What’s the point of fiscal rules?

Greetings, and happy Signalgate week.

Given the ever more extraordinary news coming out of Donald Trump’s America, Rachel Reeves’ Spring Statement to the UK parliament was not perhaps this week’s most consequential event (read all you need to know about it here). But it’s one significant piece of an important pattern that is at play all over Europe.

For weeks before the Spring Statement, the public debate (and by all accounts private government planning) had focused on how Rachel Reeves needed to restore the “headroom” allowed by her fiscal rules after economic forecasts deteriorated. Simultaneously, a policy revolution was taking place in Germany, whose infamous “debt brake” budget rule was loosened by an abrupt constitutional reform. And in Brussels, the European Commission moved to suspend the application of EU-wide rules to permit more borrowing for defence expenditures.

The common thread here is how governments are constrained by self-imposed budgetary rules, and how they choose to respond to those constraints. So this week, I want to survey the big-picture question of what fiscal rules are good for.

The UK, Germany and the EU have in the past couple of weeks demonstrated three different ways to respond to a common problem. The common problem was this: the fiscal rules conflicted with certain political imperatives. Those imperatives varied. In Germany it was the need to spend more on defence and on infrastructure (priorities shared with much of the EU). In Britain, it was to boost defence spending a little bit but mostly to keep manifesto promises on not raising taxes (further). Disappointing growth made the budget rules bite harder in all cases.

The three different responses were these. Germany reconvened its outgoing legislature and changed the constitution to exempt defence expenditure increases and a (capped but large) infrastructure boost from the constitutional limit on government borrowing. Brussels, in contrast, declined to propose a change in the EU-wide rules despite Germany’s request to do so. Instead, it exploited flexibilities inside the rules (admittedly stretching those flexibilities to the limit). The UK stuck by the rules and announced future spending cuts to remain within them.

Which was the better choice? That depends on what you hope fiscal rules are supposed to achieve. What that is — and whether they do achieve it — is not as obvious as you may think.

In very generic terms, the point of fiscal rules is to make public finances more sustainable. They grew out of the 1980s economic theorising on how politicians, left to their own devices, would borrow and spend too much and run their countries into excessive government debt burdens. That, in turn, would frighten markets and drive up the cost of debt service to taxpayers.

That’s the theory. How about the practice?

The evidence is suggestive but weak. “The evidence base isn’t as strong as you would expect for something as widespread” as fiscal rules are, says Ben Zaranko of the Institute for Fiscal Studies. That is not for the lack of studies — but there is a limit to what they can demonstrate. One reason for this is that the presence of a rule is not the same as compliance with the rule. In the UK, successive rules have not removed the asymmetry with which chancellors treat positive and negative growth surprises. The EU’s old rules, in practice, did not bind countries unwilling to comply.

Another reason is that it’s hard to prove causality. Surveys of the academic research find frequent correlations between fiscal rules and outcomes such as lower deficits, lower debts, and sometimes higher growth and lower interest rates, especially when countries have independent fiscal forecasters and generally strong institutions. But there are many ways in which governments with stricter fiscal rules and independent fiscal institutions are those more likely to achieve those outcomes for other reasons. Only “a few studies” address this problem of reverse or common causality.

The design matters a lot. Yet another reason the evidence of success is not overwhelming is that fiscal rules may be ill-designed, in which case we should not expect them to make public finances more sustainable. It is easy to see this risk in the countries I have mentioned. In Germany, the period in which the debt brake had been in force was an era of starved public investment. The lower growth this has probably caused makes public finances less sustainable.

In the UK, the current fiscal rules allow borrowing for investment so long as the government’s net financial debt as a share of GDP is projected to be falling by the end of this parliament. The non-investment budget, however, must be projected to be in balance. But forward-looking fiscal rules, combined with political choices to just meet them — leaving very little “headroom” — means that small changes in forecast require large compensatory measures. The risk is that “policy is over-responding”, says Zaranko. When the tail wags the dog like this, you get a volatile budget policy that is bad for growth, making the problem the rules are supposed to solve worse. Yet this mechanical overreaction is what passes for “stability” in the UK public debate.

Rules can try to do too much. The official rationale for fiscal rules is to “discipline” governments so they borrow less, or that they grant governments “credibility” with markets so that whatever they do borrow costs less. (Or both.) Note, however, that this only works if the rules can actually be expected to produce better economic and budgetary outcomes, overcoming the challenges of the previous two points.

The unofficial rationale is that fiscal rules strengthen the hands of finance ministries against spending departments, and are mostly a tool for intra-government bargaining.

The problem is that these rationales may work at cross-purposes. For example, a finance minister must use up their headroom to credibly resist pressure from fellow politicians, but that makes for over-responsive policymaking, which does not help with external credibility.

The most important trade-off is between present and future. In the best-case scenario, fiscal rules create virtuous cycles between budgetary stability and lower borrowing costs. This lightens the trade-offs facing governments. But they do not remove them. A roomier budget constraint is still a budget constraint, and the most relevant trade-off here is between the present and the future. Fiscal rules are generally supposed to tilt this towards the future: they increase the relative political cost of borrowing and spending today, or they enforce restraint now, which gives more room for spending in the future.

But improving the terms of the trade-off is a separate thing from judging what trade-off to make. The latter is properly in the domain of political choice. And one of the biggest problems with fiscal rules, it seems to me, is that they narrow the space for political debate and democratic political choice too much. Even as it improves the trade-off for politicians, a fiscal rule may be taking the choice for them as to how that trade-off should be made.

To be sure, this is a feature, not a bug. Fiscal rules came into being because enough people thought politicians were biased towards borrowing and spending more than everyone thought was wise. (There is a parallel here with Kenneth Rogoff’s 1980s model of the “conservative central banker” — the idea that political biases mean you need central bankers who are more hawkish than the average person to get the monetary policy the average person would prefer. In the 2010s, however, it seemed like we rather needed more-than-averagely-dovish central bankers.)

Today, it is a legitimate question whether politicians in leading countries may be too responsible and unwilling to borrow, spend, or run the economy hot when needed. Highly debatable, of course, and indeed debated — but it’s a debate that surely should be democratically engaged with, not forestalled by one-sided rules.

And here is the biggest question mark. In both Germany and the UK, the signs are that the fiscal rules have significantly narrowed down the space for democratic politics. And the German experience is telling. While there has rightly been much international attention on the path-breaking constitutional change, don’t forget what came before. The ideological differences between the three parties of the previous “traffic light” coalition were compressed into fighting over just a few decimal points of GDP. That turned out to be too little room for political manoeuvre, and the government foundered over an amount that was economically minor but was forced to carry more political weight than it could bear.

So while Germany in the end decided to change its rules, it only come to that after the rules had broken a government. It remains to be seen if Reeves and the Labour party will follow the same sequence in the UK.

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