Case study 1 : Fiscal policy turns golden brown

Immediately on taking office in 1997, UK Chancellor Gordon Brown launched a pre-emptive strike on monetary policy by giving the Bank of England operational independence in setting interest rates. Brown thought this make monetary policy more transparent and remove political temptations for a boom-bust cycle in interest rates. Many observers think the policy has been a success. Details of how monetary policy is now conducted are shown on this part of the Bank of England's website.

Less well known is the attempt to do something similar with fiscal policy. Chapter 22 points out how bad an indicator of fiscal stance the budget deficit or surplus really is. Bad indicators make it hard to know what fiscal policy is really doing. Chapter 22 emphasised how the budget fluctuates with the business cycle, so that surpluses sometimes reflect higher tax revenue in the boom rather than higher tax rates themselves.

For recent Treasury estimates of these effects, see the Treasury website. Look up 1999 and then download paper Fiscal Policy and the Cycle. The punch line is that a rise of output, relative to potential output, of 1 percent for two years yields an extra net revenue of 0.75 percent of GDP. The Treasury paper also shows charts estimating UK business cycles for the last 20 years, and the implications for 'structurally-adjusted' budget estimates that control for the state of the business cycle.

Another difficulty is the distinction between current and capital spending. Current spending (on consumption) does little to boost future capacity, whereas capital spending (on physical investment) boost future capacity, future output, and hence future tax revenue. Prudent businesses borrow to finance profitable investment but do not keep borrowing to finance wages or other items of 'current' expenditure.

Chancellor Brown's Golden Rule puts these principles into practice for UK fiscal policy. The commitments apply to averages over the business cycle. The reason for this is to recognise that the position fluctuates with output. Tax revenues and some spending commitments (eg unemployment benefit) vary with output levels.

The Golden Rule commits the government not to borrow in the medium run except to finance investment. Current tax revenue has to pay for all of current spending, once cyclical fluctuations are averaged out.

This all sounds very clear cut, but the reality as always is more complicated. Health care and schooling show up as current government spending. However investment in human capital - through better health, education, and training - may increase future output capacity just as much as investment in plant and machinery.

In the 2000 budget, the Chancellor pre-announced large rises in health spending for 5 coming years. One reason the Treasury argued that this was compatible with the Golden Rule was that they began with a large surplus (even larger than previously predicted); another was that they forecast continuing growth of actual output, and hence tax revenues. Economic forecasting is an important part of policy setting. To see how the UK government does this, look at this part of the Treasury Website

Many assessments of Gordon Brown's budget of 2000 are easily accessed through websites, for example that of the Financial Times. Even the eminent FT economists themselves were divided on a final assessment on the budget. Sam Brittan declared it a 'rather conservative Budget' (FT, 23/03/00) in its fiscal arithmetic, whereas Martin Wolf observed 'to put the point brutally, casualty wards have been chosen over car producers' (FT, 22/03/00). By this he meant that an even tighter budget would have depressed aggregate demand sufficiently to induce the Bank of England then to cut interest rates. Lower interest rates would have reduced the value of the sterling exchange rate making exports more competitive. Nowadays, budget loosening or tightening does not directly change output and unemployment, since it provokes an offsetting response from the Bank of England in order to keep inflation on track.

 If the Treasury loosens, the Bank may be forced to tighten