If Darling wants to be ‘Mr Prudence’ then now's the time to change the rules

10th March 2008
By Simon Kirby

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In his Pre-Budget Report last October, Alistair Darling forecast a deficit on the government’s current budget of 0.6 per cent of money GDP (£8bn) this fiscal year — a projection which began to look optimistic almost immediately.

However, February’s publication of Public Sector Finance Statistics included revisions to past data that improved the current budget by almost £3bn. At the same time a surge in self-assessment tax receipts from 2006-7 delivered extra revenues, meaning the projected deficit will probably be close to what Mr Darling expected.

That said, the outlook for the economy is less robust than it was six months ago. Many forecasters expect GDP growth over the next couple of years to be export-led, suggesting less buoyant tax receipts. The MPC has recently downgraded its GDP growth forecasts, while highlighting the increased uncertainty surrounding the economy’s outlook.

Overall, in the absence of any changes to fiscal policy, in his first Budget this month Mr Darling should acknowledge the weaker outlook and revise down his projections for the public finances for the coming fiscal year.

The reality is that forecasts, especially forecasts of government borrowing, rarely turn out to be exact. The fact that forecast errors exist should not be of concern, but study of past forecasting errors can indicate how uncertain projections are. This in turn can help inform economic policy options and the policy structure.

The Code for Fiscal Stability, approved by the Commons in December 1998, explains how fiscal policy is to operate in the UK. The study of uncertainty is enshrined in the Code. The Treasury does analyse the impact of a variety of possible outcomes, but this is restricted to the little read Long-term Public Finance Report.

As the title to the Report suggests, the focus is on the public finances in the long run rather than over the next five years. In the core documents such as the Budget and Pre-Budget Reports, which focus on the short-term path for public finances, little account is taken of the uncertainty around the forecasts. Although the notion of uncertainty is implicit in the work underlying the public finance projections, there is only a limited demonstration that it has been fully taken on board.

Given this, a more prudent approach would be to present the central public finance projections embedded within a range of probable outcomes.

 The publication of fiscal fan charts by the Treasury would be an appropriate and welcome improvement to the debate. There is nothing new in this — the Bank of England has published its inflation forecast as a fan chart since February 1996 and the US Congressional Budget Office has published the federal budget balance forecast as a fan chart for much of the past decade.

The National Institute of Economic and Social Research (NIESR) has published its government borrowing forecast as a fan chart since the start of 2003, the latest of which is presented in the figure.

Of note is the size of the probability bands, which suggest the magnitude of uncertainty associated with projection of government borrowing is large. The actual differences between NIESR’s and the Treasury’s forecasts are relatively small.

In comparison, forecasts of GDP growth and inflation have much narrower probability bands associated with them. However, the fact that GDP growth forecasts have associated uncertainties helps undermine the current ‘golden rule’. This rule calls for the government’s current budget to be in balance over the (uncertain) economic cycle.

The emphasis on the economic cycle suggests that the chancellor has to focus on data going back a decade ago, rather than keep his eyes on the current state of the public finances. Furthermore, the analysis is based on forecasts with no indication about how things might go wrong or what actions will be taken if they do.

A more forward-looking approach to fiscal policy could establish a medium-term range for the current budget balance. Fiscal policy can then be adjusted each year to keep government borrowing in range.

Mr Darling’s current difficulties arise from the hubris in past forecasts. If he is to meet the golden rule in the current economic cycle, probably 2006-7 to 2010-11, then he must tighten fiscal policy in this Budget. The lack of fiscal flexibility currently enjoyed by Mr Darling is highlighted by his forecasts published in the Pre-Budget Report 2007.

Data for the first three years of the previous economic cycle (1997-8 to 1999-00) suggest the public sector current budget was, on average, in surplus to the tune of 1.1 per cent of GDP.

In comparison, for the first three years of the current economic cycle (data for 2006-7 and Treasury forecasts for 2007-8 to 2008-9), the current budget is expected to be in deficit by 0.4 per cent of GDP, a difference of 1.5 per cent of GDP (£20bn). Of course, extending the length of the current economic cycle in order for the fiscal rules to be met is a possible response and one the government has experience of.

The introduction of the current fiscal rules was a welcome step towards sound fiscal policy. However, their time has passed. The suitability of the rules for future fiscal policy is limited, while their credibility has been shattered.

A strict interpretation of the current rules would imply a tightening of fiscal policy. This might not be wise when economic growth is expected to be weak this year. Clearly reform of the fiscal rules is Mr Darling’s best option. Simply tinkering with them is not enough. Rather Mr Darling should use the Treasury’s experience from the past ten years and introduce wholesale reform.

Simon Kirby is the Senior Economist responsible for publishing the NIESR’s economic forecasts for the UK.

Filed Under: , , Budget 2008, Fiscal Rules
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