George Osborne's budget surplus rule is nonsense and it could haunt Britain for decades

Osborne masksPeter Macdiarmid/Getty ImagesMasks depicting Chancellor of the Exchequer George Osborne are lined up on a wall opposite Downing Street by anti austerity protesters on December 2, 2014 in London, England.

On Wednesday night UK Chancellor George Osborne will make the case for a law that will force governments to always run a budget surplus, during his annual Mansion House speech.

According to the Treasury he’ll talk about the “unsustainably high” national debt, requiring a “permanent commitment” to raising more revenues than the government spends during “normal times”.

That means that when the Office for Budget Responsibility judges the the UK economy is running at full capacity, the government should be running a surplus. It won’t apply, for example, when there’s a recession.

But Osborne’s speech doesn’t admit one crucial thing that most people don’t seem to know: There’s no need to run a budget surplus at all to reduce the national debt in the only way that actually matters.

All you need is for the size of the economy (GDP) to rise more quickly than the debt.

Imagine a man who earns £100 for each shift he does, and whose income increases by 5% each day. He’s also got £50 of debt, and he racks up more, equivalent to 2% of his income each evening.

In the beginning his debt is worth half of his wages. By the end of the first week, his debt has risen to £64.28, but it’s now worth just 47.97% of his income, which is £134. By the end of the first month, the debt is worth £164.81, but it’s equivalent to only 44.14% of what he’s earning (now £373.35).

Do you see where this is going?

On a national level, this just means that if your economy grows faster than your deficit, your debt burden will decline. It’s happened for years at a time in recent British history.

For example, in the entire period between 1971 and 1987, the British government was a net borrower every single year. That’s 16 straight years in which the UK couldn’t balance the books, and spent more than it reaped in revenues.

Intuitively, it seems like the UK’s total debt must have gone up — and in nominal terms (counted in pounds), of course it did. But as a proportion of the economy debt was cut by about a third. Public debt as a proportion of GDP fell from 58.2% in 1971 to 38.6% in 1987.

This chart from HSBC shows just how rare running a surplus has actually been in recent British history:

So it’s clear that running a surplus is not necessary for debt to fall as a share of the economy. And it’s the size of the economy that matters to service that debt, and to what extend it is a risk. In the same way a £300,000 mortgage might be too much for someone with an annual income of £20,000, nobody’s going to fret about the same debt held by someone earning a six-figure salary.

All of this is complicated by the fact that Osborne is also planning to pass a law banning increases in national insurance payments, income tax and VAT, which collectively make up two thirds of the taxes raised in the UK. If you can’t raise taxes, then running a surplus will mean finding further significant spending cuts.

These facts alone don’t mean that running a surplus is a bad idea, just that it’s not necessary to reduce debt levels. Small deficits would do the same thing — and they have in the past.

But there are reasons to think a permanent surplus is a bad idea per se, too.

Predictions and fears of debt crises in the big advanced economies of the world were rife after the financial crisis. Seven years on, there’s no sign whatsoever of the worst fears coming true (outside the fragile eurozone). An International Monetary Fund paper released in May suggested that Britain was one of the countries which could feasibly live with high debts indefinitely. If that’s even halfway true, running surpluses is an unnecessarily urgent way of reducing debt levels.

More generally, a permanent surplus requirement ties the hands of any government that might want to invest in the future. If the UK needs more high speed rail 50 years from now, the debt might not be there to create that. (In the private sector, some companies are punished by analysts if they believe they have too little debt as it indicates that management is failing to invest in furture growth.)

Osborne is well aware of the fact that surpluses aren’t necessary for debt reduction, as is everyone who’s advising him. He’s also likely to have been briefed on the IMF paper (or similar arguments).

George OsborneREUTERS/Toby MelvilleBritain’s Chancellor of the Exchequer, George Osborne, delivers a keynote address at a dinner held by the CBI (Confederation of British Industry) in central London May 20, 2015.

So why is he doing it?

There’s a clue to what Osborne’s actual likely reasoning for the change in his speech (emphasis mine):

“Indeed we should now aim for a permanent change in our political debate and our approach to fiscal responsibility — just as they have done in recent years in countries like Sweden and Canada. The result of this recent British election — and the comprehensive rejection of those who argued for more borrowing and more spending — gives our nation the chance to entrench a new settlement.”

Who could Osborne be hoping the electorate might comprehensively reject after such a law permanently changes the UK budget? (The Labour Party, obviously.)

The references to Sweden and Canada are telling: Sweden’s surplus rule is nearly 20 years old. Since the mid-1990s Canada has generally had a “balanced budget or better” norm, surviving administrations of both the centrist Liberal party and the centre-right Conservatives. I
n the New Statesman George Eaton remarked that this is one of Osborne’s favourite political plays: “In opposition, you move to the centre … In government, you move the centre.”

Osborne has decisively won the battle over fiscal politics in the UK — he’s now bayoneting the wounded. When aiming for a budget surplus becomes the fiscal “baseline” (the norm), any deviation can be attacked. Even calling for a balanced budget would be seen as profligate by comparison. Osborne has a public that really doesn’t like the idea of government debt on his side — even when they dislike the individual cuts needed to achieve his aims.

If Osborne can embed the surplus rule into politics in the way that has been done in those countries, he may well be casting a shadow over British tax-and-spending decisions for decades after he’s left office.

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