IMF calls on UK government to adhere to its fiscal rules;
The second issue that I would like to highlight concerns the appropriate macroeconomic policy response to these more difficult economic circumstances. Two key elements of the U.K.'s policy framework, namely, maintaining public net debt below 40 percent of GDP, and an inflation target of 2 percent, are likely to be breached for extended periods.
Despite the challenges, our view is that these are not the right circumstances in which to loosen the targets on either the budget or inflation sides. Such steps would unnecessarily complicate the management of the immediate threats to stability and growth.
That said, a balance does have to be struck between the need to respect the framework objectives by avoiding an excessively sharp policy adjustment to achieve that aim.
Accordingly, for fiscal policy, our recommendation is that concrete adjustment plans should be devised to bring debt back under the 40 percent ceiling in a reasonable time frame. In that regard, we welcome the already announced fiscal adjustment of 0.5 percent of GDP in each 2009 and 2010. But this adjustment should be regarded as a starting point and as a minimum. More should be done on that front over the next few years. Frontloading the adjustment and elevating the status of nominal expenditure ceilings would send a strong signal of the government's commitment.
More from the Staff Report;
The rules-based fiscal framework aims to improve credibility and transparency
The framework comprises two rules, together with periodically issued medium-term spending objectives:
• A sustainable investment rule. For the current cycle, this is expressed as a commitment to maintain net public debt below 40 percent of GDP and, since 2003, to observe this limit in every year.
• A golden rule, measured by the cumulative current balance since the beginning of the cycle, as a percent of GDP.
• Compliance with the two rules is supported by comprehensive spending reviews which set departmental spending limits three years ahead.
Like inflation-targeting, this is a framework of constrained discretion
Although medium-term sustainability is emphasized, discretion is considerable in several dimensions—annual budget balances can swing substantially, revenue and expenditure ratios are unanchored as long as they move together, the headroom to be maintained against the rules and the treatment of debt stock adjustments are undefined, and the authorities largely self assess compliance. And public debt remains low compared to other EU advanced economies, even though its continued rise in recent years goes counter to the reductions achieved by most of these countries.
However, some use of this discretion has created difficulties
In particular, despite output close to potential over the entire decade, headroom under the debt rule has been steadily eroded (see Annex 4). Expenditure has tended to exceed the multi-year projections, even when the latter anticipated significant increases. Recent revisions to external data underscore the toll the associated high deficits—in the context of buoyant private demand—took on the external balance. And in light of the uncertainties surrounding the cyclical position of the economy, the authorities have not yet established an end point for the cycle that began in 1997, complicating assessment of adherence to the fiscal rules.
The debt rule should be maintained, but other adjustments to the rules to constrain discretion may be appropriate
The net debt ceiling underpins the medium-term and sustainability focus of the current framework, which reflects aging and other factors (Figure 7). In this light, any softening of the ceiling—even a reversion to casting it “over the cycle”—would be inappropriate, especially at the current juncture because of elevated inflation expectations, current account developments, terms of trade losses, and the difficulty of establishing the credibility of a higher ceiling or an alternative framework.
Indeed, a stronger medium-term fiscal path than that implied by the authorities’ plan would support the necessary shift from domestic to external demand and help secure headroom under this cap to accommodate stabilizers in future. Further, any leeway arising from prospective upward revisions to official estimates of GDP, such as those expected from revised estimates for financial sector value added, would best be applied to headroom under the debt ceiling, not to a relaxation of the recommended fiscal stance. If, however, the ceiling is breached in coming years, as appears likely, prompt announcement of plans to bring it back under the ceiling on a sustained basis and create the necessary buffers over the medium term to allow automatic stabilizers to operate will be critical.
The status of the spending guidelines should be raised
The net debt rule needs the support of other elements of the fiscal framework. In that regard, nominal spending caps are simple and transparent, facilitate multi-year expenditure planning, constrain upward expenditure drift directly, allow automatic stabilizers to operate on the revenue side, and strengthen fiscal resistance to inflation. Binding three-year global current expenditure ceilings could be set on a rolling basis—building on the system of three year departmental expenditure limits as well as steps towards multi-year public service nominal pay awards—so that each new budget would introduce a further year, with limited scope for revision.
Cyclically-sensitive items such as unemployment benefits could be excluded if a contingency reserve to accommodate cyclical spending proves infeasible. Concern to secure investment spending could be reflected in adoption of a multi-year floor on investment. Medium-term policy on the revenue ratio would be implicit in the expenditure and debt targets. Adherence to the golden rule could still be monitored—much as nominal spending relative to target is now—but it would no longer play a primary role in the fiscal framework. Such a shift in emphasis would also reflect the success of broader policy frameworks, which have underpinned reduced economic volatility thereby diminishing the need to define fiscal or other rules “across the cycle.”
Related from News & Blogs;
IMF Slashes U.K. Economic Forecasts on `Grim' Outlook
Fiscal rules: a political question
Accounting rules for public duty and private failure
A prudent policy rethink is needed
Treasury to reform Brown’s fiscal rules
Last post for Brown’s fiscal non-rules
A conceptually attractive rule might look like the permanent balance rule advocated by Clemens Grafe and myself (see (in increasing order of illegibility) “How to reform the Stability and Growth Pact”", “Ten Commandments for a Fiscal Rule in the E(M)U” and “Patching up the Pact; Some Suggestions for Enhancing Fiscal Sustainability and Macroeconomic Stability in an Enlarged European Union”.)
A basic backgrounder: Fiscal policy: principles and practice
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