Rachel Reeves's One Good Option

As the chancellor considers how to reform the fiscal rules to enable more investment, a guest post by John Crompton on the potential dangers in some of the proposals and which one she should choose

Photo by Alexandre Debiève on Unsplash

I am delighted to publish another guest post by John Crompton on the options facing Rachel Reeves as the chancellor considers how best to reform the fiscal rules. John is a former investment banker and three-times Treasury official as well as as co-author of Public Net Worth, which was published earlier this year. As he says, some of the quick fixes being discussed contain serious deficiencies and could leave the country in a worse long-term position. John has a much better solution.

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Update on Fiscal Rules and Rachel Reeves’s choices

by John Crompton

Back in August, we discussed the “£22 billion black hole” that Rachel Reeves announced she had discovered in the finances that she inherited from the Conservative government. We suggested that she had an opportunity at the start of her tenure to introduce new fiscal rules based upon Public Net Worth that would better address the country’s long term financial challenges, would remove constraints on government investment and over time could allow for substantial improvement in the government’s financial position.

There now seems to be some momentum behind this idea. Baroness Patience Wheatcroft raised the issue in an article in The New European, and set out the arguments further in the House of Lords Budget Responsibility Bill debate on 9^th September. More recently, Gus O’Donnell, the former cabinet secretary, and Martin Wolf, the FT’s chief economics commentator, have made similar arguments in the Financial Times, as has Paul Johnson, the director of the Institute for Fiscal Studies, in The Times. 

There are also suggestions that Rachel Reeves is taking the idea seriously. The Times reported on 26 September that she “has now asked officials to draw up options for changing the way the government measures debt”.

So it is perhaps timely to review what might be on the cards, and to highlight the opportunities – and potential dangers – associated with various alternative strategies.

As a starting point, Rachel Reeves has made a commitment that current expenditure should not be financed by borrowing. This underpinned her response to the “black hole” discovery and the funding of public sector pay awards; unspecified cuts in capital programmes, and the cancellation of the pensioners’ winter fuel allowance suggest a willingness to make tough – and unpopular – choices. But as we pointed out, such measures do not promote public finances that are sustainable for the long term. Cutting (good) investment projects impoverishes future taxpayers. And increasing public sector pay brings with it increased pension obligations that sit conveniently outside the fiscal rules – but are very real, and very expensive.

The current focus appears to be on amending fiscal rules so as to enable public sector investment in activities that will support UK economic growth. 

Not So Golden Rules

One idea that has been in circulation for some decades is that borrowing to support government investment could simply be carved out of the borrowing targets, which is effectively what Gordon Brown did as chancellor with his so-called Golden Rule and Sustainable Investment Rule. This is superficially attractive, but misses one very important point: physical assets wear out over time and require replacement. So fiscal rules would need to reflect the rate at which assets were being consumed – in accounting terminology, “depreciation” – if they were adapted along these lines. Otherwise, once assets financed in this way had reached the end of their lives, the government would be left with a bigger debt burden than it would have had under the old rules, and with no assets to show for it.  This is an important issue, to which we shall return.

There has also been a good deal of talk about using Public Sector Net Financial Liabilities (PSNFL) as an alternative measure of national debt. PSNFL nets off the government’s financial assets against its financial liabilities. In the case of the UK, this would include the Student Loan portfolio (valued at £151bn in the Department for Education’s 2023-24 Accounts) and the value of its holdings in NatWest bank, for example.

However, the standard definition of PSNFL does not include unfunded public sector pension liabilities, which are greater than the government’s financial debt and which, as we have discussed, create a huge financial loophole in the management of public expenditure. 

It would be very much hoped that PSNFL-based rules, if adopted, would include pensions and other liabilities within the definition, otherwise they would offer little improvement over existing rules as a means of promoting sustainable finances. For example, the most recent Whole of Government Accounts (2021-22) assessed the cost of unfunded pension benefits accrued by public sector employees in-year as £89 billion. This rather large sum – over 3% of GDP – does not count as current spending under the Chancellor’s existing fiscal rules, and would not contribute to PSNFL.

The focus on financial assets embodied in PSNFL also raises important issues. On the positive side, it would allow the government to borrow and invest in financial assets to fund its public sector pensions liabilities - a measure which we argued in our August piece could improve government finances by the equivalent of 3% of GDP per year over the long term. On a much smaller scale, this would also support the government’s plans to create a National Wealth Fund. 

But PSNFL-based rules have nothing to say about non-financial assets. Borrowing to spend on (say) infrastructure or hospitals does not get netted off against the value of those assets because they are not financial assets. So the only way that this type of much-needed investment would be supported is if the government were to set a new PSNFL limit, higher than current PSNFL, that provided it with extra borrowing headroom. And this approach suffers from the same drawback as the Golden Rule: as the newly-acquired assets are consumed (depreciated) the debt will remain in place, and the headroom will have been permanently used-up.

No Short-term Fixes

So PSNFL-based rules do not take into account the scale of our unfunded public sector pensions liabilities or the rate at which they are being incurred (though they would allow the incurrence of debt to fund these pensions which we believe could be very beneficial; however there is no indication that the government is considering this). They also do not measure non-financial assets, or recognise their consumption. Overall, there is a risk that PSNFL-based rules would prove to be no more than a short-term fiscal fix to allow the government to expand investment for the short term without strengthening, and perhaps weakening, long-term fiscal sustainability.

As we argued back in August, there is a better solution – and encouragingly, this seems to be emerging in the current policy debate. Using a measure of Net Worth as the basis for setting fiscal rules addresses all of the points relating to asset and liability recognition that undermine the usefulness of PSNFL or other less complete measures. It will also encourage much better transparency of, and accountability for, how the government is managing its assets – a potential benefit to public finances, over time, of the order of 1% of GDP per year, to add to the 3% that can be captured through investing in financial assets to meet pension liabilities. 

Of course, whilst Net Worth is the most comprehensive measure of fiscal position, like any other single metric it does not tell the whole story. The fiscal position of a government, like that of a company, is more complex than can be captured in a single number or rule. So the fiscal framework needs also to reflect key factors which impact on fiscal position, such as revenue, expenses and surplus or deficit, as well as key aspects of balance sheet structure, such as levels of debt and of financial assets.

But Net Worth should be at the heart of the new framework. Let’s hope the Treasury includes it in its list of options for the Chancellor!

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JOHN CROMPTON is a former investment banker and three-time HM Treasury official and advisor, and the co-author, with Ian Ball, Willem Butter, Dag Detter and Jacob Soll, of Public Net Worth—Accounting, Government and Democracy (Palgrave MacMillan 2024).