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.