Hamish McRae: Tories have chance to make history

Economic Life: In a generation's time, governments may not even have the sole power to determine tax levels
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The Independent Online

Will there be a "Bank of England moment" for the Tories when they take office? Just as Labour gave the Bank independence to set monetary policy, will the Tories give their new Office for Budget Responsibility the independence to set fiscal policy? Or to put the question negatively: what will be the real sanctions that the new office will have over the Government, should the latter fail to behave responsibly?

The scale of the fiscal catastrophe is gradually sinking in. As the work of the Institute for Fiscal Studies makes it clear, even on the Government's own (I think rather favourable) assumptions, we face a squeeze on public spending that will be unprecedented in peacetime. I don't think most people quite understand what is inevitably going to happen or quite how dreadfully things have gone wrong. The disaster requires two different types of response. It has to be fixed and there is no escaping that. But I want to deal here with the longer term: we also have to figure out a way of stopping it happening ever again.

Clearly, something has to be done to rebuild confidence in the public finances, as this present Government is the first to admit. Alistair Darling referred to its proposed Fiscal Responsibility Bill, which would make cutting the deficit a legal requirement on the Government, in his pre-Budget report speech. But back in 1997 when Gordon Brown made the Bank independent, he also brought in the "golden rule" for fiscal policy, designed to make sure that the Government borrowed only for investment and not for current spending. And we now know that this particular mechanism failed.

We'll come to the reasons why in a moment, but first think back to the reasons for giving the Bank the freedom to set interest rates. There had been a global collapse of monetary discipline following the end of the Bretton Woods fixed exchange rate system. When the world moved to floating rates in the 1970s, that removed a powerful downward force on inflation, with the result that the world experienced the most serious burst of inflation in recorded history.

It was far worse than the previous worst global inflation, the one that followed the discovery by the Spaniards of gold and silver in North America, for prices rose roughly 10-fold in two decades, compared with four-fold over a century. Britain had a particularly bad experience of inflation, worse than most large developed countries, but the phenomenon was a global one.

Rebuilding monetary discipline took two decades. The principal weapon was interest rates and different countries used different frameworks to set them. The UK used monetary targets after the International Monetary Fund's emergency loan in 1976, and these were developed in a slightly different form in the 1980s. We then shifted to an exchange rate target when we joined the Exchange Rate Mechanism, but that ended in tears. So we switched to an inflation target and that framework subsequently was taken on by Labour to form the basis for the present structure. Note something really important: there was a continuity of policy between the different governments.

Other countries also followed some similar mix of disciplines: money supply targets, exchange rate pegs and inflation targets. Collectively, the developed world had re-established monetary discipline by the mid-1990s and that discipline gradually spread through most of the emerging economies too. There was, however, another failure. Because the monetary authorities focused on controlling current inflation – the price of goods and services – they failed to pay sufficient attention to asset inflation, in particular the price of residential property. That should be a good lesson against complacency.

The world is now with fiscal policy in pretty much the same position as it was in 1976 with monetary policy. We have a collective failure, the greatest surge in fiscal deficits that has, as far as I can check, ever occurred in peacetime. Some countries in the worst mess – Ireland, for example – have already begun to take corrective action. We will have to start next year. But the world does not have a common framework for setting policy. We know some things don't work. These include most constitutional arrangements that are at present in place. Our fiscal rules have failed. The Maastricht Treaty has failed, with Ireland, Greece and Spain all in pretty much the same mess as we are in. The US legislature's bodies, the Congressional Budget Office and the Joint Committee on Taxation, have failed too, for America has almost as large a deficit relative to the size of its economy as we do.

So, there will have to be a global debate about what is to be done. Different countries will take different paths. For example, Germany has just introduced a new constitutional fiscal rule that will limit the structural deficit of the federal government to 0.35 per cent of gross domestic product from 2015 onwards and will require balanced budgets for the regions by 2019. We will presumably have the Tories' Office for Budget Responsibility. But it would be naïve to expect these arrangements to work straight away. The experience of tackling inflation shows that it takes an age to correct policy errors and even when all seems hunky-dory you may get a nasty surprise.

As far as the UK is concerned, I think we can dismiss Labour's Fiscal Responsibility Bill as a useful model. It has been tried elsewhere, for example in Nigeria, but I don't know how legislation helps a government to achieve an aim when political will is lacking. And that has been the problem with the present Labour government. What actually happened is almost invariably worse than was predicted.

If you look for example at the latest year for which we have full actual figures, 2008-9, back in 2003 Gordon Brown predicted a deficit of just over £20bn. Gradually, the predictions worsened so that by the Budget last year the predicted deficit had risen to nearly £40bn. In the last pre-Budget report in November last year, already half-way through the year, it was nearly £80bn. By the Budget this year it was more than £90bn. And we were told this week that the outturn last year was even worse still, at nearly £100bn.

And it goes on. The Chancellor revised the projected deficits for this year and next only very slightly upwards, but most independent forecasters think he is being too optimistic. We can't go on like this.

So might the Office for Budget Office Responsibility do any better? It certainly could not do worse, and the appointment this week of Sir Alan Budd to chair it is an excellent start. But a bright and bushy-tailed Gordon Brown started out in 1997 with similarly high intentions. A paper this week from the Social Market Foundation, an independent think-tank, ponders whether the new body will have the necessary political legitimacy to endure. Instead, the foundation calls for the process of making fiscal projections from the Treasury and handed to an independent body protected by the national statistics code.

There is a genuine democratic issue. To what extent should it be within the authority of an elected government to determine how much it should borrow? My own view is that it should be required to take into account the interests of people who don't vote, in particular children and even the unborn. Ideas change. A generation ago, it was regarded as normal for a government to take interest rate decisions. Hardly anyone advocates that now.

So maybe, in a generation's time, governments will not even have the sole power to determine tax levels. That decision will be shared with some other constitutional body and arbitrary changes will be declared illegal. But we are not there yet, as we have learnt this week.

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