in a near- £1,200 billion economy.

Since then, things have not gone according to plan. Extrapolating Thursday’s public-finance figures gives a current budget deficit of £23 billion this year, more than double the Treasury’s budget forecast, said the Institute for Fiscal Studies. Total public borrowing, it said, was on course for £39 billion, £6 billion more than the Treasury expected.

The IFS said Brown was on course to break his golden rule. So did Price Waterhouse Coopers (PWC), which predicted an average current budget deficit of 0.1% of GDP, and said it could be as high as 0.3%.

But does it really matter? Andrew Smith, chief UK economist at KPMG, makes what looks like a revolutionary suggestion. “Would a ‘one-off’ breach of the golden rule be so serious?” he said. “Embarrassing, yes. Fatal, no.” Far better to miss the rule slightly than bring in tax rises that would be hard to explain to a public that is largely unaware of Brown’s rules. And far better to miss it than bring in tax hikes that would harm business.

Others agree. John Hawksworth of PWC said missing the rule slightly would have “no economic significance”, the only discernible effect being a red face for the chancellor. The IFS said both Brown’s guiding fiscal principles were useful rules of thumb but nothing more.

The chancellor, if he wanted, could go down the same route. The golden rule, he could say when he stands up on December 2, was never meant to be subjected to the slide-rule treatment and has been broadly met over this cycle. He could also point to Britain’s low debt (34% of GDP), which stacks up well against a G7 average of more than 80%, with France, Germany and America on more than 60%, Italy above 100% and Japan topping 160%.

He could tell us about the fiscal shenanigans in other countries. Greece has admitted giving dodgy fiscal data to support its entry into the euro. France and Germany have missed their stability-pact targets by a lot more than 0.1% of GDP and got away with it. America’s budget deficit, in relative and absolute terms, puts Britain’s in the shade.

Will he do it? Getting any politician to admit to an error is difficult. Getting this chancellor to do so is probably impossible. Expect, instead, a fudge.

The second question about the golden rule is rather more serious. Whatever nuances Brown tries to put on the outcome of this cycle, he will be heading into the next one with public borrowing at close to £40 billion a year. That is a lot of borrowing at the top of the economic cycle. It suggests that Britain’s fiscal advantage relative to other countries is likely to diminish rapidly during a third Labour term. And it suggests that, while it may be possible — and desirable — to postpone tax rises, it will be hard to avoid them entirely.

PS: At a time when many of the indicators are pointing to a modest slowdown in the economy, due to higher interest rates, high (but easing) oil prices and softer world growth, I can report that the skip index has sprung back to life. Regular readers will know that the index, based on the number of skips I encounter in the street, has been misbehaving of late.

It is not the only measure showing unexpected strength. Several correspondents have urged me to adopt the white-van index, the number of battered vehicles occupying residents’ parking bays during the day, as a sure sign that economic activity of the building variety is taking place. This is despite the fact that, according to the latest official figures, self-employment has dropped by 85,000 in the latest quarter.

What should we make of it? The latest figures for retail sales (down) and claimant-count unemployment (slightly up) suggest that the economy has not shrugged off its soft patch. The Bank of England is predicting a significant slowdown in the economy next year, and the Treasury’s 3%-3.5% growth forecast for 2005 looks to be very much on the high side.

I think I may have worked it out. These various indicators are strong because the housing market is weak. People have decided to spend on their existing properties rather than bolster the chancellor’s stamp-duty revenues or keep estate agents in fashionable little runabouts. Does this mean, after last week’s gloomy Rics survey, that the market is about to crash? Despite many “do panic” reader responses to last week’s “don’t panic” piece, it still looks to me like a recipe for stagnation.

From The Sunday Times, November 21 2004