Another Look at a Sensible Fiscal Policy for the Sharp Rise in Government Debt

Main Points

• We propose a new fiscal rule that allows the considerably expanded UK government debt to be handled responsibly yet sustainably for future generations. Our fiscal rule is based on the recognition that, in nominal terms, the cost of government debt is unlikely to exceed growth in the economy for many years to come.
• Government intervention operates in two directions: excessive economic intervention usually leads to misallocation of capital and an unfortunate tendency for the state to end up ‘picking losers’. On the other hand, excessive tightening, when such tightening is obviously not needed, unnecessarily undermines economic and political capital at a time when it is most needed.
• Since the inflation of the 1970s, debt sustainability calculations have been based on assumptions of high inflation and positive real interest rates. However, in response to a one-off spike in debt, such as archetypically produced by war, such calculations can often mislead. This approach is no longer appropriate and needs revision.
• The fiscal rule we propose forecasts the average nominal interest on government debt over the decade ahead, given borrowing costs signalled by financial markets today, and compares them with projected nominal GDP growth. Only if the nominal interest rate is expected to increase above the nominal growth rate will adjustment to future primary surpluses be triggered today. Otherwise, modest primary deficits can be tolerated. We propose that the Office for Budget Responsibility (OBR) provides the analysis to underpin this rule and to monitor compliance.