Why fiscal rules matter: growth

Last week I discussed the importance of good fiscal rules for sustainability, but the recent mess in the UK has demonstrated how poor rules can inhibit growth. When the Government took office in 2010 it faced a startlingly high deficit. It promised to eliminate that within five years, which happens to be the length of a Parliament in the UK. That’s probably not a coincidence. As Portes and Wren-Lewis point out in their paper, Governments like operational targets that they can achieve within their term of office. If you face a big hole in your budget then promising to fix it within the decade is no good if you might only be in power for half that time.

That has important consequences for the way surpluses and deficits are dealt with. It means that governments tend not to save surpluses beyond their term because they reap little benefit from it. They also attempt to close deficits within the term, which can be too rapid when the deficit is large. The recent recession in the UK is a textbook example of the latter problem. Faced with a deficit exceeding 10% of GDP, the Government sensibly altered their plans to reduce it. However, the five-year planning horizon of their term in office induced them to attempt to close it far more rapidly than would be ideal. The immediate cost was a reduction in aggregate demand just as monetary policy was losing steam. The chart shows two estimates of the cost that imposed on the UK’s output. Over the three years charted that probably amounts to a cumulative £3,500 per household.

The real costs of poor, short-term fiscal rules are twofold: they enable governments to avoid the challenge of long-term fiscal sustainability, and they encourage them to pursue damagingly rapid fiscal adjustments. An effective rule needs to solve both of these problems. It must bring the long-term challenges into focus for the current administration, but it must give the government the leeway to solve them over decades, not years.