Is the Chancellor trying to wriggle off the hook of his own fiscal rules? No.

9 November 2012 - Ian Mulheirn

Is the Treasury trying to get itself off the hook on its fiscal targets? There’s been much confusion about the effect of the Treasury’s decision to retain the interest payments it makes to the Bank of England’s Asset Purchase Facility (APF) – the vehicle that holds £375bn of gilts resulting from QE. All the Treasury has to do is pay the Bank of England interest in respect of the loan the latter provided to buy the assets in the first place. In effect, this is an (almost) interest free loan to the government, for a while, lowering public sector net borrowing.

But once the Bank rate starts to rise, the interest rate paid by the APF, and hence the Treasury, will also start to rise. Things won’t look so great for the Treasury at that point. Once interest rates are back to normal, public sector net borrowing will be higher than it would have been.

The big question here is does this affect the Treasury’s fiscal mandate - to eliminate the structural deficit on the current budget within five years – or the supplementary target – to have debt as a proportion of GDP falling in 2015-16?

The first reaction of some seems to be that this does help with the rules, but I’m not so sure. This idea seems to have taken hold because HM Treasury have said that the changes ‘will affect measured deficits and debt’.

On the first rule, once the Gilts are sold back into the market and QE unwound, the underlying fiscal position will be essentially unchanged. So the changes might lower the headline deficit, but it’s hard to see them having any substantial effect on the structural part of the current budget deficit. Only the latter counts for meeting the Government’s fiscal mandate.

But what of the debt rule that the Chancellor looked on course to miss? Is tinkering with debt levels gaming the second target? Not necessarily. While a £35bn windfall 2012-13 and 2013-14 is nice, it won’t have much effect on the change in public sector net borrowing between 2014-15 and 2016-17 – the thing that must fall to meet the second target. And if interest rates rise in 2015-16, there’s every chance the debt target will be harder to hit. Whether this change makes the debt rule easier or harder to hit is therefore ambiguous.

The effects of today’s changes are complicated, but they don’t look to me like the Chancellor trying to wriggle off the hook of his own fiscal targets.

Please add a comment

Posted by Chris Giles on Nov 11th, 2012

I am surprised Ian you are so relaxed about a change to the measure of PSNBex and PSNDex which is not refleceted in the fiscal mandate. Whatever the effect of the raid, the fiscal measures now have no consistency and we are back to Gordon Brown- style definitional changes which will be difficult to track. This is the same as banks booking profits on their US subprime special purpose vehicles, knowing a cost will come ipn the future and expecting another chancellor to pick up the tab.

Posted by Ian Mulheirn on Nov 11th, 2012

Chris - thanks. I agree with you that it will affect the debt target measure, and that messing around with measures isn't great for credibility. But it seems to me quite likely that the change makes hitting the debt target harder.

I think there's a difference between tinkering with measures in bad faith and doing so for other reasons and in ways that have an ambiguous effect on the likelihood that the target will be met.

Posted by Tony Dolphin on Nov 12th, 2012

Ian - I think this move - whatever the motives - further undermines the credibility of the fiscal rules. The first rule has already been revealed to be ineffective as its rolling five-year nature means the Chancellor can push back indefinitely the date when the structural deficit is eliminated - and he may well do so again in the Autumn Statement. The second rule requires only that the net debt ratio in 2015-16 is lower than in 2014-15. This depends on the difference between real interest rates and GDP growth in 2015-16 and on the primary budget balance in 2015-16 (not the change in borrowing). All other years are irrelevant. Whether this move makes achieving the second target easier or not, therefore, depends on its effects on real interest and growth in 2015-16 (probably close to zero, though in theory one could argue less borrowing in the next two years in aggreagte would be expected to lead to lower real rates) and on borrowing in 2015-16 (where the effect is less clear, but as you say could possibly be negative - i.e. it could boost borrowing). More importantly, though, messing around with the numbers like this can only dent confidence in fiscal policy and the deficit reduction programme - something that the Chancellor is supposed to set great store by.