The Conservative Policy Review warned that the removal of powers from the Bank of England could make it more likely a bank went under. It also pointed out that the fiscal rules were well and truly broken a year ago and suggested ways to remedy them:
2.1. Making the Bank of England Independent
The Chancellorâ€™s early decision to make the Bank of England the independent judge of interest rates, with the creation of the Monetary Policy Committee, was an idea whose time had come. It has been welcomed by all political parties and the business community, and has combined with the effects of globalization to continue the relatively benign interest rate and inflation environment we have enjoyed since 1993. However, it is important to understand the limitations that the Government placed on the Bankâ€™s independence; and we will recommend that, in contrast, a Conservative government takes action to strengthen the MPC still further. It is also important to understand that the first decade of a more independent MPC has coincided with a very favourable business and interest rate climate worldwide, and with easy money globally. It should be remembered that the Chancellor also took substantial powers away from the Bank, transferring banking regulation to the FSA and removing the Bankâ€™s role in managing public debt.
(Commentary on benign climate and UK higehr rates) But there are two reasons for our performance still not rivalling the best of our international competitors, which relate to Government actions; and these need to be considered if we are to create an optimal mix of inflation and interest rates in the future.
The decision of the Chancellor in 2003 to change the Bank of Englandâ€™s target rate of inflation. He replaced a 2.5% annual increase in prices as measured by the RPI with a 2% target as measured by the CPI (which typically rises by 1% per annum less). It is widely agreed that this led to a relaxation of anti-inflation policy at a crucial time. And its result can also be seen as further proof of the destabilization consequent upon attempts to bring fiscal policy in line with Europeâ€™s; which was earlier seen in the deleterious effect of the ERM policy (which had Bank of England and all-party backing).
(ERM passage )
The second reason is the deterioration in the public accounts from 2001 onwards. After two years of following Conservative spending plans, with sensible and tight controls on public spending, repayment of borrowings and fiscal prudence, the Chancellor turned to a large increase in public spending. This resulted in substantial inflationary expenditure in the public sector, and large debt issuance. Money growth was strong, and the public finances worsened rapidly.
This has resulted in the Bank of England struggling to reduce inflation from a high of 4.8% on the RPI (3.1% on the CPI). It is being forced to tighten monetary policy, in an attempt to offset the impact of inflationary public spending, rapid money growth, and increases in public sector charges (in particular, postal prices and student fees).
In relation to this, we are also concerned about the appointment process for the MPC. The majority of its members are chosen by the Chancellor, who has at times failed to fill a vacancy promptly, and whose decision-making is opaque. We recommend that an incoming Conservative government should make this process a far more transparent one.
We are concerned about the division of responsibility between the FSA and the Bank over banking and market regulation. Fortunately, conditions in the last decade have been benign internationally, with no serious threats to banking liquidity. We think it would be safer if the Bank of England had responsibility for solvency regulation of UK-based banks, as well as having an overall duty to keep the system solvent. There could be important delays as information was exchanged between the two regulators if a banking crisis did hit, and there might be gaps in each regulatorâ€™s view of the banking sector at a crucial time when early regulatory action might spare a worse problem.
2.2. Recommendations on Economic Management
1. The Government should neither reintroduce exchange rate targeting into its monetary policy, nor enter the Euro: these are likely to prove destabilizing, and to reduce the UKâ€™s competitiveness.
2. An independent MPC should continue to be supported in its role of controlling inflation through the setting of interest rates.
3. There should be further debate about whether the CPI is fully reflecting important inflationary pressures, including the cost of housing, and whether the Bank of Englandâ€™s target needs reviewing.
4. The independence of the Bank from any external pressures should be buttressed further by introducing an open selection process, and formalizing the role of the Treasury Select Committee in scrutinizing appointments to the MPC.
5. Whenever possible, fiscal policy should support, rather than undermine, keeping both monetary supply and inflation under control.
2.3. The Fiscal Framework â€“ and its Weakening Foundations
2.3.1. The State of the Public Finances
Under the Labour Government, there has been a rapid build up in debt, and official figures show the UKâ€™s public sector net debt at Â£497.7 billion (April 2007). However, recent work by MPs and the Public Accounts Committee has revealed that the true extent of the UKâ€™s public sector financial obligations is almost three times this stated amount. A report from the Centre of Policy Studies in 2006 itemised the following:
Stated net debt Â£487 billion
Public unfunded pension liabilities Â£720 billion
Local government unfunded pension liabilities Â£90 billion
PFI Â£25 billion
Network Rail guaranteed borrowing Â£18 billion
TOTAL public sector obligations Â£1,340 billion
Even these figures could be increased, however, if allowance were made for the possible failure of some PFI projects, with the consequent need for the Government to spend more on them; the current rapid growth of the public sector pay bill, and hence of pension liabilities; and probable further borrowing by Network Rail. (Estimate raised to Â£1.5trillion on Northern Rock nationalisation)
PFIs, in particular, are misleadingly valued in the public accounts. In July 2003, the capital value of PFI projects was included as Â£20 billion on the Governmentâ€™s balance sheet. And yet payments due under those contracts amount to Â£138 billion over the next twenty-five years (from 2005/6). It is also worth noting that there are many PFI contracts entered into by local government, which do not appear in these figures at all.
2.3.2. The Fiscal Rules â€“ Flexible Friends?
Two fiscal rules were established by the Chancellor, to reassure those who remembered previous Labour Governmentsâ€™ economic mismanagement that this time things would be different. The Golden Rule required that the current budget should not be in deficit over the cycle as a whole; and the Sustainable Investment Rule required that public sector net debt should not exceed 40% of GDP.
In the early years, this framework worked well, as the Chancellor effectively followed Conservative spending plans. The Government repaid debt and ran surpluses. However, this has all changed in recent years. Public spending has expanded rapidly, which has plunged the country into large annual deficits.
As a result, the Chancellor has been able to remain within the Golden Rule only by changing the years of the cycle; and similarly, he has remained under the Sustainable Investment ceiling only by keeping many public sector borrowings, and unfunded liabilities, off the official balance sheet. This willingness to undermine his own rules, and to exercise such flexibility within apparently sensible and tight controls, has damaged both his credibility, and the Governmentâ€™s reputation for financial management.
This is a pity, since we agree with the principles that initially formed the basis of the Chancellorâ€™s fiscal framework. We believe that governments should not as a rule borrow to pay for current spending; but instead should run healthy current account surpluses in the good years of an economic cycle, so that some latitude is possible in the weaker years. We also believe that there should be a limit on the total borrowings of the public sector as a percentage of national income, both to reduce any crowding out of private investment, and to preserve a good sovereign risk rating on world credit markets. The common theme here is that borrowing is simply deferred taxation, which ultimately will have to be repaid by taxpayers, with interest.
2.3.3. Public Capital Expenditure â€“ Sustainable Investment Rule Proposals
The distinction between current and capital spending is clear. Daily expenditure on wages and supplies, for example in the education and health services, is recorded as current spending in the public accounts. In contrast, the construction of a school or new hospital ward is recorded as capital spending or investment: items that will be available for a period of years, once the initial sum has been spent.
The contrast between public and private capital spending is, however, an added complication. In the private sector, a company invests to produce a future return; if that return is inadequate, the investment has to be written off. If the investment is sufficiently large and badly judged, it might, in extreme circumstances, even lead to that companyâ€™s bankruptcy. As most private investment yields a return higher than the cost of borrowing, it is usually appropriate to borrow some, or even most, of the money to make that investment, increasing both risks and rewards for shareholders. So, for example, a car manufacturer might borrow to invest in a new factory, in the belief that he can then make and sell extra cars; this extra revenue will then bring in sufficient cash flow to pay both the extra cost of his new factory, and the interest on his loan.
Much public sector investment spending, however, does not generate such useful additional revenues, and hence there can be no automatic assumption that an investment can be afforded on these grounds. If a local Education Authority spends capital on a new school, there will be extra costs in future years, but no extra revenues. Staff will have to be paid to maintain, clean and staff the school, but the service that it provides is of course free. The only possibility of extra revenue is if the school is due a government grant under the education funding formula, for example if it is to cater for extra pupils.
All of this requires careful management, as there is no market test for many of the capital projects a government will want to carry out. We believe that a new government will need a revised framework for capital spending, to ensure a sensible balance between the need to control spending, and the need to make enough money available to upgrade and expand public facilities in core areas like health and education.
We therefore propose that an incoming government should consider adjusting the Sustainable Investment Rule to:
1. Include guaranteed borrowings (such as those of Network Rail) in the calculation of public borrowings.
2. Include a more meaningful figure, to be settled by the NAO, for public sector liabilities under PFI and PPP contracts.
3. Adjust the limit on state borrowing to take these changes into account.
4. Continue to exclude public sector unfunded pensions liabilities from calculations of debt for the purposes of the Sustainable Investment Rule. Instead, they should be represented openly on a restated, and more accurate, government balance sheet.
5. Value government assets such as schools and hospitals on a â€˜replacement cost minus assessed depreciationâ€™ basis, in order to take into account their state of repair and fitness for purpose.
These adjustments should be made to reflect existing liabilities and should not lead to any loosening of fiscal control. In addition, we need to make it easier to decide sensibly the priorities for the limited supply of public capital. We believe that the best way to mitigate this capital scarcity is to allow worthwhile and appropriate infrastructure projects to take place in the private sector, for which there will always be (in normal conditions) readily available capital. This approach, adopted for most capital investment in a free enterprise society, can be applied to the following types of investment, which, in the UK, have typically taken place in the public sector: