(The views expressed here are those of the author, an investment strategist at Panmure Liberum.) 

In recent decades, poorly designed fiscal rules have forced UK and European Union governments to react to short-term fluctuations in economic growth and interest rates, making it more challenging for them to make the type of sound forward-looking decisions that are likely to enhance growth long term.

What the UK and Europe need now are rules that differentiate between productive government investment and wasteful spending.

In the wake of the global financial crisis and the European debt crisis, the UK, many European countries, and the EU as a group introduced fiscal rules to keep deficits and government debt at sustainable levels. This has done a lot of good in the form of lower borrowing costs and healthier government finances than, say, in the U.S.

But this came at a significant cost. Most European countries that had to reduce their deficits aggressively following the financial crisis have suffered from weak economic growth. That’s because these fiscal rules have often acted as straitjackets, preventing governments from making necessary investments.

Mechanisms that were intended to be pressure valves in an emergency have increasingly been applied as a matter of course. And then in actual emergencies, they tend to be jettisoned. In the last five years, European countries have had to suspend their fiscal rules and debt brakes, first, in reaction to the pandemic, then during the cost-of-living crisis in 2022, and now to finance defence and infrastructure spending.

FIRST DO NO HARM

A rethink is clearly needed.

While the EU and even fiscally prudent Germany are doing just that, loosening their straitjackets to accommodate new realities, the UK insists on sticking to its ill-conceived debt rules. The result is procyclical fiscal policies and government actions that will likely reduce growth.

The UK’s fiscal rules are set by the government of the day and thus change regularly over time. But a common component is always the goal of making sure the debt-to-GDP ratio is lower in the future than it is today.

There are a few obvious problems with this simplistic rule. If growth slows, the projected ratio increases even if no change is made to government spending. In turn, the government must then cut spending or raise taxes to avoid violating its self-imposed rule. Unfortunately, both actions tend to reduce growth even further, making things worse in the long run.

Meanwhile, if growth is accelerating, the government gets more fiscal headroom and can stimulate the economy even more, thus risking overheating the economy.

Indeed, governments tend to max out their fiscal headroom whenever possible. That means spending almost always increases whenever the Office for Budget Responsibility (OBR), the UK’s government watchdog, adjusts its growth forecasts for the next five years.

The shifts needed to violate the rule are also pretty modest. The OBR currently estimates that the government will be in violation of its fiscal rules if projected nominal GDP growth drops by 0.1 percentage points, inflation rates come in one percentage point higher than expected or, most crucially, the average yield on 10-year government bonds increases by 0.65 percentage points more than forecast.

So, in theory, an increase in gilt yields on the scale seen in September and again in December 2024 could determine whether the government hikes taxes. And then there is the margin of error. The OBR’s forecasting errors for GDP and inflation are, respectively, one hundred times and six times larger than the moves needed to force the government into additional austerity.

The current UK fiscal rules are simply unfit for purpose, as they essentially force the government to react to short-term noise in the economy and financial markets. This makes long-term planning and investments in future growth virtually impossible.

As many EU member states are finally recognising, fiscal rules do more harm than good when they do not differentiate between productive investment in infrastructure or R&D and wasteful spending on government consumption.

Governments on both sides of the Channel can make changes. For starters, the UK, and the EU in its growth and stability pact, could either exclude or, at the very least, substantially increase the limits on government investments in infrastructure and defence. Infrastructure investments have been shown to improve GDP growth by more than they cost, while defence spending is the foundation for our continued existence as free and democratic countries.

So governments don’t need to abandon fiscal prudence altogether. They just need better fiscal rules.

(The views expressed here are those of Joachim Klement, an investment strategist at Panmure Liberum, the UK's largest independent investment bank).

(Writing by Joachim Klement; Editing by Anna Szymanski)


Reuters