Budget 2024: Chancellor Rachel Reeves and the Fiscal Rule Flexibility for Long-term Investments

Budget 2024: The Constraints of Fiscal Regulations on Long-Term Investments – Rachel Reeves' Potential Responses

Exploring the ways in which Chancellor Rachel Reeves might adjust fiscal policies to gain additional budgetary flexibility, potentially increasing her spending capacity by tens of billions and pushing back debt repayment timelines to support extended investments.

Economics and data editor for Sky News: @EdConwaySky

Sunday, October 6, 2024, 11:

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Before we delve into the budget and explore potential adjustments Rachel Reeves could make to her financial guidelines to allow for increased spending, let's take a moment to consider a recent analysis from the Office for Budget Responsibility (OBR).

This report from the OBR didn't garner the same level of focus as its major publications that accompany each budget, which are typically packed with projections and assessments concerning the economy and government finances.

Rather, it was a thought-provoking study that posed the inquiry: when the government allocates funds to a project—such as a road, railway, or a new school facility—how much time typically elapses before the benefits of that investment are realized?

According to the findings of the report, the impact of government spending on investment takes a considerable amount of time to materialize. Specifically, if the government allocates an amount equivalent to 1% of the national income for investment purposes this year, it will only generate an additional 0.4% in GDP after five years. This means that there is a net economic loss of 0.6% of GDP.

However, it's crucial to consider the bigger picture. A high-speed rail system is built for the long haul, intended to endure and enhance lives over many years. Consider the daily time savings for commuters—these may seem minor individually, but over time, they accumulate significantly. Thus, although the initial financial outlay is substantial, the advantages increase and become more apparent as time progresses.

According to the OBR's analysis, a public investment equivalent to 1% of GDP would yield a return of 0.4% of GDP after five years. However, within a period of 10 to 12 years, this investment would nearly match the initial expenditure, effectively reaching a break-even point where the initial outlay is entirely recouped through economic benefits.

By the time the investment reached its 50th year, it was projected to yield economic advantages equivalent to 2.5% of the GDP. According to calculations from the OBR, this would provide significant benefits to future generations.

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With that introduction, I encourage you to consider the economic regulations facing Rachel Reeves as she approaches her inaugural budget. Specifically, reflect on the debt rule that mandates the chancellor to ensure the national debt — more precisely, the "public sector net debt excluding Bank of England interventions" — is on a downward trajectory within a five-year span.

It should be emphasized that this rule is not inherent or essential. Reeves adopted it from the Conservative Party, who conceived it only a few years back, post-COVID. Before this, numerous rules aimed at curbing the national debt were in place and, quite honestly, they often failed to achieve their purpose.

Given Reeves' desire to demonstrate Labour's commitment to fiscal responsibility before the election, she opted to maintain the existing Conservative guidelines. This political strategy is comprehensible, though its economic rationale might be less clear. Admittedly, I've often harbored doubts about the efficacy of such regulations.

Essentially, she must ensure that the national debt decreases in the period from the fourth to the fifth year of the Office for Budget Responsibility's (OBR) five-year projection to comply with the rule. The most recent forecasts from the OBR, which were released during Jeremy Hunt's final budget, indicate a reduction in the debt. However, the decrease is slight, amounting to only £8.9 billion. This figure might sound familiar because it's the often-discussed yet poorly grasped "headroom" number that many around Westminster often mention.

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It appears that, in adhering strictly to the guidelines, a common trend among Westminster insiders, the chancellor finds herself with limited fiscal space in the upcoming budget. She has merely an additional £8.9 billion available for borrowing.

Every financial choice, including those related to investments, the National Health Service, welfare benefits, or other areas, is influenced by the daunting £8.9 billion surplus figure. Given that the Chancellor has previously highlighted during her "black hole" presentation earlier in the year that the Conservatives committed to substantial additional expenditures that were not accounted for in their budget—perhaps not the entire £22 billion she frequently references, but a significant amount nonetheless—it logically follows that there's essentially "no money left."

Is that necessarily the case? Up to this point, we've adhered strictly to the financial regulations, but now it's time to ponder: why exactly? To begin with, these rules aren't sacred. There isn't an unalterable decree mandating that the national debt must decrease within the next five years.

Secondly, let's recall the insights from the OBR document. It highlighted how certain investments can yield returns that surpass their initial costs. However, adhering strictly to a debt regulation results in the borrowed funds for these investments being viewed solely as a liability, rather than an asset. Additionally, because this rule only considers a five-year forecast, it tends to focus on the immediate expenses without considering the point at which costs are recovered.

Thirdly, the government's chosen debt rule centers on a specific metric of national debt, which may not be the most appropriate. This could seem strange, but it's important to note that there are several methods to quantify the UK's national debt.

Our present method of measurement does not include the Bank of England, a decision that appeared logical a few years back. The Bank has been implementing a strategy known as quantitative easing, which entails extensive trading of government bonds, thereby skewing the figures for national debt. It might be wise to continue omitting it from our calculations.

Lately, the actions of the Bank of England have been increasing the financial losses for the government. While delving deeply into the specifics could be complex and confusing, the key point is that many economists believe it is rather illogical to concentrate on a debt metric that is currently influenced more by the central bank's shift in monetary policy than by any direct governmental actions.

To put it another way, there is a compelling case to be made for shifting the focus from the former Bank of England's net debt metric to a more comprehensive net debt indicator. Upon examining this broader metric, it becomes apparent that there is a notable reduction in net debt from the fourth to the fifth year. Specifically, this approach reveals significantly greater fiscal leeway, with nearly £25 billion available, compared to just below £9 billion when using the previous measure that excludes bank-related debt.

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Could Reeves announce, either during the budget presentation or in the period leading up to it, that it would be more logical to concentrate on the total PSND going forward? It's entirely possible. Although it might seem like a bit of manipulation, in her defense, it's a shift from one somewhat arbitrary regulation to a marginally less arbitrary one.

This would also give her additional capacity to take on debt for investment purposes, should she decide to go that route. However, this does not address the underlying problem: both approaches focus primarily on the immediate expenses associated with debt, ignoring the extended advantages of investing, as discussed in the OBR document.

Should Reeves decide to adhere to what some might consider an arbitrary five-year timeframe for reducing debt, yet wishes to acknowledge the positive impacts of investment, she has the option to select from two alternative metrics for this guideline.

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She might concentrate on terms like "public sector net financial liabilities" or "public sector net worth". These metrics account for state-owned assets alongside its debts, aiming to provide a more comprehensive view of the advantages of increased investment.

The issue with these metrics is that they often undergo significant adjustments, for instance, when accountants reassess the worth of national transportation infrastructure like roads or railways. Therefore, some critics believe that these metrics are more susceptible to fluctuations and manipulation compared to straightforward net debt.

Nevertheless, these actions would significantly alter the financial flexibility available. Suddenly, Reeves would have more than £60 billion in financial leeway. This is more than sufficient for her to invest heavily without violating her budgetary policy.

Another amendment to the regulation that could be more logical than previous suggestions is extending the current five-year limit to either 10 or 15 years. With such an extended timeframe, investing a pound in a sound venture would likely yield a net economic benefit rather than being seen as a financial burden.

The decision Reeves makes about her initial steps in office hinges on her preferred approach to her tenure. Is she aiming to set a precedent as a stringent, budget-conscious Chancellor, possibly easing up as her term progresses? Alternatively, does she prioritize early investment, hoping to see tangible results within the next ten years or so?

In truth, economic principles present no barriers to her selecting either option. There really aren't any stringent fiscal regulations that could deter her, especially since they are fraught with imperfections.

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