Free the government’s hands by taking back its fiscal brain

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer, an FT contributing editor, is a former chief economist at the Bank of England

The Office for Budget Responsibility was created by then chancellor George Osborne in 2010 to provide independent assessments of the UK’s public finances. It was lauded at the time, rightly, for helping to depoliticise analysis of fiscal policy — mimicking the independent fiscal policy councils successfully operating in a range of other countries.

Except in one respect. The OBR was made responsible for macroeconomic forecasts and assessing the impact of fiscal measures. Unlike elsewhere, however, these tasks were moved from the finance ministry to the OBR, together with much of the in-house expertise producing them. At a stroke, the role and expertise of the Treasury on macro matters was outsourced.

This institutional configuration has meant that, whereas fiscal councils in other countries largely provide a “second pair of eyes”, in the UK the OBR has de facto monopoly rights over judgments on debt sustainability — it is prosecutor, judge and jury. As fiscal and growth prospects have darkened, the consequences have become increasingly jarring, economically and politically.

Since 2010, fiscal policy has involved delicately balancing measures to stimulate growth with maintaining fiscal discipline. The OBR’s mandate covers only the second. Its scoring of fiscal measures decisively tips the institutional balance towards conservatism over growth. Or rather, it has reinforced the Treasury’s long-standing fiscal-first instincts. A cynic might think this was “austerity Osborne’s” ulterior motive.

With no institutional sponsor, public investment and growth have been the casualty. After years of under-investment, the UK’s public sector capital stock is estimated to be around £2tn lower than its international counterparts in 2019, a gap almost certainly larger now. Not coincidentally, growth has stalled. An unedifying sequence of gossamer-thin growth plans has been accompanied by mounting political disquiet at OBR conservatism. This culminated in Liz Truss’s decision to sideline the OBR in preparations for the fateful 2022 “mini” Budget.

The resulting bond market meltdown led present chancellor Rachel Reeves to hardwire OBR assessments into fiscal events, making the de facto monopoly de jure. Buyer’s remorse has been rapid. With a weakening outlook and far too little fiscal wriggle room, Reeves finds herself impaled on the OBR’s horns. On its educated guesses — and that inevitably is what they are — now hang the fortunes of the chancellor, the economy and tens of millions of taxpayers.

This is neither an economically sensible nor politically sustainable system of macroeconomic management. Nigel Farage, whose Reform UK party leads comfortably in opinion polls, suggests that weak growth is the OBR’s fault. This is wrong: it is doing (perhaps rather too well) the job given to it. But he is right to say the fiscal system in which it is enmeshed is a problem, not only for growth but also for governance.

There is growing recognition of this fact even in government. Reeves has suggested slimming the number of OBR assessments from two to one a year. This would somewhat reduce the uncertainty around fiscal policy — a significant recent headwind to growth — but would not tackle the inflexibility embedded in the fiscal system.

One way of freeing the government’s fiscal hands is by partially taking back control of fiscal assessments. Outsourcing your brain is rarely wise. As with the Bank of England for monetary policy, the Treasury should produce and publish its own economic projections and assessments of fiscal choices. The OBR’s role, as in other countries, would then be to audit these assessments.

With the Treasury no longer as tightly bound by OBR conservatism, the institutional balance would be tipped towards growth while preserving independent scrutiny. Increasing transparency around fiscal choices improves public debate. But, as the bank’s experience demonstrates, it would also provide strong incentives to improve Treasury macroeconomic expertise and analysis, which was gutted in error.

Alongside this, the fiscal framework itself needs to be rebalanced towards growth. In other areas of public policy with high uncertainty and where objectives are traded-off, such as inflation-targeting, flexibility is provided through tolerance bands (within which there is no assumption corrective action is required) and lengthening the horizon over which objectives are assessed. Fiscal policy needs both.

A tolerance band of 1 per cent of GDP around the fiscal rules would remove the need for a growth-limiting squeeze to boost fiscal headroom. Meanwhile, a longer assessment horizon for these rules, beyond one parliament, would allow the full fruits of growth-friendly investment to score, as they should, towards sustainability assessments.

In last year’s Budget, the government switched to a broader measure of public debt recognising financial assets. This was wise, allowing extra investment of £20bn a year over five years for housing, transport and energy. A better step still would be to recognise non-financial assets explicitly in the debt definition. That rule change would enable perhaps a further £20bn a year in growth and tax-friendly public investment.

No change in the fiscal framework is cost free, especially with markets fragile. What matters to markets ultimately, though, is a framework capable of delivering the great debt redeemer: growth. The current framework is a hindrance. Countries with the fiscal flex to invest are rewarded with higher growth and lower bond yields. In the upcoming Budget, that prize lies within the chancellor’s grasp.