Do fiscal rules matter?

Bonjour,

I had the opportunity last week to attend a panel with the theme: fiscal rules, can the UK take example on the Swiss experience? It was attended by two UK conservative party MPs and Philippe Hildebrand, the ex- Swiss National Bank governor.

The context

The Swiss have established their own fiscal rules in the early 2000’s, after a decade of worsening public finance balance. In the 1990’s, the country went from having a debt/GDP of 32% to having a  58% ratio. The debt-brake was then invented as a solution to cap the rise in indebtedness, in case Switzerland would want to join the EU and comply with its associated Maastricht criteria (one of which is a debt/GDP ratio of 60%).

The Swiss debt brake, written in the constitution, sets a maximum spending number per year and ask the government to match any expenditure with revenues.

As a result, from 2003 to 2012, the debt/GDP ratio declined from 58% to the current 35%, despite the financial crisis and the billions needed to save UBS.

In 8 years, debt declined as a percentage of GDP by 23%, which is around 3% per annum. In effect, nominal debt stayed flat.

>  Switzerland outgrew its debt by keeping it stable nominally

The UK trying to be cautious

In the UK, Gordon Brown and more recently George Osborne have tried to install a rigour in the budget exercise.

Gordon Brown had 2 golden rules:

-          A balanced budget throughout the economic cycle

-          Debt/GDP kept at the then  current prudent level (40% ratio)

George Osborne has promised a “fiscal mandate” alongside 2 ideas:

-          A cyclically adjusted fiscal balance by the end of the conservative tenure (in 2015)

-          Net debt to fall as a percentage of GDP

Both chancellors have shown initiatives but these are merely rules that they both bent.

In contrast, the Swiss model has no reference to a cycle, has a pre-announced framework for exceptional times (such as 2008) and its rules are written in the constitution (which followed a popular vote by referendum).

Germany has also written its fiscal balance rule in its constitution, with 2016 as the target date for balancing the books.

Debt-brakes coming to the UK or France?

Could that be applied to France and/or the UK, the current two largest offenders in Europe?

There seems to be difficulties to do so for a number of reasons.

1)      Rules would need to be truly legally binding / enforced

The Maastricht criteria were never respected because France and Germany breached them without any consequences. The framework has to be legally solid.

2)      Rules would need to be broadly supported

The Swiss and in a lesser extent German models are not easily transferable tot the UK and France because of the local politics. While Switzerland and Germany are used to coalitions ruling the country (see how Germany will get a new grand coalition), France and the UK are not (the UK are experiencing the first Tory-Libdem coalition though). With a political game so marked, what a party is doing during their mandate is often unwound by the next party in the next mandate.

Broad support is vital to get a fiscal rule written in the constitution.

3)      Rules would need to be clear

An aim to balance the budget in times where the economy is growing around its potential should be a clear rule.

However, this supposes to know where the potential is and have decent forecasting tools. In the UK, the Office for Budget Responsibility (OBR) has been proven very inaccurate on its forecasts up to now. This would be an impediment if a rule were to be defined according to long term forecasts.

4)      Do rules matter?

The Swiss acted when their debt/GDP approached 60%.

The French, German or UK ratios are close to 90% and yet, no panic was really visible in the sovereign bond markets nor has there been agitation in the public.

Historical examples also show that nations can support much higher levels of debt relative to the size of their economies. In fact, despite debt levels going up 50% since 2007, interest rate levels are still modest relative to long-term history, a seal of confidence from markets.

Finally, what would have been the impact of the financial crisis on Britain or France, have their budget been balanced in 2008?

What history tells us about debt levels

Contrary to the Rogoff and Rheinhart thesis (developed here), history is rich of examples of high indebtedness which did not affect the growth potential of a country nor its long term interest rates.

A great albeit forgotten one is the UK in the 19^th century.

The UK debt/GDP ratio peaked above 260% in 1821 to fall to 25% by 1913. (graphs courtesy of Chris Golden of EFFAS-EBC)

 

See how the current level is still below the 110% long term average: you have to compare this to Chancellor George Osborne mentioning a “debt problem” in the UK in 2010. 

The following graph shows interest rates on the debt: notice how a 260% ratio did not scare investors at the time. Only wars and inflation have an impact on interest rates levels.

Now matching both graphs:

An explanation for the low interest rates in the UK example was that nominal debt remained flat, giving confidence to investors that debt would be outgrown.

Keeping nominal debt stable should be the major task of any government as growth, even modest and some inflation will help to reduce the burden.

To meet that aim, reaching a modest primary fiscal balances which translates into flat nominal debt should be the top priority. There is no need for massive austerity nor for rushing structural adjustments.

Other great historical examples include:

Canada

 

Sweden

If we now look at the primary balances of European countries (table below), one will notice that the situation looks finally secure. The Eurozone has a primary surplus of 1.7% while Europe as a whole is nearly at 1%.

On that basis, Europe needs only modest nominal GDP growth to keep its nominal debt stable.

If GDP growth reaches 1.5% and inflation remains around 1%, Europe will deflate its debt/GDP ratio by around 1pp every year, which is sufficient.

Investment conclusion:

Looking at history, one can conclude that bond yields may not rise much despite the high perceived debt burden, unless there is inflation or war.

>  This may mean the rotation from bonds to equities may be already over!

The trades you want to commit to in this framework remain being long the perceived risky countries such as Italy (massive primary surplus), Portugal (see idea here) or for the most courageous: Greece!

I would buy any primary surplus above 3% and sell primary deficits above 2% as a macro slow-down will renew fears of unsustainable debt burden.

On that reading, a long Italy 10YR and short UK 10YR may be relevant to capture the respective fiscal positions.