Osborne will need to bend his fiscal rules

George Osborne is under pressure from all sides.

A poll on Tuesday indicated that half of all voters want the chancellor shuffled out of Number 11. A slew of post-Budget U-turns have damaged his credibility with his own colleagues. Evangelists for Heathrow expansion are again preaching from the backbenches. But changing the chancellor or shifting aviation policy will not solve the pressing problem facing the government: growth forecasts have crashed.

Independent forecasters predict UK output will be almost 2 per cent lower by the end of 2013 than official projections from March suggest. In a few months, the Office for Budget Responsibility is all but certain to make revisions to its forecast. This means big trouble for the coalition. As the government’s plan heads towards a cliff edge, the chancellor increasingly resembles the cartoon character Wile E. Coyote.

In the face of a heavy downgrade of OBR growth projections last autumn, the government just avoided the drop. The chancellor was told to find a further £15bn in annual savings to meet his fiscal rule of eliminating the structural deficit. Fortunately for Mr Osborne, he has a rolling five-year period in which to do it. The downgrade was also not bad enough to imply a breach in his second fiscal rule: for public debt to be falling in 2015-16.

But this year Wile E. Coyote has run out of road. The debt rule looks set to be broken. The chancellor is pedalling furiously in mid-air. He needs a plan for when gravity reasserts itself on the official projections this autumn. But that poses a dilemma that goes to the heart of the government’s claim to fiscal credibility.

The chancellor has two options. If he wants to stick to the debt rule, he will have to cut much more than planned between now and 2015-16. For an economy languishing well below its potential, further fiscal tightening in the next two years would be disastrous for growth, undermining progress to the target. Meanwhile, loading all the additional cuts on to 2015-16, to take effect just a month before a probable election, would be politically impossible.

The alternative is to ditch the 2015-16 rule, perhaps shifting it back by a couple of years. But self-imposed rules only boost investor confidence if they are seen to shape policy rather than be shaped by it. How confident could investors be in a government forced into redesigning its spending framework by the failure of its initial plan?

Nevertheless, resetting the debt rule is the least bad option as long as it is combined with two measures to shore up a new plan’s credibility. First, the government must now be explicit on where the necessary savings will ultimately come from to meet the new target, since vague promises of future cuts will no longer wash. Taking some political pain for tough decisions, such as cutting pensioner benefits for the better-off, is the price of restoring credibility. U-turns on pasties and charities don’t worry bondholders while the fiscal rules hold but when the rules come unstuck investors will need to see more mettle.

However, more cuts in the absence of growth will not engender confidence, as the past two years have shown. The plan must involve a state-led investment strategy to kick-start growth, rather than rely on monetary interventions alone.

These two elements of restoring credibility can be mutually reinforcing. By axing policies that have a low impact on growth the government can recycle public money into output-boosting infrastructure investment. That could provide a large fiscal stimulus without altering the pace of the cuts.

The politics of regaining credibility would be horrible for any chancellor in this situation, but for the coalition, this could be terminal. Prime ministerial words protect winter fuel payments to the over-60s. And since the Budget, when the chancellor said the coalition would need to find another £10bn in annual welfare cuts, getting the Liberal Democrats on board for a full pre-election spending review has become improbable. More than two years into this government, seeking detailed agreement on further savings may test it to destruction.

Tight control of public borrowing, represented by the fiscal rules, was supposed to be the basis for the government’s credibility. Instead, the credibility of the new plan must rest on detailed policy and political resolve. It is more serious than simply changing chancellors. If this government cannot take the difficult decisions required, it might be time to say “that’s all folks” and give way to one that can.


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