Voters should be thankful for the fiscal vigilantes

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The Independent Online
One of the achievements of the Major Government has been the doubling of Britain's national debt. Interest payments on this debt are the fourth biggest category of government spending, after social security, education and health.

The debt matters for a variety of reasons but not necessarily in the ways that many people would expect. For instance, the obvious worry - that the nation is building up a liability that taxpayers will eventually have to honour - is a red herring. For one thing, it is a government liability mainly to British citizens, for whom it is an asset in the form of holdings of gilt edged securities. For another, the level of debt is the result of financing past deficits and has to be serviced. It is unthinkable that the British Government should default so we have to grit our teeth and pay the taxes that pay the interest.

A more interesting explanation of why the national debt matters is given in a new book by Francis Cavanaugh, a Washington consultant who used to work at the US Treasury*. The national debt and proposals for a balanced budget have been a hot topic across the Atlantic, where the Federal government had to shut down twice last winter because Congress had not authorised an increase in its debt ceiling.

Mr Cavanaugh argues that stopping the debt from growing any further is a necessary step to restoring public confidence in government. He writes: "Much of the public cynicism about government undoubtedly arises from the fact that for 26 years leaders of both political parties have failed to deliver on their promises to balance the budget.

"Even voters who do not worry much about the deficits conclude that politicians are liars or incompetents because they do not achieve what they [the politicians] say should be achieved."

The same point has been made recently by another American economist, Herbert Stein. "Nothing better reveals the vacuum in economic policy than the gap between the nearly universal statements of aversion to budget deficits and the prospect of exceptionally large deficits as far ahead as the eye can see," he wrote in a paper in 1994.

In other words, the national debt matters because its increase reflects the fact that governments have consistently run big budget deficits, despite telling us voters that big budget deficits are a bad thing.

Despite or perhaps because of their performance shortfall, the politicians' message has become more insistent. Kenneth Clarke, Chancellor of the Exchequer, tells anybody who will listen that his aim is to balance the budget in the medium term.

His Labour shadow, Gordon Brown, tries to outdo him in the toughness of his rhetoric. European governments have started to make heroic efforts to meet the ceilings on deficit and debt set out in the Maastricht Treaty, and are negotiating how to bind themselves to these ceilings after the start of the single currency.

The fashion amongst politicians for the hair shirt raises two interesting questions. Why has fiscal prudence come into vogue? And how will they walk their talk, and put the prudence into practice?

The answer to the first question lies in the power of the financial markets, which have filled the policy vacuum Mr Stein referred to. There have been several episodes during the 1990s of what it has become fashionable to describe as fiscal vigilantism by the markets: a country whose budget deficit has reached alarming proportions finds that its currency comes under attack from speculators.

Calm is restored by a mix of higher interest rates and emergency budget measures. Italy, Spain and Sweden have suffered, for example. Many economists think the weakness of the dollar in the year before the G7 took action in April 1995 was an extended example of financial markets taking fright at a government deficit.

Despite the criticism implied by referring to them as vigilantes, the "speculators" tend not to push matters to a crisis until a government has got itself into very big trouble. There have been more crises because some European governments have got themselves into potentially explosive fiscal problems. It would be useful, in fact, to get a bit more foresight from the markets so they would do their vigilante act well before crisis- point. Even so, they are flagging a useful warning of unsustainable debt creation and future tax increases. Voters ought to be grateful rather than critical.

This home truth explains why fiscal caution has entered the vocabulary of politicians. Ministers of finance are well aware that if they appear to be lackadaisical about their budgets, they run the risk of a run on the currency and an increase in market levels of interest rates. Whether they are genuine converts to deficit reduction or just embrace it in order not to be martyred by the markets, they have to appear to believe.

The more difficult question to answer is how governments will achieve their fiscal consolidation. Yesterday's Green Budget, presented by investment bank Goldman Sachs and the Institute for Fiscal Studies, calculated what a sustainable government deficit would be in the case of the UK.

There are several possible principles of prudence. One is the "golden rule" that the government should only borrow to finance investment. The appropriate definition of investment is open to debate, but roughly speaking, the rule implies a shortfall between revenues and spending of around 1 per cent of GDP.

An alternative principle, stabilising the level of national debt, would allow borrowing of 2.5 per cent of GDP on plausible assumptions about likely growth and interest rates. The single currency is likely to set a permanent 3 per cent ceiling on the budget deficit, which would also imply aiming for about 1 per cent of GDP on average. Mr Clarke's balance in the medium term obviously implies a figure of zero instead.

As the Green Budget ** points out, with the PSBR likely to be 3.3 per cent of GDP this year, there is some way to go. If the Government hits its current spending plans, however, it calculates that borrowing would fall below 2 per cent of GDP in 1998/99 and below 1 per cent of GDP in 2000.

Unfortunately there is good reason to be sceptical about the plans. The three big categories, social security, health and education, are the motors of growth in government spending. Their share of the total has grown steadily. David Walton of Goldman Sachs posed the question clearly yesterday: "The fundamental issue is how the Government's objective of achieving a declining share of spending in GDP can be squared with maintaining the provision of these front-line services at a level and standard that the public expects or needs."

Taxpayers in the rich industrial countries want their government to continue increasing spending on these services, increasing the quality of health care as medical science advances, for example, or making sure there are computers in classrooms. These things have a cost.

This also goes to the heart of Mr Cavanaugh's book, a moral that applies as much to the UK as to the US: politicians can not have the pleasure of spending without the pain of taxing. Their rhetoric has to go one step further and admit that either the quality of public services is safe in their hands but taxes will have to go up, or that taxes can fall further but that means a continual squeeze on health, education and social security.

Both parties give us only one side of the equation in the hope that a long-term improvement in economic growth will materialise to transform the algebra for the better. It is a dishonest formula to put before the electorate.

* "The Truth about the National Debt", Francis Cavanaugh, Harvard Business School Press, September 1996.

** Available from the IFS, 7 Ridgmount Street, London WC1E 7AE, pounds 20. The IFS runs "Be Your Own Chancellor" on its Internet site, http://www.ifs.org.uk.

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