Please note that this is BBC copyright and may not be reproduced or copied for any other purpose. RADIO 4 CURRENT AFFAIRS ANALYSIS BENDING THE GOLDEN RULE? TRANSCRIPT OF A RECORDED DOCUMENTARY Presenter: Diane Coyle Producer: Zareer Masani Editor: Nicola Meyrick BBC White City 201 Wood Lane London W12 7TS 020 8752 6252 Broadcast Date: 11.03.04 Repeat Date: 14.03.04 CD Number: PLN 409/04VT1009 Duration: 27’23” Taking part in order of appearance: Kenneth Clarke, M.P. Former Chancellor of the Exchequer Ed Balls Chief Economic Adviser to the Treasury Bridget Rosewell Chairman of Volterra Consulting Former Adviser to the Treasury Sir Alan Budd Provost of Queen’s College, Oxford Former Chief Economic Adviser to the Treasury Laura Tyson Dean of the London Business School Former Chief Economic Adviser to President Clinton Gerald Holtham Chief Investment Officer of Morley Fund Management Robert Chote Director of the Institute for Fiscal Studies Katinka Barysch Chief Economist at the Centre for European Reform COYLE: Next week’s Budget could mark a turning point for the Chancellor of the Exchequer. Gordon Brown has always made prudence his watchword. But he’ll end up borrowing around £37bn this financial year, and some critics believe he’s losing his grip on the government’s finances. Among them is Kenneth Clarke, his Conservative predecessor as Chancellor. CLARKE: For his first couple of years, Gordon was the ultimate iron chancellor. Then of course, perversely, as they got more confident and as they won the confidence of the city, from about 2000 onwards they completely changed tack. And I’ve been very critical of Gordon ever since then for being irresponsible and profligate and steadily getting the public finances into a worse state. BALLS: We are showing that you can deliver stability in the economy and have strong public services. I think it would have been unthinkable in Ken Clarke’s time to have the lowest level of unemployment since the early 1970s, to have the lowest level of interest rates for mortgage payers since the early 1970s, and to have the lowest level of debt interest payments on the national debt since I think 1913. COYLE: Ed Balls, the Chief Economic Adviser to the Treasury, and one of the main architects of the rules Gordon Brown set himself for keeping government borrowing under control. BALLS: We set out clear fiscal rules which we stuck to every year for the longest period of a sustained and stable fiscal framework in Britain in the post-war era. We repaid more debt in one year – 99/2000 – than all the debt repaid cumulatively by all governments between 1945 and 1999, the result of which is that we have the lowest level of debt of any of the large industrial countries. COYLE: Prudent or profligate? The strongest government finances amongst the major economies - or a widening gap between public spending and the tax revenues available to pay for it? In 1997 many people expected the first Labour Chancellor for 18 years to announce big increases in expenditure on services like health and education. But Gordon Brown insisted he’d stick to the tight spending plans Kenneth Clarke had already set for the next three years. And in case anybody still doubted his toughness, he introduced new rules for the public finances, in addition to those already imposed on EU countries by the Maastricht treaty. The Chancellor’s golden rule says the government can only borrow money for investment, or capital spending. Taxes have to raise enough to pay for its day to day spending and running costs. He also brought in a second rule to limit the amount of this borrowing. Former Chancellor Kenneth Clarke’s rule just said the government had to balance its budget over a number of years. CLARKE: Gordon altered the rules for the sake of it really. His public spending rules – the golden rule and all that kind of thing – were also splendidly flexible. I mean they were looser than mine. The golden rule is what you make it to mean. It’s anybody’s guess what you really count as capital spending and what you count as current spending. And so despite his tough two years, he’d got himself a more flexible set of rules when it came to launching on his spending spree, which he did. COYLE: Do you think he’s actually going to break his own rules with this spree? CLARKE: I think he’s going to break even his own rules. He’s produced his red books with the figures for the public finances in a pretty generous, slightly obscure fashion, and he’s still going to break them. And he’s also going to break the one thing that he and I used to joke at the expense of the rest of the House of Commons because we both agreed with it – he’s going to break the Maastricht rules as well. He’s about to go through the 3% of GDP limit on fiscal deficits. I always took the view of the Maastricht limit that it was perfect commonsense for any Conservative chancellor and that I couldn’t conceive of any Conservative chancellor ever wanting to go above 3% of GDP. Well we all know that Gordon’s about to sail above that. COYLE: The Maastricht rule, which applies to all member countries of the EU, says the government shouldn’t borrow more than 3% of GDP in any single year. Britain has now joined France and Germany in breaching this limit, although in our case only by a fraction of a percent. But how much does slipping the restraint of all this fiscal bondage, and missing any of the targets, really matter? Economist Bridget Rosewell is chairman of Volterra Consulting and a former adviser to the Treasury. ROSEWELL: I don’t think it really matters from a sort of economy point of view whether it’s missed by a little bit. I think it does matter from, if you like, a political economy point of view in the sense that Gordon Brown has hung his hat on meeting these particular targets and he looks weak, inadequate if he misses them. COYLE: And if he does lose credibility by missing them, is that actually harmful for the rule itself and his ability to run a tight fiscal policy in future? ROSEWELL: Yes, I think it is. Losing credibility is the sort of worst thing you can do if you’re a chancellor really. So I think it weakens the whole status of the Treasury if putting in place these rules and at the sort of first test, the first hurdle you fail – I think that’s actually quite significant. COYLE: But it does seem very hard for politicians to stick to any kind of rule that means they keep spending in line with tax revenues because we see this not only in the UK but in other countries too. ROSEWELL: All rules will always have exceptional clauses. If things go wrong, if there are unexpected shocks, you should be able to have some flexibility around that. The rule which Gordon Brown has given himself is over a cycle. This says that he needs to balance his taxes and revenues over that cycle. I think the worry is that he risks breaking his rule in a period where there has not been a recession, so his difficulty is that he had his spending plans and although the economy is keeping growing it is not generating the tax revenues which enable him to meet his rules. That is a more structural worry and he’s right to be very concerned about it. COYLE: It might sound a bit like a circus trick, but there are good reasons for this cyclical balancing act. When there’s a recession, government spending automatically rises because of higher unemployment, and tax revenues automatically fall because incomes and profits are down. So even if the Chancellor does nothing, borrowing will rise during a downturn – and should just as inevitably fall when the economy’s growing fast. This is why the golden rule is meant to average out the good times and the bad. Sir Alan Budd, Provost of Queen’s College, Oxford, was Chief Economic Adviser to the Treasury from 1991 to 1997. BUDD: The idea of the business cycle is that it allows you to borrow more when the economy is in a recession and less when it’s booming, and that is very, very sensible otherwise you’d be raising taxes and cutting public expenditure as the economy was turning down. There’s no sense in that at all. So I think that idea that’s embodied in balancing over the cycle is sensible, but it does cause difficulties in knowing whether you’re succeeding or not because of the difficulty of knowing when a cycle begins and ends. And there’s also a risk, which is a current risk, that you may over a cycle balance, if you take all the years together, but start with a very large surplus and end with a very large deficit. So though you’ve met the rule, you’ve actually left yourself with a position which is not sustainable. COYLE: Is that the situation we’re in now? BUDD: There is a risk that that’s how we will be; that if we do balance over this cycle, it will be because we started with a large surplus and end with a rather large deficit. And so that means that if you look ahead something has to be done about the current balance between spending and taxation. And you can only stop worrying if you believe that this deficit is not so much cyclical as temporary. In other words, that it’s partly a matter of expenditure being very high because of such matters as the Iraq War and other rapid increases in some forms of social expenditure, and the revenues are low for reasons we don’t quite understand, but you hope that they will come back to normal before too long. COYLE: It isn’t only in Britain that some people are starting to get worried about going into the red. Some other big economies in the so-called G7, the rich industrial countries, are facing the same problem. Kenneth Clarke sees this as a dangerous change in the international climate. CLARKE: The mid 1990s were a time when most of the G7 were on their way to steady growth with low inflation and keeping there. The governments of John Major, Bill Clinton, Mitterand, Kohl were producing pretty good economic results. And now, I think, the American, British, French and German governments are in the hands of totally irresponsible people who keep persuading themselves - and then their public - that somehow it doesn’t matter that you try to solve every problem by spending public money and that your deficits soar. I do worry whether this is sustainable and what the different major economies are going to do to get themselves out of the fiscal problems they’re piling up. COYLE: If they don’t, and we are in a situation where all these major economies have large deficits, what do you see the consequences being? CLARKE: Well they’re bound to have the effect, at the very least, that growth will be less than it otherwise would be. I mean what happens if you pile up public borrowing too high, particularly if it coincides with a time when – as in America and the United Kingdom – private household borrowing is going too high, is it drives up interest rates and it drives up taxation. And the effect of both of those is that it slows down growth and, if it goes too far, in the end it works through to people’s day to day lives, and if you get it completely in a mess you start getting a recession. COYLE: When he became Chancellor in 1993, Kenneth Clarke inherited a budget deficit he thought had reached crisis levels. He decided to increase taxes and limit public spending. At about the same time, across the Atlantic, Laura Tyson, now Dean of the London Business School, became President Bill Clinton’s chief economic adviser. She too had to grapple with a stubbornly large government deficit. TYSON: The structural problem, it was thought, endangered economic prosperity in a couple of ways: one, by squeezing out private investment over time through higher interest rates; and by increasing US dependence on foreign lending to the United States. So if you believe the numbers that we’ve had something like – and the numbers keep getting larger – a ten trillion dollar shift from five trillion of surplus to five trillion of deficit, or a recent number I saw was more like twelve trillion over a decade, well you can figure out using those numbers what the reduction in investment would be – about half of that – and what the additional foreign lending to the United States required to finance the larger current account deficit would be. And then you say alright do we want to set ourselves in a trajectory where we have to depend even more on the rest of the world’s savings. COYLE: And it affects the rest of the world too, does it, because we also get higher interest rates, America being so large in the global markets? TYSON: Yes, that would be the case. I mean the estimate now is that this could mean a percentage point on US … on global interest rates, so that’s a lot. And it really does come from the fact that the US is such a large player in terms of absorbing global savings. It’s almost … You could liken it to a foreign aid programme for the United States whereby the central banks of Asia accumulate these dollar assets to the tune of two and a half percent of the world’s GDP outside the US, and the US, as a consequence of the accumulation, can continue on a low interest rate trajectory, which it’s on right now, and finance this huge savings gap. COYLE: This is in stark contrast to the healthy state in which Laura Tyson and Bill Clinton left the American government’s finances, with a very large budget surplus. Now the rest of us are financing a huge American deficit - and for the privilege we’re paying much more for our own mortgages and business loans, because global interest rates are higher than they might otherwise be. In theory, the more governments borrow, the smaller the pool of funds available for private sector borrowers and the higher the cost of borrowing for everybody. America calls the tune in the world economy. But what about the much smaller British government debt, which is currently 34% of GDP? Is that pushing up our interest rates too? Not according to Gerald Holtham. He’s chief investment officer of Morley Fund Management, one of the biggest investment firms in the City of London. HOLTHAM: Our debt ratio’s around 34. You can hardly find a country with a lower debt ratio than that and you can hardly find a country with higher interest rates than that. Most of the Europeans have got much lower interest rates. The world capital market is one place government has to do something quite extraordinary to push its own interest rates out of line with others. And if we’re going to see a generalized rise in interest rates around the world, it will be either because the world economy’s picking up and short-term interest rates rise or because there’s such a general loss of discipline if you like by global governments that the government debt to GDP ratio for OECD countries as a whole goes up. That’s what it would have to take. COYLE: But if any one country can have almost no effect on its own interest rates through its own government borrowing, why on earth are people worrying about the level of government borrowing at the moment? HOLTHAM: Diane, you’ve got me. I think the real reason is that there is quite a lot of genuine concern about whether the increased government expenditure in this country is well spent. I would assert that if, if those concerns are baseless and that in fact this money is being well spent, there is no macroeconomic reason why it shouldn’t continue for quite a long time. ROSEWELL: What you need is proper procedures inside government to decide what sort of investments are valuable and what are not. COYLE: Economist Bridget Rosewell is advising the Mayor of London on how to do just that. ROSEWELL: An example, something that I’m concerned in a lot at the moment, is the Cross Rail project for London Transport which would relieve pressure on London’s transport system, which is creaking and groaning at the seams, and which will generate benefits, including more jobs, more tax revenues for government. If you do any of the calculations, you would say that it has if you like a financial return which will over a long period pay for itself – just in tax revenue terms. COYLE: So you’re saying we’re just not very good at figuring out what the benefits are, what the value for money is in what the government invests in? ROSEWELL: I think that’s right. I think that we’re not very good at thinking about what is a benefit and how we would measure it in monetary terms, in tax revenue terms. I think we’re not very good at measuring what if you like a non-monetary output is likely to be like the output of the education system, for example, or indeed the health system. COYLE: The golden rule, remember, allows the government to borrow money in order to invest. But it doesn’t set the criteria for deciding whether or not any particular investment will be good value for money or tell us which investments to choose. So is there much point to having the golden rule? Robert Chote is the director of the Institute for Fiscal Studies. CHOTE: If you have an investment that future generations are going to benefit from, then it’s reasonable that they should pay some of the cost; and one of the ways you might do that is for the government to invest, to take on debt and then for future generations to help repay it. And so the golden rule is about … basically about fairness. But the government judges that by saying: “Is this particular piece of spending, does it count as an investment according to the national accounts”, those are international accounting standards. So, for example, under those rules the millennium dome is an investment but spending on teachers’ pay isn’t. But it’s not clear that if you think what’s going to benefit future generations more, that teachers’ pay might well be more beneficial than something like the millennium dome or paying for new facilities to host the Olympics. And so in that sense, it’s only at best a good rule of thumb, a reasonable guide, and it’s not an optimal one. COYLE: It certainly seems fair to make our children pay something towards the benefits they’ll get from money the government spends today. But what about the Chancellor’s second rule, known as the sustainable investment rule, which limits government borrowing, even for good investments, so that the national debt never climbs above 40% of GDP? What’s so magical about that number? CHOTE: Too much borrowing is when the financial markets start to get worried about it, so that’s a slightly moving target. Certainly if you look at the amount of debt that governments build up, that is hard to say whether a particular target – and the government here says that debt shouldn’t rise above 40% of national income – there’s no good underlying, theoretical reason why it should be 40%, 50%, 30%. You can look internationally, you can look historically and say: “Well, have countries tended to get into trouble at that sort of level?” And they haven’t really. COYLE: Still, our rules are more flexible than a strict ceiling applied each year, like the Maastricht 3% of GDP limit. France and Germany have both breached that level in the past year. And what’s more, they’ve decided they won’t even try to get back below it for the forseeable future. Is there any point in having such a tough rule if it’s not enforced? Katinka Barysch is chief economist at the Centre for European Reform. BARYSCH: There are countries in the Eurozone that have much higher public debt and that have a history of instability in their public finances. And obviously we’re getting new members into the European Union and eventually into the Eurozone. That’s why we need the rules. And it was the Germans and the French, to a lesser extent, who initially wanted the rules to impose discipline on the other countries, not so much on themselves. COYLE: It’s ironic indeed that most of the smaller EU countries have stuck to the Maastricht rules, while Germany and France have failed to live up to the fiscal discipline which they helped formalise for the Eurozone in what’s known as the stability and growth pact. The excuse is that economic growth has recently been so weak that it would have been the wrong time to reduce budget deficits. BARYSCH: They should have reduced their deficits when the going was still good. Until about three, four years ago, we actually had fairly good growth rates in the European Union and these countries probably should have used that time to tighten the purse and start saving for a rainy day. That’s exactly what the stability and growth pact says – you should balance the budget if the going is good. And Germany and France and also Italy did not do that. They didn’t tighten the purse strings. They continued borrowing and spending, and then when the economy went down and these economies came close or actually went into recession, their deficits were already quite close to 3%, so then they had no room for manoeuvre left. And that’s why they then found themselves in a position to have to tighten fiscal policy at a time when the economy was weak, which is not very good for growth. COYLE: While they’ve only got themselves to blame, it’s easy to see why the French and German governments decided to suspend the Maastricht rule. The alternative would have meant raising taxes or cutting public spending at a time when that was the last thing their economies needed. It obviously makes sense to avoid reducing government borrowing if that’s going to make a recession even worse. But does that mean governments should go further and deliberately use fiscal policy to boost a weak economy or cool down one that’s overheating? Not often, according to Bridget Rosewell. ROSEWELL: Fiscal policy’s hard to use for fine- tuning; you can’t make sort of little tiny adjustments in taxes as you can in interest rates. You have to change systems to collect taxes. And say you change the VAT rate, everybody’s got to recalculate and there’s the huge administrative burden of all of that. On the other hand, there are certainly circumstances where you might well say that an imbalance is such that you would want to put some fiscal policy into the mix, that there isn’t enough movement in monetary policy. Particularly if we have low and relatively stable interest rates because inflation is very low, you might get less ability to move that. So that in Japan, for example, where they’ve had a long period of very low growth, it’s been quite hard to use enough monetary policy because interest rates are practically zero in any case, and there fiscal stimulus might become important. But it’s more a sort of … it’s the big stick when you’ve run out of everything else really, rather than it’s a regular tool. COYLE: Few economists would disagree. In the past it was common for governments to try to fine-tune economic growth by adjusting the level of their own borrowing – so common it had a name, Keynesianism, after the famous economist John Maynard Keynes. But the administrative burden wasn’t the only difficulty. As Katinka Barysch reminds us, Keynesian fiscal management only ever worked in one direction, and that was inflationary. BARYSCH: The other problem that we found with Keynsianism was that politicians have a very short horizon which normally lasts until the next election, so they couldn’t be relied upon to then make savings when growth picked up again. There is a case to be made to bind politicians’ hands because our experience seems to be that if we just leave budgetary spending to the political cycle, it tends to go off the rails. So we have rather good experience in some countries with national fiscal rules, the politicians are binding their own hands, and if their voters come along and their trade unions and their interest groups and say we want more money for this, that and the other, they can say: “Well, I don’t have that money, my hands are tied, we have fiscal rules, I need to stick to them.” And on a national level, that seems to work quite well. And in theory it should work even better at the European level where there is a certain amount of peer pressure and surveillance between the countries. COYLE: But the trouble is, it hasn’t worked at the European level. The politicians have had their way. BARYSCH: We don’t actually quite know whether it has worked or not. It might well be that if it wasn’t for the stability and growth pact, the German and the French government budget deficits might actually be much larger than they are at the moment. They’re not huge – they’re between 3 and 4% of GDP. That’s actually not massive. There is a case to be made that the rules have actually worked to a certain extent; that the governments would have borrowed even more had it not been for the pressure that the other European countries have put on them. COYLE: A sobering thought for French and German taxpayers. But there’s a real dilemma here. Whatever the rules, whether the strict European version or the flexible British one, government borrowing is creeping up in most of the G7 countries. Does this tell us that fiscal policy should be taken out of the political arena and handed over to independent experts? After all, this Government’s decision to give the Bank of England the power to set interest rates has been judged a huge success. BUDD: The government can’t possibly delegate the task of raising and spending money. That more or less defines a government. The best it can do is perhaps delegate the authentication of the numbers it’s producing. COYLE: Sir Alan Budd. BUDD: I sometimes feel it would be a reasonable rule that the government’s finances are only sound if external forecasts say that they are sound. At the moment we are relying on the government’s own forecasts of its own financial future, but it is inherently worrying if the finances only look right on the government’s forecasts which turn out to be more optimistic than everybody else. So the question is whether there is some way of setting up an authoritative body to look at those forecasts or even produce its own forecasts, and it’s against those forecasts that the government should be judged. COYLE: The Treasury’s forecasts have tended to be more optimistic than anybody else’s. In the 1980s and early 90s this optimism proved to be unjustified, but since then it’s usually turned out to be more accurate. Ed Balls, as Chief Economic Adviser to the Treasury, now does the job Alan Budd once did for Kenneth Clarke. He believes that the Treasury has got its sums more or less right, and he doesn’t like the idea of delegating fiscal decisions to an outside body. BALLS: We judged that it would not be right for our political and constitutional system to have independent fiscal policy decisions. Those decisions have got to be made by ministers and accountable to Parliament. But what we do think is that accountability needs to be real and that depends upon the widest degree of public debate and scrutiny. We have actively promoted that, it happens all the time. Now should we have an independent fiscal committee scrutinizing fiscal policy? I don’t think so. Ken Clarke in 1993 established his panel of wise men to comment on his job on running the economy. What he proved with his wise men was that they could never, ever between themselves agree. It meant that there was less degree of scrutiny and more confusion. COYLE: It must be right that in the end the buck stops with the elected politicians when it comes to how much of our money they’re going to deduct in tax and how they’re going to spend it. It’s up to us as voters to decide whether we prefer the newly-announced Conservative plans to cut spending and taxes, or the current government’s emphasis on investing more in public services. But it’s important that we don’t fool ourselves that more borrowing won’t have to be paid for later by higher taxes. Sir Alan Budd. BUDD: If politicians pretend that public spending can be paid for other than by the taxpayer, they are deceiving the public and it’s their responsibility to explain to the general public that every penny of public expenditure has to be paid for sooner or later. The cost of doing so isn’t in any sense removed by borrowing; it’s simply postponed. And of course in some sense there’s not the slightest difference between borrowing and taxation except that if you borrow there’s an interest cost on top of all that. If the government’s finances are becoming dangerous in the sense that people don’t believe that it can pay for the amount of borrowing that it’s currently undertaking or won’t be prepared to raise the taxes to do so, then to me the answer is that it has to raise the taxes. COYLE: Excessive borrowing only delays higher taxes, because the interest has to be paid on government debt. It’s just the same as when we as consumers buy more than we can afford on credit - and end up with an even bigger bill because of the interest. If we want more spending on public services, wouldn’t it be better to pay for them through higher taxes now, rather than putting off the day of reckoning? Ed Balls, once a political adviser to Gordon Brown and now a Treasury civil servant. BALLS: We I think have been honest about the choices the country has faced. But in order to deliver the kind of investment people want to see in the health service, we also in the 2002 budget raised taxes, raised national insurance in order to invest in health. And if you look today at the surveys of public opinion, I would say that the large majority of the public support the need for investment in public services and recognize that you have to pay for that investment. You can’t get something for nothing. COYLE: Here’s a hint that Gordon Brown will raise taxes by as much as it takes to stick to his rules and still pay for his promises on public services. Borrowing more instead would only give us an illusion of being able to afford more public spending. The reason we need the golden rule is that it stops the government mortgaging the future. So let’s hope the Chancellor stays just as prudent as he started out. 2 - -