A useful but modest step forward on fiscal management

A year ago the Minister of Finance gave a pre-Budget speech in which he restated the fiscal rules Labour and the Greens had campaigned on.  Among them

We will reduce the level of net core Crown debt to 20 percent of GDP within five years of taking office.

Here was what I said at the time

In general, debt targets –  with relatively short time horizons to achieve them –  aren’t very sensible as operational rules.   Such a rule can mean that a few fairly small, essentially random, forecasting errors in the same direction can cumulate to produce a need for quite a bit of (perhaps unnecessary) adjustments to spending or revenue.  More seriously, recessions can throw things badly off course for a while, and risk pushing a government into a corner –  either abandon the target just as debt is rising, or fallback on pro-cyclical (recession exacerbating) fiscal adjustments –  even though, in across-the-cycle terms, the government’s finances might be just fine.  No one looks forward to a recession, but governments (and central banks) need to work on the likelihood that another will be along before too long.   Natural disasters –  the other shock the Minister mentioned –  can have the same effect.

I see I omitted to mention that other pro-cyclical fiscal risk that a (point) debt target exacerbates: the temptation to spend up further in good times to keep debt from undershooting the target.

And so I am pleased see reports today of another pre-Budget speech from the (same) Minister of Finance, in which he said

The Government will scrap specific debt targets in favour of moving towards a target range, Finance Minister Grant Robertson has announced.

The current target, part of Labour’s Budget Responsibility Rules, is to reduce net debt to 20 percent of GDP by 2021/22. When that target is achieved, it will be replaced with a debt range.

Robertson did not specify what this was, but said Treasury had provided him with advice.

“At this point we are looking at a range of 15-25 percent of GDP, based on advice from the Treasury,” Robertson said.

Does it create risks?  Yes, it does, and that is why I would still favour dropping debt targets altogether.  There will be increased pressure for more spending up front.  But, operated responsibly, the proposed new debt-range provides only trivially greater amounts of flexibility.    Why?  Because no one ever expects the government will keep debt/GDP at a constant point every single year, but if they take the new range seriously people will expect them to keep within the sort of range all the time.  It is wide enough, it should be able to encompass the effects of most booms and busts, but only if in normal times debt/GDP is kept close to the midpoint of the range.  You probably give yourself a degree of freedom to have debt fluctuate between 19 and 21 per cent in normal times, but you always have to remember that a recession could be along any time.  A couple of years in which revenue is 2 percentage points of GDP below average and you will be on course for the top of the debt target range pretty quickly if your starting point is anything much higher than 21 per cent.  Tax revenue as a share of GDP fell from 31 per cent in the year to March 2006 to 25 per cent in the year to March 2011, and (a) while the economy started from a materially positive output gap, and (b) there were some tax cuts, a fall of a couple of percentage points of GDP is easy to envisage, and necessary to plan around.

My own preferred approach, without a debt target, is as I outlined it last year.

Personally, I would be much more comfortable with only two key quantitative fiscal rules:

  • a commitment to maintaining the operating balance in modest surplus, once allowance is made for the state of the economic cycle (cyclical adjustment in other words) and for extraordinary one-off items (eg serious natural disasters), and
  • something about size of government.    Simply as an economist I don’t have a strong view on what the number should be, although as I’ve noted previously it is curious that the current left-wing government, arguing all sorts of past underspends, was elected on a fiscal plan that promised spending as a share of GDP that undershot their own medium-term benchmark (that around 30 per cent of GDP).

The suggested fiscal surplus rule isn’t an ironclad protection (any more than a real-world inflation target in a Policy Targets Agreement is).  There are uncertainties about the state of the cycle and how best to do the cyclical adjustment, and incentives to try to game what might be counted as an “extraordinary one-off”.   That is why the fiscal numbers and Budget plans will always need scrutinising and challenging.  But if followed, more or less, such a rule would be sufficient to see debt/GDP ratios typically falling in normal times, and to avoid things going badly wrong over a period of several decades.  That is probably about as much as one can realistically hope for.

The focus would be on the first of those, the structural balance rule.

Part of the necessary scrutiny and challenge would be provided by that fiscal council the government consulted on last year, but about which nothing has been heard for months.

2 thoughts on “A useful but modest step forward on fiscal management

  1. Such budget responsibility commitments and debt level rules are simply virtue signaling. The proper tests are surely around the purposes of taxation (why tax and in what way?) and Government spending (why spend the money and for what purpose?).

    In a country with no constitutional constrains and statutory freedom to pass any laws Government wants, fiscal restrictions of any kind are not only useless and able to be overturned, but may have an unintended outcome of restricting spending which adds value to the economy as much as they may restrict wasteful spending.

    Money available to be spent by Government must be financed by taxation revenue, borrowing, or available money reserves. In a world of fiat currency and limited or no external borrowing by Govt, the only constraint on Government spending is that it leads to exceeding an “accepted” level of inflation.

    If monetary policy is ineffective in increasing inflation to the “accepted” level, Government spending (financed by “borrowing” from the Reserve Bank at zero interest for an indefinite time), can be used to ensure the money supply is maintained at a sufficient level to maintain “full” resource use (employment). i.e. in recession times, if Banks don’t create money (or actually destroy it as people save and repay loans) using the Government to create money keeps the economy active. [Michael I think that this form of fiscal QE is the only answer to what plan or policy does the RB have to stimulate the economy when interest rates are at the lower bound (0) – i.e. it doesn’t have one. it just won’t say so].

    Our only overall concern should be that the spending by Government contributes to and encourages productive activity growth, so that the level of income per capita grows and people’s financial wellbeing (does anyone think this is not important to their emotional wellbeing?) improves. – otherwise we are going nowhere or backwards as you keep reminding us!

    The message for me is to worry about better metrics to link Government spending to productivity and per capital income growth outcomes. Wellbeing metrics and debt limits are just a diversion.


    • It is not appropriate to refer to interest rates at zero bound when real residential Overdraft interest rates which most of our small businesses rely on is still closer to 5.85%. Commercial Overdraft interest rates are still around the 7% to 9% mark. No where close to zero bound interest rates.

      Part of the reason is the still heavy handed use of macroprudential tools such as equity restricted LVR at 35% which limit bank credit to small businesses.


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s