Chancellor Philip Hammond faces calls to relax fiscal policy in next week’s Budget. How much scope he has to do so, however, depends upon which of his fiscal rules is most important. Three of them are relevant here.
First, “the public finances should be returned to balance as early as possible in the next Parliament”. Of course, everything hinges on that word “possible”. But it looks unlikely that balance will be achieved in the first year of that parliament. Back in March, the OBR forecast a deficit in 2021-22 (the latest year it forecasts) of £16.8bn. It is likely to revise this higher next week because it will revise down future economic growth and hence tax revenues.
The second rule is that “cyclically-adjusted borrowing should be below 2 per cent by the end of this Parliament”. Such borrowing is currently forecast to be 0.9 per cent of GDP in 2021. However, because the OBR will revise down trend growth, it will revise up its forecasts for cyclically-adjusted borrowing. Sam Hill at RBC Europe says these revisions will take forecast borrowing on this measure up to 1.5 per cent of GDP in 2021. This gives room for a fiscal expansion of less than half a per cent of GDP per year by then.
The third rule is that “public sector net debt as a share of GDP must be falling by the end of this Parliament”. This gives more room for manoeuvre, as debt is currently forecast to fall from 87.7 per cent of GDP now to 84.8 per cent by 2021.
In fact, the maths of debt sustainability are still good. A simple equation tells us this. It says that to know the primary budget balance required to stabilise the debt-GDP ratio we must first take the gap between real growth and the real interest rate, then divide this by the GDP growth rate, and then multiply by the debt-GDP ratio.
Now, real long-term index-linked gilt yields are minus 1.6 per cent and the Bank of England believes trend growth to be around 1.5 per cent. Plugging these numbers into our equation, along with the debt-GDP ratio of 87.7 per cent, tells us that the chancellor can stabilise the debt-GDP ratio over the long run with a primary deficit of 2.7 per cent of GDP. But this deficit (which is government borrowing excluding interest payments) is forecast to become a surplus in 2019-20.
By this measure, the chancellor could loosen fiscal policy by three percentage points of GDP. When interest rates are negative, borrowing is sustainable.
So, which rule matters most? Economically speaking, none do. Simon Wren-Lewis and Jonathan Portes have argued that fiscal rules should be suspended when interest rates are ultra low and that governments must borrow more to return interest rates to more normal levels.
Instead, there are two other constraints upon the chancellor. The minor one (for us) is the political embarrassment of him not hitting his self-imposed rules. The more significant one is that if the Bank of England is right to believe there is little slack in the economy, then extra borrowing might add to inflation and thus require a higher Bank rate. Many economists, however, regard this as a feature of looser fiscal policy and not a bug.
