Osborne introduces his budget surplus law – but he may have a hard time sticking to it

Making a risky promise. Peter Macdiarmid / PA Archive/Press Association Images

UK chancellor George Osborne has announced a law that requires the government to run a budget surplus in “normal” times. Speaking to bankers and merchants at his annual Mansion House address, Osborne’s budget surplus law would prevent future governments from spending more than they receive in tax revenues when the economy is growing – though the exact definition of normal will be revealed in the budget next month. The Office for Budget Responsibility will play a role in monitoring the economy.

Politically this has been widely seen as setting a trap for his opponents who will now have to define their position on the issue. But the wisdom of this move is questionable. In 2009, Osborne himself opposed such a suggestion, commenting:

No other chancellor in the long history of the office has felt the need to pass a law in order to convince people that he has the political will to implement his own budget.

There are precedents here: Osborne has pointed to similar proposals in Canada and somewhat similar provisions in Sweden (although the Swedes are now considering moving away from this). The EU has its stability and growth pact, designed to ensure budget balance, with budget deficits not supposed to exceed 3% of GDP.

But in practice these targets have often been missed, even before the 2008 financial crisis. And, as the Institute for Fiscal Studies has pointed out, post-war UK governments have usually been in deficit rather than surplus:

What a chancellor can control

Contrary to much of the popular discussion, chancellors do not directly control the deficit or surplus. Of course, chancellors set their budgets determining tax rates and the government’s spending plans, but the outcome for the budget deficit or surplus depends on what happens in the rest of the economy.

Osborne’s experience in the 2010-2015 coalition government illustrates this point well. He was unable to achieve his original target of eliminating the deficit over the lifetime of that parliament. While largely successful at achieving its targets of cutting departmental expenditure, the problem was that the economy did not grow as fast as projected. With lower growth, tax receipts were substantially lower than expected and it was this that slowed deficit reduction.

Fundamental principles

That chancellors cannot determine the budget deficit or surplus relates directly to a fundamental principle here. As economic commentator Frances Coppola, among others, has reminded us there are three basic balances in an economy that must, as a matter of accounting arithmetic, add up together. The government’s budget position, the net lending or borrowing of the private sector (firms and households) and the current account (the country’s external balance with the rest of the world).

If the government is borrowing then logically someone – domestic firms, households or foreigners – must be saving and lending to it. Following on from this, for the government to eliminate the deficit and achieve a surplus, then households must spend more and save less or firms invest more or exports to the rest of the world rise – or some combination of these.

Any of these would tend to raise economic activity, leading to higher tax receipts (and probably lower social security expenditure) and thereby reduce the deficit. But none are directly under the control of the chancellor. In the past when there was talk of rebalancing the UK economy the first of these was seen as undesirable as likely to replace public debt with private household debt.

Sustainable debt?

Osborne has talked of the UK debt position as being unsustainable. For economists the issue of sustainability is not determined by any particular level of spending, but crucially whether the ratio of the total outstanding debt to GDP is rising or falling. An ever-rising debt to GDP position is clearly unstable.

More broadly, high levels of borrowing and outstanding debt may negatively affect the economy if they lead to high interest rates and undermine confidence. The key here is whether interest rates are higher than the growth of the economy (so the payments on outstanding debt tend to grow faster than GDP and thereby lead to rising debt to GDP ratios). Or the reverse, in which case a government can run a budget deficit which will add to the total outstanding debt, but the debt to GDP ratio may not rise.

Current conditions in the UK are of historically very low interest rates, even on long-term government debt – around 70% of UK debt is held in the UK. Recent research by the International Monetary Fund indicates that current UK debt levels are within a sustainable range. It cautions against policies aiming to rapidly pay down the debt, as this risks undermining any recovery, and spending cuts may hit potentially productive expenditure (particularly with capital and infrastructure projects).

Osborne’s plans may be designed to trap his opponents, but he has not made a convincing economic case for them and may yet struggle to achieve them.