Extracts from Conservative Economic Policy Report on fiscal framework

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 Chancellor’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 Bank’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 Bank’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 England’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 Europe’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 regulator’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 UK’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 England’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 – 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 UK’s public sector net debt at £497.7 billion (April 2007). However, recent work by MPs and the Public Accounts Committee has revealed that the true extent of the UK’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 £487 billion
Public unfunded pension liabilities £720 billion
Local government unfunded pension liabilities £90 billion
PFI £25 billion
Network Rail guaranteed borrowing £18 billion
TOTAL public sector obligations £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 £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 £20 billion on the Government’s balance sheet. And yet payments due under those contracts amount to £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 – Flexible Friends?

Two fiscal rules were established by the Chancellor, to reassure those who remembered previous Labour Governments’ 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 Government’s reputation for financial management.

This is a pity, since we agree with the principles that initially formed the basis of the Chancellor’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 – 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 company’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 ‘replacement cost minus assessed depreciation’ 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:

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15 Comments

  1. Posted July 19, 2008 at 4:52 pm | Permalink

    All good worthy stuff but getting into growth rather than just stopping the fall into the current hole will come from cutting the government’s share of spending, cutting corporation tax & cutting our outrageous regulatory costs.

  2. Kit
    Posted July 19, 2008 at 7:04 pm | Permalink

    "4. Continue to exclude public sector unfunded pensions liabilities"

    This I think is a mistake. The largest cost in any "Sustainable Investment" is that army of civil servants that get employed. If you exclude their pension costs you can hardly claim any "investment" is "sustainable".

    p.s. Government "investment" is just a cost on us poor tax payers – NOT an investment.

  3. Tears for Tier 1
    Posted July 19, 2008 at 7:50 pm | Permalink

    No mention of making policy less pro-cyclical.
    – How do you prevent our Anglo-Saxon desire for a housing boom every time the economy does well?
    I'm afraid the answers are tough ones, beyond the policy scope of opposition parties-
    1. Extending Capital Gains Tax to first homes, thus leveling the fiscal playing field and increasing the tax take as the housing market booms.
    2. Applying stamp duty to all loan advances rather than property transactions. – The rate of stamp to increase, the smaller the deposit.
    3. Automatically increasing Banking capital requirements on areas of the UK Banking Systems combined loan book that have been increasing in size by the fastest percentage in previous years.
    4. Doing the same as (3)for individual Banks within the system.
    5. Extending FSA controls over journalist "pushing" stocks and stock markets to property and the property market.

    Developing other automatic policy dampners for the UK housing and property markets.

  4. Posted July 19, 2008 at 8:06 pm | Permalink

    Elephant in the room…………….

    The European Union cost the UK £12.6billion last year (the equivalent 5p in the £ income tax)

    Today the Prime Minister told British troops at Basra Air Station: “You are now working with the Iraqi forces (ay a cost of £5 billion pa) to train them up so that they can take over their responsibilities, so that we can complete our work here to bring Basra to democracy, security and prosperity.”

    NOTE: Brown addressed the troops and he wasn’t wearing a stab jacket

  5. Posted July 19, 2008 at 8:26 pm | Permalink

    We should value government assets such as schools and hospitals on a ‘replacement cost minus assessed depreciation’ basis, in order to take into account their state of repair and fitness for purpose.

  6. mikestallard
    Posted July 19, 2008 at 9:24 pm | Permalink

    Just a little thought here:
    As taxes skyrocket, it pays people to wriggle out of them.
    Has anyone got the figures for how much tax is actually being collected by the extraordinarily inefficient Treasury at the moment?
    I suspect that the true figures for this shortfall might be extremely interesting………

  7. Stuart Fairney
    Posted July 20, 2008 at 9:03 am | Permalink

    I've heard it suggested elsewhere that the government are on a "scorched earth" mission. It is suggested that they know the next election is lost and so are determined to hand the tories a poisoned economic chalice by racking up debt whilst taking a last chance to hand out favours to their friends in return for party funding. Then 18 months after the next election Milliband/Harman or whoever say how beastly and useless the tories are. It sounded a bit unlikley to me…at first.

  8. Acorn
    Posted July 20, 2008 at 11:22 am | Permalink

    As Stewart says, it is not impossible that by the time of the next election – assuming the nation is still a democracy by then – the UK will be close to being "beyond economic repair". Stalin 1928, is no longer on the never-to-be-repeated list.

    Assuming there are still some honourable civil servants at the Treasury, who know the truth and are still minded to print it whenever possible; have a look at:-
    http://www.hm-treasury.gov.uk/budget/budget_08/do

    Particularly at:- http://www.hm-treasury.gov.uk/media/6/8/bud08_eco

    There is some very interesting data in the latter. You can see where the credit exploded and things like PFI payments being around £9 billion a year for the future decades.

    Also, it is not impossible that a future government may have to renege on a portion of its internal debts – public sector pensions for instance. You talk John, of the future mandate for the Monetary Policy Committee; it may now be time for you to establish a shadow Fiscal Policy Committee; and, have it ready to go into action on day one of your next government. It may be given a mandate say, of reducing and maintaining public sector spending at 33% of market price GDP. One thing is for sure, you have to start getting your people inside the Treasury infrastructure now, you are going to need them!

    As an amateur government studier, one thing that strikes you time and time again; eight years is the maximum that ANY government can sustain competent performance. By year ten, it becomes obvious to the lay observer, that things are falling apart. I read sometime back that "… no politician should be more than two years away from an election …". I am starting to think that this should be a prime directive in our constitution.

    By the way. We are now electing far to many people with little talent. The days of sixty / seventy member Councils have passed there sell-by date. Likewise Trust boards etc – NHS; Police Authority etc,. – provide no added value and are basically ignored by their paid management; who take their instructions from central government alone. We have ended up with a government front bench that has little management experience and most should not have risen above their District Council competence level. There is a major task for the future of educating voters to look for competence in any individual they elect. Voting for a donkey with a coloured rosette on his collar, is not good enough anymore.

    Am I still in favour of a democracy? Oh yes. But, I want my democracy to have a management structure more like Tesco than fiasco!

  9. Stuart Fairney
    Posted July 20, 2008 at 12:06 pm | Permalink

    It is also slightly amusing to conclude that an inexperienced and frankly clueless senator from Illinois (if elected) will effectively determine when UK troops leave Iraq as it is impossible for us to remain following a US withdrawl.

  10. David Eyles
    Posted July 20, 2008 at 2:03 pm | Permalink

    From my layman's point of view:

    2.2 para. 3: There should be no need for debate at all regarding the use of CPI. This was an obvious fiddle right from the very start to maipulate the MPC and to make the government look good. Many people are suffering from two digit levels of inflation because they are trapped by fixed incomes and are at the mercy of raging taxation inflation – pensioners for example. Don't talk about it, get rid of and replace it with RPI and some other measure to take into account fiscal and public sector inflation.

    The whole of section 2.3 terrifies me. Stuart Fairney may be right……maybe there is a scorched earth policy. But if there is, it is likely to backfire on the Labour party. Once the Tories form government and find out and publicise just how bad the situation really is, the likelyhood is that the electorate will never forgive them. Roll on the Lib Dems being the next main opposition party. It will serve Labour right, because much of the damage they have done to this country has been absolutely deliberate. I speak as a livestock farmer who has watched their TB strategy with open-mouthed horror.

    But there are two or three areas which deserve closer attention: The first is that of local government which Acorn has mentioned; The second is that of quangos and third is that of charities.

    Quangos are managed in such a way as to be unaccountable to the electorate, despite spending huge amounts of our money. When they make a mess of things, e.g. SATs, the appropriate minister is able to wash his hands of responsibility. Witness Ed Balls' mind blowing evasion of his responsibility the other night on Ch.4. There has to be some way of bringing important parts of public expenditure back into political control and responsibilty so that ministers can and should be sacked when things go wrong because of their officers' incompetence. This will sharpen up civil servant quality.

    Charities are being talked about by David Cameron as organisations who can help in some vague undefined way with public matters. I am uncomfortable with this. I have watched the RSPCA, National Trust and others be taken over by those with a particular political bent. In some cases the original purpose of the charity has been lost and they are now campaigning organisations with altogether lopsided agendas. With this suggestion by DC, whichever government is in power, the tendency will be for charities to become quasi regulatory bodies and, again, will be unaccountable to the public.

    I would be interested to see the development of Conservative policies on both of these subjects.

  11. adam
    Posted July 20, 2008 at 6:51 pm | Permalink

    David Eyles, you are right about the charities thing. I didnt know Dave C had talked about it.
    It comes from the UN/sustainable development movement they are using the voluntary sector to fulfil roles the public sector used to do. Thats the limit of my understanding of it. Its worrying to here Dave mouthing these ideas, hes too green for me.

  12. adam
    Posted July 20, 2008 at 7:11 pm | Permalink

    As for Ed Balls, i saw his laughable interview on C4 too.
    When confronted with the absurd state of our marking system he replied with the advice of not to worry things are functioning at the usual standard. By the time he had stopped dribbling the rest of his nonsense even Jon "I have a limited intellect" Snow had thought up a suitable response to that one.

    He does come across as one of the dumbest of the Zanu LP cabal.

  13. Freeborn John
    Posted July 21, 2008 at 12:25 pm | Permalink

    Thanks Mr. Redwood for the distinction between public and private capital spending. I see why you are interested to control borrowing that funds capital investment in the public sector when it produces a rate of return that will be lower than the interest rate, and perhaps as low as 0%. I also see the case for valuing public assets on a ‘replacement cost minus assessed depreciation’ basis if they do not produce in a revenue stream that might provide an alternative valuation.

    A market will settle on a price for a product or service below which that good will not be supplied. If the consequences of not providing a service to those in need of it (e.g. the education of children or the care of the sick) cannot be tolerated by a civilised society then it becomes a legitimate role of the state to step in and do what the free market is not willing to do. But by abandoning the market mechanisms we also lose useful tools such as return on investment which greatly complicates the investment decisions. It seems to me that the ‘return on investment’ must still be there because society is willing to pay for public education and health, but the value seems to have been converted (at least partly) from a monetary currency to one of morality.

  14. Lazarus
    Posted August 18, 2008 at 7:12 pm | Permalink

    "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."

    So taxation for education is spent on wages, fixtures and fittings, stationary & maintenance, and not on the education of the individual. The value of learning should therefore be considered a by-product of this expenditure.

    • mikestallard
      Posted August 19, 2008 at 8:26 am | Permalink

      This sounds silly, but here in Wisbech (Cambs) we have a potential situation which fits this scenario. We have a 1,500 Comprehensive which simply does not deliver the goods (Fresh Start, Head resigning in the middle of term etc etc).
      What we badly need are some smaller schools which can deliver the goods and the Conservative Policy is, actually, to provide these schools.
      The local government answer to that is that more schools are impossible because "we" have to fill the places in the huge Comprehensive.
      Although this argument is totally against educational excellence (as you point out), it does make sense financially, I suppose.

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    John Redwood has been the Member of Parliament for Wokingham since 1987. First attending Kent College, Canterbury, he graduated from Magdalen College, and has a DPhil from All Souls, Oxford. A businessman by background, he has been a director of NM Rothschild merchant bank and chairman of a quoted industrial PLC.
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