How Brown could frame his fiscal stability pact

`There is no reason public debt should be eliminated altogether, even in the most draconian theory of public finance. It is sufficient to ensure the debt/GDP ratio is stable, or that public assets rise in line with public liabilities'

One of the first acts of the Labour Government was to put into place a new framework for the operation of the Bank of England which aimed to enhance the effectiveness, transparency and accountability of monetary policy-making in this country. Unveiling this reform, the Chancellor said he was introducing a British solution to a British problem, implying the new framework was intended to operate outside EMU, rather than providing a bridge that would make entry into EMU more likely. Indeed, several aspects of the new system were not compatible with EMU membership, thus emphasising that the Government was preparing for at least a period of life outside the single currency.

After his success with the new monetary policy framework, the next item Gordon Brown might examine is the parallel framework for fiscal policy outside EMU. After all, the signature last week of the Stability Pact in Amsterdam has taken care of that problem for future EMU members but, as in the case of monetary policy, countries remaining outside the single currency will need to act for themselves. While there is no urgent need to make changes to our present mechanism, there could be advantages in so doing, and I would like to put some possibilities on the agenda for discussion.

The importance of the Stability Pact for future EMU members has not been fully grasped. At Amsterdam, member states signed a resolution that promised that after EMU they would aim to hold their budget positions "close to balance or in surplus" over the medium term. Although resolutions are simply statements of political intent, without the full force of Community law behind them, this announcement is a big step in the direction of a "balanced budget constitutional amendment" for the EU. The accompanying regulation agreed in Amsterdam, which does have the force of law, would punish countries only if they allowed their budget deficits to exceed 3 per cent of GDP, but there will be continuous EU surveillance procedures based on the medium-term objective of budget balance.

It seems that the Council of Ministers will be able to recommend that member states should make changes to their plans to ensure the balanced budget objective is respected in the medium term.

This amounts to nothing more than moral suasion, but over time it may become increasingly difficult for EMU members to present medium-term plans to the EU on any basis other than fiscal balance. The same may be true, incidentally, in the US, where the balanced budget constitutional amendment failed by one vote in the Senate last year, but has now been replaced by an agreement between President and Congress to eliminate the government deficit by 2002.

Given all this, it is tempting to conclude that the UK should simply submit itself voluntarily to the medium-term objective of the Stability Pact (though obviously not to the fines), even if we do not join the single currency. But there are problems with this approach, since the objectives of the Stability Pact do not necessarily coincide with those contained in the Labour manifesto. Before the election, the Government promised that the ratio of public debt to GDP would be stabilised at a low and prudent level, and pledged it would maintain the "golden rule" of public finance, whereby the public sector would borrow only to invest.

These two commitments translate into targets for the budget deficit of 2.5 per cent and 1 per cent of GDP respectively, both much higher than the the budget balance criterion in the Stability Pact.

In my opinion, the Pact is unnecessarily tough, and the Brown criteria are basically superior. The EU requirement to balance the budget over the medium term implies that the outstanding stock of public debt will in future be unchanged in nominal terms, which in turn would mean it eventually dwindles almost to nothing compared to the rising level of GDP. There is absolutely no reason public debt should be eliminated altogether, even in the most draconian theory of public finance. It is sufficient to ensure the debt/GDP ratio is stable, or that public assets rise in line with public liabilities, whichever is the tougher objective. This is the thinking behind Mr Brown's "criteria".

One option for the Chancellor would therefore be simply to reiterate his twin targets in each Budget speech, and to ensure that his fiscal programme matches these requirements each year. This would essentially maintain the present system unchanged. However, the case against this procedure is that the budgetary process is subject to political manipulation, as we saw in the final Ken Clarke Budget, which made a series of questionable assumptions to flatter the state of the public finances. This tendency to bend the rules of public finance around election time imparts a long- term upward bias to the level of public debt, and it would be useful to have a countervailing force in the system to make this more difficult.

In New Zealand, the Fiscal Responsibility Act of 1994 was passed to address this need. It was designed to improve the transparency and accountability of fiscal decisions, without eliminating the justifiable right of elected politicians to adjust the budgetary stance when they choose to do so. An equivalent Act in the UK would do the following: first, it would establish over-arching long-term objectives for public debt management - called the fundamental principles. These would be the golden rule, or the stability of the debt/GDP ratio at a prudent level, whichever was the more stringent objective. (The relationship between the two would vary over time, depending on the level of public investment.) Second, it would establish a set of accounting practices and disclosure requirements which would make it difficult for the Chancellor of the day to manipulate the published accounts to his or her own advantage. Third, it would establish a reporting procedure the Chancellor would need to use if there were any short-term deviation from the fundamental principles. One option here would be for the Treasury to produce a Green Budget document around four months before the Budget itself, and to have this document subjected to scrutiny by the Commons Select Committee on the Treasury. Fourth, an independent body would be given the task of examining and publishing a report on the fiscal arithmetic, both at the Green Budget stage and immediately after the Budget itself. This independent body could be the National Audit Office, employed by Mr Brown last week, but it would need to beef up its level of economic expertise if it is to be taken seriously in a wider role.

The overall objective of these reforms would be to ensure that future Chancellors would not be able to bloat the level of public debt without this being open to full public scrutiny and debate. The aim would not be to prevent fiscal policy from responding to short-term economic needs, but to make such decisions transparent and subject to political accountability. In these respects, the reform would be the fiscal hand-maiden of the Bank of England Independence Act shortly to be presented to Parliament.