Robin Marris: Why it won't matter if Brown bends his golden rule a little

Is Gordon Brown breaking his golden rule (ie that the Budget should balance over the business cycle)? If he is, does it matter?

The traditional objections to budgets deficits are basically three. First, interest has to be paid on government borrowing which means either higher taxes or more borrowing. This can get out of control. More borrowing, more interest burden, bigger still potential deficit.

Second, government borrowing may crowd out the money markets, driving up interest rates and/or squeezing financial resources available for productive investment in the private sector.

Third, borrowing can be said to distort public expenditure policy. The public may seem to be getting something for nothing when, in truth, given a limit on national production, there is no free lunch.

The strength of all these objections depends crucially on the potential deficit's actual size when expressed as a percentage of GDP and the tax base. It is easy to calculate that a deficit which is no more, say, than 1 to 2 per cent of GDP, or maybe 3 to 5 per cent of the tax base is not big deal. So to answer the leading question, one has to do some calculations.

One has to make long-term forecasts of GDP, tax revenue with current tax rates and public expenditure.

In practice, there is a crucial preliminary question: whether a deficit of a certain size matters depends very much on the general health of the economy.

If the economy is basically sound, there is a margin. If it is not, a chronic "structural" deficit, most people think, will make things worse. One crucial question is whether the economy is growing briskly and steadily, so that growing public expenditure can be balanced by a growing tax base.

It is my personal opinion that both now and in the medium-term future the UK economy is probably as healthy as it has been for about 100 years. In economic growth as measured by GDP per head we are outperforming not only the unfortunate eurozone but also the US (see Chart 1).

Readers who find the chart surprising must understand that most commentators reporting on American economic performance forget to allow for population growth. While the British population is at a standstill that of the US is forging ahead at 1 per cent. The US GDP has to grow at 1 per cent just to keep living standards constant.

Chart 2, which is highly significant, shows that also we have not fully recovered from the recent recession. The OECD estimates we still have maybe half a point of reserve capacity. That general view is also shared both by the Treasury by independent forecasters. Chart 3 shows a similar story about unemployment.

The UK is also currently blessed with a pro-active, energetic and open-minded ministry of economics (aka the Treasury) which not only makes its own complex statistical forecasting model available to the general public but concerns itself with a wide range of questions, such as both public and private productivity or child welfare.

The Treasury website currently carries a paper on the labour market which reports, inter alia, that half of all lone parents are now in work, implying inevitably a strong reduction in absolute poverty among children.

The Treasury, using its own model, gave us a pre-Budget report projecting some key statistics as far forward as 2008. Long-term annual economic growth came out at about 2.75 per cent. Strictly, the growth rate is "endogenous" in the model, ie fully determined by other factors. In practice, for technical reasons, other experts, using the same model, came out with a growth rate that was in fact higher, rather than lower, than the Treasury forecast.

Chart 4 shows, however, that that situation was not mirrored in the field of public finance. The Treasury somehow managed to have tax revenue rising at a faster rate than other users of the same model. In effect, the Treasury seemed to have "tweaked" the model to make it forecast that the golden rule would not be violated.

As a result, independent forecasters* are satisfied that it is probable that if public expenditure follows its planned path, by the end of the decade the UK will be running a chronic deficit lying between 0.5 and 1 per cent of GDP.

I for one am not alarmed. First, the percentage of GDP is quite small. Since it is smaller than the GDP growth rate, it does not imply rising interest rates or a rising burden of interest on the tax revenue.

Second, although we really need a Treasury-model run for a longer period, my hunch is that the situation will be stable and maybe improving. The reason is that in the earlier years planned public expenditure is really growing fast. This is the consequence of the nation's decision that it needs to recover the backlog of past under-expenditure on the public services and infrastructure.

Once this task has been achieved I see no reason in fact for long-run public expenditure to grow faster than long run GDP. By contrast, current plans mean that in the next three years public expenditure will be growing no less than slightly more than twice the rate of GDP. Third, I cannot really feel that the economy will somehow become unbalanced if we finance a very modest fraction (less than one-thirtieth) of total public expenditure by borrowing.

Fourth, the projected "current" deficit (the number you arrive at when public investment projects are removed from the figures) is in fact on a similar scale to the actual projected investment. In other words, this is a familiar process or borrowing to finance infrastructure.

So where, in light of all this, stands Gordon Brown? In my estimation, very definitely up. I suspect he knows exactly what he is doing, namely paying obeisance to the political prejudices of the financial markets (and also to the anachronistic EU stability pact) while basically serving the clear collective needs and desires of the nation's citizens. We want those schools and hospitals and we want value for money. Given those points, I doubt we are deeply concerned if a small fraction of the cost is financed by debt rather than taxation.

Professor Robin Marris is Professor Emeritus of Economics at Birkbeck College and the author of 'Ending Poverty'.

* See especially, Professor Peter Spencer, York University, 'Economic Update' ITEM Club, autumn 2003 issue of 'Economic Outlook for Business'.