Budget 2024: How fiscal rules hamper long-term investment – and what Rachel Reeves can do about it

Before we get to the budget and what Rachel Reeves can do to shake up the fiscal rules and give herself a little more room to spend, I want you to think for a moment about a recent report from the Office for Budget Responsibility (OBR).

It wasn’t one of those big OBR reports that get so much attention – like the documents and figures it publishes with every budget, full of forecasts and analyzes about the state of the economy and public finances.

Instead, it was a chin-scratching working paper that asked the question: If the government invests in something – say, a road, a railway line, or a new school building – how long does it typically take for that investment to come to fruition?

According to the report, the answer was: quite a long time, actually. Imagine that the government will spend a significant amount of money this year – 1% of national income – on investment. In five years, these investments will generate only 0.4 percent of GDP. In other words, on a net basis, it cost us 0.6% of GDP.

But this is also important, look a little further. The high-speed rail network is designed to last for decades, and as those decades pass, it gradually improves people’s lives – think of the time saved every day by every traveler – small amounts every day, but incrementally. So, although the investment costs money in the short term, the benefits gradually increase in the long term.

The OBR calculated that although a public investment of 1% of GDP would yield only 0.4% of GDP over five years, after 10 or 12 years the investment would amount to close to 1% of GDP. In other words, there would be equalization. The money paid at the beginning will be fully refunded in the form of benefits.

And before the investment would reach 50 years, it would bring economic benefits of as much as 2.5% of GDP. Future generations would benefit enormously – at least that’s what OBR figures say.

Having explained this, I would like you to now think about fiscal rules Rachel Reeves faces this, its first budget. Most pressing is the issue of the so-called debt rule, which stipulates that the Chancellor’s public debt – well, technically it is “public sector net debt excluding Bank of England intervention” – falls due over a five-year period.

There is, it is worth emphasizing, nothing fundamental here. Reeves inherited it from Conservative Partywho dreamed of it only a few years ago, then COVID. Previously, there were countless regulations in place to prevent the national debt from falling, and to be honest, they rarely succeeded.

But because Reeves wanted everyone to know how serious this situation was before the election Work it was about managing public finances, she decided she would stick to Tory principles. This kind of politics can be understood; economics to a lesser extent – on the other hand, I admit that I have always been a bit skeptical about all these principles.

The effect is that to meet this rule, public debt must fall between the fourth and fifth years of the OBR’s five-year forecast. And according to the latest OBR forecasts, which date back to Jeremy Huntthis is the last budget. But not by much: only by £8.9 billion. If this number rings a bell, it’s because it’s the much-vaunted but not much understood “clearance” figure that many people in Westminster like to talk about.

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And – if you take these rules very literally, as everyone in Westminster seems to be doing – the conclusion is that the Chancellor really doesn’t have much room left to spend in the coming budget. It only has £8.9 billion of extra freedom to borrow!

Every spending decision – whether on investment, the NHS, benefits or anything else – is made in the shadow of a terrifying figure of £8.9 billion. And since the Chancellor had already explained at the black hole event earlier this year that the Conservatives had promised a lot of extra spending that they had not budgeted for – perhaps not the entire £22 billion figure she likes to quote, but a nice chunk nonetheless – then it is obvious that there really is “no more money”.

Does it exist? So far, we have treated fiscal rules quite literally, but at this stage it is worth asking ourselves: why? First, there is nothing evangelical about these principles. There is no tablet in stone that says the national debt must fall within five years.

Secondly, remember what we learned from the OBR article. Sometimes investing in things can actually generate more money than they cost. However, sticking to the debt rule means that the money you borrow to finance these investments is always counted as a negative, not a positive. And because the debt rule only looks five years into the future, you only see the costs, not the break-even point.

Third, this government’s debt rule actually focuses on a measure of public debt that is not necessarily accurate. This may seem strange until you realize that there are several different ways of expressing the scale of the UK’s public debt.

The measure we currently use excludes the Bank of England, which seemed reasonable a few years ago. The bank engaged in a policy called quantitative easing, which involves buying and selling lots of government debt, which distorts the national debt. Maybe it’s better to rule it out.

However, recently these interventions by the Bank of England have actually served to increase the state’s losses. I won’t go into detail here so as not to cause a headache, but the result is what most economists believe, focusing on the debt measure, which is currently most influenced not by government decisions, but by changes in the central bank’s monetary policy, it seems quite perverse .

In other words, there is a very strong argument that, rather than focusing on a measure of former BoE net debt, fiscal rules should focus on an overall measure of net debt. And here’s the thing: when you look at the net debt measure, you’ll notice that it declines more between years four and five. In other words, there is much more headroom: just under £25 billion, rather than just under £9 billion based on this other measure of debt excluding the bank.

Could Reeves declare – at the budget or in the run-up – that it would make much more sense to focus on the overall PSND from now on? Quite likely. And while it’s a violin in some respects, in her defense it’s a violin leading from one stupid rule to an even slightly less stupid rule.

It would also mean it has more room to borrow and invest – if it so chooses. However, this does not solve the deeper problem: that both of these measures focus on the short-term cost of debt without taking into account the long-term benefits of investment – let’s go back to the OBR article.

If Reeves is determined to stick to what some say is an arbitrary five-year deadline for reducing debt, but wants to take some measure of investment benefits into account, she can always choose one of two other measures of that rule.

It could focus on something called “public sector net financial liabilities” or “public sector net worth”. Both of these measures include some of the state’s assets as well as its debts – and as a result, they hopefully reflect a bit more of the benefits of investing more money.

The problem with these measures is that they are subject to quite frequent revisions, when, for example, accountants change their minds about the value of the national road or railway network. So some argue that these measures are susceptible to greater volatility and manipulation than simple net debt.

Nevertheless, these measures would radically change the image of “clearance”. Suddenly, Reeves would have over £60 billion at his disposal. That’s more than enough to splurge on plenty of investments without breaking your fiscal rules.

There is one more change to this rule that would probably make more sense than any of the above: changing the five-year deadline to 10 or even 15 years. Over this time horizon, a pound spent on a decent investment will suddenly have a positive impact on the economy rather than being a drain.

Whether Reeves wants to do any of the above ultimately depends on how he wants to start his term. Does she want to establish herself as a tough, fiscally conservative chancellor – perhaps with an eye to resting in her later years? Or does he think it’s more important to start investing early so that some of the potential benefits can become obvious within a decade or so?

There’s really nothing in economics stopping her from choosing either path. It is certainly not a flawed set of fiscal rules.