Long-term fiscal sustainability

The problems facing George Osborne when he delivers his Autumn Statement are clear: he has committed to eliminating the structural deficit within five years and to have net public debt falling as a proportion of GDP between 2014-15 and 2015-16. But because of an economic recovery far slower than expected he appears unlikely to achieve these targets.

Yet even if the Chancellor of the Exchequer meets his fiscal targets, gross government debt would still be in the danger zone where growth is at risk. Recent estimates suggest that public debt levels over 85 to 90 per cent of GDP could reduce the annual growth rate by up to 1 percentage point. Under the Chancellor’s plans gross debt is still expected to exceed 90 per cent of GDP by 2013.

There are many measures of fiscal sustainability and, as Reform argued in 2010, the criteria used by credit rating agencies should only be seen as a minimum standard. One key measure is the sustainability of the level of debt (to avoid a “debt spiral”). This means that over the business cycle the Government must ensure that its average annual surplus is large enough to cover the interest payments on debt. Governments may run deficits to support the economy in periods of weakness, but over time they must, on average, have a surplus that at least covers the cost of servicing debt.
Measures of the sustainability of UK government debt show a long history of unsustainable borrowing: the surplus has been great enough to reduce public debt in only six of the past 34 years. The UK is a persistent offender.

Fiscal rules can play an important role in helping the Government commit to a sustainable medium-term plan to deal with the debt problems it faces. Yet their previous use in the UK has not been a success. From 1998 to 2008 the UK had two rules: a golden rule to ensure budget balance, and a sustainable investment rule to constrain total debt. These rules did not prevent the increase in government debt in the UK between 2003 and 2008, even before the global financial crisis.

A better approach is required. International experiences with fiscal rules show a range of approaches can work, so long as they are appropriate to the situation. No one size fits all. However, key features that determine the success of fiscal rules include: comprehensive coverage of the Government’s accounts to avoid gaming, the flexibility to deal with unexpected contingencies, and supporting institutions that hold the Government to account.