Balancing day-to-day spending could become the new fiscal rule

There are just over two weeks to go before Rachel Reeves’s maiden budget and an unusual amount of uncertainty still lingers over how radical or reticent the government will be in its fiscal plans for the next five years.
The uncertainty hinges entirely on how the chancellor chooses to interpret her fiscal rules — with a plethora of options being touted through trial balloons in the press, which have begun generating reams of analysis and number-crunching from City analysts and think tanks.
Before digging into those options, it’s worth remarking on the long and arduous run-up to this Halloween budget — a wait that has spooked businesses and households in a series of economic surveys taken in September. Labour has justified its plans by saying that it needed to give the Office for Budget Responsibility the customary ten-week notice period, but that could have meant a budget in late September.
Reeves’s predecessors got to work much faster. In 2010 George Osborne delivered his emergency austerity budget less than six weeks after inking the rose garden coalition agreement. Gordon Brown did the same in 1997. Liz Truss waited a mere 19 days — a record that is unlikely to be matched, for good reason.
The near three-month wait for a budget has given Reeves time to formulate many different versions of her fiscal rules, all with varying degrees of risk and fiscal breathing room.
One big reason Reeves is almost certain to ditch the current target — to reduce the debt-to-GDP ratio in the fifth year of the OBR’s rolling forecast — will have landed on her in-tray at the start of this week. On Monday, the OBR will have sent the Treasury its initial estimates of the “pre-measures” fiscal headroom Reeves has to hit the rule in an environment where interest rates are higher than expected in March and where growth is beginning to slow after a strong start to the year.
In March, the watchdog said Jeremy Hunt had a slim £9 billion in headroom against the debt rule — one of the lowest figures on record for any chancellor. This figure is likely to have halved to less than £5 billion this October, according to estimates from Barclays. The deterioration is down to the still high borrowing costs paid by the government on its debt and probable downgrades to the OBR’s already optimistic growth projections.
The £5 billion in headroom unduly constrains a new government promising to lift growth and investment and is a straitjacket that will be rightly ditched by the chancellor at the end of the month.
For the past two months, the most likely alternative under consideration has been to switch the target from the current “public sector net borrowing excluding the Bank of England” to one called “public sector net borrowing”. Confusingly, the latter will mean the Bank’s tens of billions of losses will not have an immediate impact on the government’s tax and spending decisions and could free up between £16-£18 billion in breathing space at the budget.
Yet in the past few weeks, Reeves has focused on the need to raise capital spending in the economy, an emphasis that has generated speculation about a bolder shift in the fiscal rules that could theoretically unlock limitless spending on investment. Treasury officials have pointed to increasing a measure of “public sector net worth” in the fiscal rule — a metric that subtracts debt from the value of the stock of assets like roads, infrastructure and buildings owned by the government.
This shift would give Reeves close to £60 billion in headroom, according to figures from the Institute for Public Policy Research. Labour grandees like Sir Peter Mandelson, and allies like Mark Carney, one of Reeves’s most high-profile admirers, and Andy Haldane, former chief economist of the Bank, have put their weight behind expanding the fiscal rule to include the state’s assets as well as liabilities.
It would be a radical change from the current system. The switch to a net worth measure would decouple the government’s fiscal target from strict borrowing limits. In this new world, if the OBR tots up the productive value of an investment project in a clean energy plant or a railway project as outweighing the initial borrowing used to fund it over a certain time frame, it would boost the measure of public sector net worth — which has been steadily declining for the past decade. The UK’s public sector net worth to GDP ratio is one of the lowest in the rich world, second only to Italy.
But having launched the net worth trial balloon, the Treasury is battling with criticism about the difficulties of making the switch. The Institute for Fiscal Studies is among the biggest detractors, warning that measuring the true value of illiquid assets is too complex to use as a government target.
Bond investors have also begun taking note of headlines claiming that Reeves could unleash a £50 billion borrowing-to-invest spree. This has yet to translate into a meaningful rise in gilt yields, despite warnings about a new “Liz Truss” moment and a “buyers’ strike” from the investors whose kindness the UK relies on. Pre-emptive fears about a gilts crisis are overdone: whipsawing moves in yields this month is driven by shifting interest rate expectations and is not the bond vigilantes assuming formation against Reeves.
The chancellor will feel she is facing an invidious choice as accusations of “moving the goalposts” will abound whatever she decides. This ignores that almost every one of her predecessors has chosen and then broken their self-imposed fiscal rules at will for the past three decades.
To defang her critics, changing the current debt rule to one that focuses on investment will mean that the current secondary rule — to balance day-to-day spending — will become the most binding constraint on the government going forward. This in effect will become the new fiscal rule and one that will continue to constrain the chancellor’s tax and spending decisions in years to come.