A British debt brake

Britain currently has two emergency fiscal rules. There is a commitment, roughly speaking, to eliminate the structural deficit and to start shrinking net debt by 2015-6. These short term measures are designed to deal with the current debt crisis. If the government meets its objectives, the question then becomes, ‘what next’?

Deficits are not inevitable. In the eighty-three years between 1816 and 1899, the UK ran a deficit greater than 1% of GDP in only four years. The Victorians followed a simple rule, making sure spending matched tax revenues in each year. The downside to this simplicity was that it lacked flexibility to respond to economic downturns.

Some kinds of flexibility are more than important than others. The overall deficit is made up of two components. One portion of the deficit is caused when, in a recession, the cost of benefits increases and the revenue from taxes falls. This imbalance corrects itself when the economy returns to normal. The second part of the deficit is the structural deficit. This part is caused by the long-term shortfall between tax revenue and spending. This remains even when the economy is fully healthy. Governments often run a structural deficit to boost the economy with greater spending and lower tax. Unfortunately, this type of discretionary fiscal policy has a poor track record. Demand management can be left to the central bank, providing a country has its own currency.

A modern version of the balanced budget rule can be seen in the ‘debt brake’ rule adopted by Switzerland in 2001. Gross Swiss debt moved from around 38% of GDP in 1990 to over 60% by 2000. In response, the Swiss government introduced a new ‘debt brake’ constitutional amendment, requiring a balanced structural budget. This rule still allows the short term automatic deficits covering the costs of higher unemployment and lower tax revenues. The Swiss debt brake was fully implemented in 2006, and debt immediately started to fall. A structural balance rule ensures, in practice, that government spending grows no faster than tax revenues. Growth of government spending in Switzerland has slowed from 4.3% per year in 2003 to 2.6% now. Germany has also recently adopted its own debt brake.

Britain should copy the Swiss. Once the structural budget has been balanced, we should pledge to keep it that way with our own debt brake. Of course, no fiscal rule can perfectly predict the future. However, they can counter our focus on the short term. In good times, we should be balancing the budget and paying down the debt. That way we can be better protected when the next crisis arrives.

Kwasi Kwarteng is the co-author (with Jonathan Dupont) of Binding the Hands of Government: a credible fiscal rule for the UK.

4 thoughts on “A British debt brake”

  1. Posted 31/05/2012 at 13:05 | Permalink

    What Adam Smith wrote about war might be applied also to other kinds of government expenditure: “Were the [exceptional] expense of war to be defrayed always by a revenue raised within the year, the taxes from which that extraordinary revenue was drawn would last no longer than the war … Wars would in general be more speedily concluded and less wantonly undertaken.” It is the ‘wanton undertaking’ of government commitments (e.g. pensions, but many other examples could be given) that has, cumulatively, landed us in such a mess. So although the proposal for a debt brake isn’t foolproof, it’s certainly a step in the right direction.

  2. Posted 31/05/2012 at 21:49 | Permalink

    “The downside to this simplicity was that it lacked flexibility to respond to economic downturns.”
    On the contrary this is one of its greatest benefits, increases in deficit spending by government during the recessionary part of the business cycle are what delay corrections from occurring and malinvestments from being liquidated – this only serves to prolong the recession to cause depression, since there can be no real growth untill the structural problems are removed by this liquidation process.

    Unemployment benefits are particularly destructive since they allow people who have lost jobs to remain out of work, which the lack of income would otherwise prohibit, in the anticipation of a job opening at a similar rate of pay to that earned before lost their job. However the very cause of the business cycle recession – malinvestment, usually fuelled by inflationary monetary policy – is such that large numbers of people, in some trades more than others (especially those associated with bubles) will be employed with salaries above what is sustainable for someone with their specific skills. This government expenditure, enabled only by deficit spending, prevents the market wage level from falling and ensures that what would be a brief period of elevated unemployment becomes a long term problem.

  3. Posted 01/06/2012 at 06:30 | Permalink

    I’m not sure that the government has any plan/intention to start reducing net debt by 2015/16 (or indeed, by any date).

    Their intention, I believe is to start reducing debt as a percentage of GDP, not in absolute terms. It is debt as a percentage of GDP which really matters.

    You do not have to run a balanced budget or a surplus to reduce debt as a percentage of GDP. You simply have to run a deficit which, measured as a percentage of GDP, is lower than the growth rate of GDP (again in percentage terms).

  4. Posted 02/06/2012 at 13:11 | Permalink

    I have to disagree with your article. There are many different reasons, why it could not work in GB. Switzerland is an unique country in the world terms and they never had such a debt issues like we do.

    What I see as a real problem is the question of the high household debt of our country and also the question of financial responsibility of our population. If we want to mark the difference, we do need some coherent government plan, but the answer is not to establish balanced budget than rather to fund meaningful projects.

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