In a previous post I talked about why it made sense to keep the form of the current government’s fiscal mandate, although the five year rolling target should involve the deficit rather than the cyclically adjusted current balance. But what about actual numbers?
I start the analysis in financial year 2015/16, with the OBR’s forecast for headline public sector net borrowing (hereafter the deficit) of 3.8% of GDP. Let us also assume that the debt to GDP ratio at the beginning of that financial year is a nice round 80% (the OBR’s forecast is slightly less). That is the deficit and debt that any new government will inherit. Let us also assume that by that time interest rates are above the Zero Lower Bound (ZLB) and are more likely to rise than fall back to the ZLB. That is by no means certain, and in my view it is critical. If interest rates are still stuck near zero, fiscal policy should be aiming to speed the recovery, not reduce the deficit.
A deficit of 3.8% is too high to start bringing public debt down, and the analysis outlined here or here suggests it makes sense to bring debt down. So the key question is simply - how fast should the deficit and debt fall?
Year | Slow | Medium | Fast | Osborne |
2015/16 | 0.038 | 0.038 | 0.038 | 0.038 |
2016/17 | 0.036 | 0.034 | 0.032 | 0.022 |
2017/18 | 0.034 | 0.03 | 0.027 | 0.009 |
2018/19 | 0.032 | 0.028 | 0.022 | 0 |
2019/20 | 0.031 | 0.026 | 0.018 | 0 |
2020/21 | 0.03 | 0.024 | 0.015 | 0 |
2025/26 | 0.025 | 0.015 | 0.005 | 0 |
2030/31 | 0.02 | 0.01 | 0.005 | 0 |
2040/41 | 0.01 | 0.005 | 0.005 | 0 |
Long run D/Y % | 25% | 12.5% | 12.5% | 0% |
Alternative paths for the deficit to GDP ratio
Economic theory only really tells us one thing on this question: deficit reduction should be fairly slow, if there is no danger of default. So in the table above I look at four possible paths. In the ‘slow’ path, the target for the deficit 5 years ahead made in 2015 would be 3% of GDP. If we make the assumption that long run growth in nominal GDP is 4% a year, then maintaining a 3% deficit would stabilise the debt to GDP ratio at 75% of GDP. I think that is still too high, and for various reasons it is good to plan for a steady fall in the debt to GDP ratio over the next few decades. So the slow adjustment path involves a steady but slow reduction in deficits to 1% of GDP by 2040, which if maintained would eventually stabilise the debt to GDP ratio at 25%. The path of debt, assuming 4% nominal growth each year, is shown below.
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| Alternative paths for the debt to GDP ratio, assuming 4% nominal GDP growth |
This ‘slow’ path is much slower than anyone is currently talking about, but I’ve included it just to make the point that it should be an option that is on the table and seriously considered. It gets debt down to a smaller share of GDP than at any time in the UK over the last two hundred years. It may do so too slowly, but it is important to discuss why it is thought to be too slow.
The path labelled medium is more ambitious in two respects. First, the five year target made in 2015 is a deficit of 2.4% of GDP rather than 3%, so the pace of deficit reduction from 2015 is more ambitious. Second, the target is an eventual debt to GDP ratio of 12.5% of GDP. So the deficit is steadily reduced to 0.5% of GDP. However both of these paths fail to noticeably reduce debt by 2020 compared to 2015. (With 4% nominal growth, and starting with debt to GDP at 80%, the deficit needs to be below 3.2% for debt to start falling).
The ‘quick’ path involves a deficit target of only 1.5% by 2020, and further reductions so that the deficit reaches its steady state level by 2025. However I assume for this path that the desired long run debt level is the same 12.5% of GDP as on the medium path. If public investment stays at around the 1.5% of GDP mark projected by the OBR, then the 2020 figure for the deficit would correspond to achieving current balance by that date.
The final path, labelled Osborne, involves the OBR’s forecasts for the deficit under current plans for 2016 and 2017, and a zero deficit thereafter. This brings debt down much more rapidly, and with a zero deficit the debt to GDP ratio steadily tends towards zero. I cannot see any logic to such rapid deficit and debt reduction, so it seems to be a political ruse to either label more reasonable adjustment paths as somehow spendthrift, or to continue to squeeze the welfare state. What it already seems to have done is shift the opposition's position towards the fast adjustment path.
Labour’s current commitment is to achieve a current balance surplus as soon as possible, and certainly by 2020. If public investment stays at around 1.5% of GDP, that would correspond to the fast path above or even faster. It is less clear what the LibDem plans would be, either in terms of numbers or rules, although Giles Wilkes suggests here that they are broadly similar to Labour's plans.
There is nothing complicated in all this - anyone can produce similar numbers on a spreadsheet. Yet they really matter. As Giles Wilkes and also Steven Toft note, achieving deficits of the kind shown on the fast path will be very painful unless growth is very strong. So where is public debate about which path is more desirable? I guess it went the same way as the public debate over austerity. As Aditya Chakrabortty aptly observes, the fiscal policy debate at Westminster is in danger of becoming like Monty Python's Four Yorkshiremen sketch.
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