Gordon Brown’s legacy

The case for an independent Treasury.

So Gordon has gone. I’ll save my opinion on the new Liberal Conservative government until the full details emerge. I’d just like to jot down a few thoughts about the mess they’ve inherited.

Gordon Brown became Chancellor of the Exchequer in 1997 promising Prudence. His “golden rule” was to borrow only to invest over the economic cycle – a noble principle aimed at macroeconomic stability and the end of boom and bust. It soon became clear that the term “investment” was being applied to activities normally classed as spending. A few years later, the economic cycle was conveniently redefined, and shortly thereafter the golden rule was quietly dropped and never mentioned again. During this entire period, a time of boom and overflowing coffers, government borrowing was on the increase. One doesn’t have to be a fanatical Keynesian to know that continual borrowing during good times is financial lunacy, but that is exactly what Gordon did, leaving the UK with one of the worst debt burdens in Europe.

The only consolation to this story is that he didn’t make as big a mess as Fianna Fáil did in Ireland. They arrived at the same destination from the other direction – tax cuts. The bubble that this engendered left Ireland with an even more disastrous economic crash than the UK, and provided us with one more example of how cutting taxes is a more efficient way of boosting an economy than increasing spending.

In order to soften the impact of the economic cycle, it is commonly held that government should increase spending during a downturn in order to stimulate employment. This Keynesian view is not universally popular – a certain amount of government spending is intrinsically counter-cyclical, such as unemployment benefit, but cash pumped indiscriminately into the economy mostly goes to waste. Instead, critics argue that economic recovery is best stimulated by tax cuts. But either way, if the national debt is too high when the downturn comes, the extra burden of borrowing will push the state towards default and bankruptcy, as we see happening in Greece right now.

If politicians were truly acting in the interests of the long-term economy, they would run a budget surplus during economic growth to make sure that debt is at a minimum when recession eventually comes and emergency borrowing is required. But no politician believes, or wants to believe, that the dark times will come on his watch; or if he does he fears telling the electorate the hard truth that economic booms must be restrained by hoarding away cash for a rainy day.

No, the short four- or five-year electoral cycle always allows the longer economic cycle to be ignored until after the next election. That is, until it can’t be ignored any more and suddenly the coffers are empty, triggering a debt crisis. Modern governments have sensibly forbidden themselves from printing cash to cover holes in the balance sheet, after discovering the hard way that it always makes matters worse. If the boom/bust cycle is to be tamed, they must similarly be forbidden from excessive borrowing.

Operational independence for central banks is now a key element of most advanced economies. Treating the money supply as a regulated public service instead of an arm of government has largely removed the malign influence of the electoral cycle on inflation rates. But boom and bust has not yet been tamed – instead of generating inflation, overheating economies now manifest themselves in asset price bubbles, in particular the housing market. Just as central banks must restrain inflation through controlling the money supply, so treasuries must prevent overheating by controlling the deficit. And as governments have proven themselves just as incapable of controlling the deficit as they once were at controlling the money supply, so the case for an operationally independent Treasury is made.

Just as central banks are given an inflation target to maintain, an independent Treasury would be given a deficit target (or more accurately, a surplus target). It would have at its disposal the power to vary the base rate of certain taxes, such as income tax or VAT. Counter-cyclical spending such as unemployment benefit would be paid directly from the Treasury at a long-term fixed rate set by law – the basis of such a unified tax/benefit system is already in place in many states. The total amount of revenue supplied to the other Government departments would then be fixed at a long-term rate.

All other departments would thus have fixed budgets to spend. All borrowing would be managed by the Treasury as part of its stabilisation mandate. There would probably be the need to maintain an emergency fund to smooth over unexpected liabilities, but this would not count towards the Treasury’s surplus. The Chancellor of the day would be responsible for defining the long-term parameters that the Treasury would operate within, but would leave taxation and borrowing rates for the Treasury to manage. The Treasury would be required to maintain a budget surplus as a function of the growth rate, thus making counter-cyclical fiscal stimuli automatic.

The Treasury would then have a simple set of levers to work with, and a narrowly-defined responsibility. Knowing the revenue requirements of Government (now fixed at a long-term rate) and benefit liabilities (predictable from its models and the fixed benefit rates) it can choose to either raise taxes, thereby decreasing the borrowing requirement and slowing the economy, or lower taxes, thereby increasing borrowing and speeding the economy. The overall aim would be to maintain a budget surplus or deficit as appropriate to the position in the economic cycle, thus softening the impact of the inevitable. The medium-term growth trend of the economy would then depend primarily on the revenue requirement imposed by the Chancellor. In this way, the linkage between economic growth and the tax burden is more clearly evident. (Structural issues in the economy are of course also important to growth, but tend to change on longer timescales)

This system is more flexible than the mandatory balanced-budget approach taken by many US state governments. It restrains borrowing while providing automatic counter-cyclical fiscal stimuli. And it is based on the very successful central bank model now in use worldwide.

I commend this motion to the House.

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3 thoughts on “Gordon Brown’s legacy

  1. Keynesian theory actually requires government to be running a surplus and laying off staff in the good years. So called Keynesians in practice always seem to forget this point. Keynesianism was designed to deal with cyclical recessions in closed economies, hence it is much less effective in today’s open economies, especially so when stricter planning permissions, environments impact studies, etc prevent large infrastructure projects. More importantly, it cannot help with structural recessions, hence the failure of stimulus programmes in Japan over the last 20 years and why it won’t work in the likes of Greece or California now. Finally, it failed even in the USA in the 30’s (FDR is probably the worst president in US history). No, I’m not a Keynesian.

    What works in a recession is for the government (inc. central banks) to do nothing. No stimulus plans, no printing money, no bailouts. See http://www.youtube.com/watch?v=czcUmnsprQI (rather long). Recessions are not the problem – they are the solution (however painful). The real problem is a false boom, caused by mal-investment or excessive investment in particular sector. Most frequently in the UK this is in property prices, encouraged by artificially low interest rates and a criminal lack of tax on land values, at least since Schedule A was abolished in the early 60’s (I think).

    I need to think more on your idea of an independent Treasury. One immediate fear is that the EU already wants the job. Another important thing to note is that when we talk about balanced budgets, deficits, surpluses etc for government, we do it purely in cash-flow terms (tax raised this year – money spent this year). This ignores commitments made now for future expenditure, most importantly on unfunded defined-benefit pensions for government workers and citizens. A private company finance director who produced such artificially optimistic and misleading financial reports, and profited from doing so, would go to jail.

  2. I have begun to wonder if there is a role for the President in this. As a…regulator or something. It seems that the government is supposed to write the laws, but there needs to be someone independent to enforce them.
    So the financial regulator would be answerable to the President, who would have the fairly narrow brief of ‘make sure due process is followed’. The president could also be required to sign off on a budget, and if the budget was not in surplus (as required by the boom bust cycle) could reject it.

    Problem with making an independent treasury responsible for tax is that there are two reasons for taxes. One is just to raise revenue. The other is to regulate the market. So a carbon tax is introduced to bring the cost of pollution into the market. Alcohol and smoking tax brings the cost that those activities impose through health and law enforcement problems into the market. Those sort of market regulations should remain the role of elected officials, and require judgement calls.

    But then the president needs an independent income, otherwise dail can reduce the size of regulation by reducing budget. hrm. How can you make regulation pay for itself, and who pays, those who are regulated, or those on whos behalf the regulation is done?

  3. Ed,

    Two points. Yes, the construction of an independent Treasury would be much more complicated than that of an independent Central Bank, but I don’t see why it couldn’t be done in principle. As for recessions, of course they are a natural part of the economic cycle, but there’s a difference between a recession and a sovereign debt crisis.

    Jon,

    The Treasury would still report to the Chancellor, but they would be operationally independent in the same way that the Bank of England or the ECB is independent. The real challenge is not to make sure the Treasury is under control, but to ensure that the Chancellor keeps his hands out of the till.

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