Brian Easton asks whether we should pursue a ‘Golden Rule’ where any public borrowing for consumption is temporary

This is a re-post of an article originally published on pundit.co.nz. It is here with permission.

This columnist is a fiscal conservative who is cautious about government borrowing for public consumption. I was not originally. The Keynesian model I first studied said borrow as much as is necessary to sustain demand. But the model was of a closed economy. In a small open economy, borrowing blows out through the external current account which can lead to painful interactions with overseas creditors. (Keynes was well aware of the issue. His macro-model was designed to show that even if there was no external sector, there could still be depressions. In his days the additional spending was often in investment in government businesses and infrastructure.)

As my thinking progressed, I realised that there was also a moral problem. We are not immortal. When we borrow for today’s consumption, we are leaving future generations with a debt they have to service. I am very uncomfortable with such a strategy.

Fiscal conservatism can be simplified to the ‘Golden Rule’ of fiscal management. It is articulated in various forms; one is that the government should not borrow in the long term for consumption. It acknowledges it may be necessary to borrow, or draw down reserves, in the short term for a crisis but in the medium term, say five years, it should repay the debt or rebuild the reserves.

Actually, the spirit of fiscal conservatism is not too different from Richard Thaler’s summary of observed human savings behaviour. (Thaler was awarded the Nobel Prize in economics for his research in behavioural economics.) His household rules were:

1. Live within your means. Do not borrow to increase consumption except during well-defined emergencies (such as unemployment).

2. During emergencies cut consumption as much as possible.

3. Keep a rainy day account equal to some fraction of income. Do not raid the account except in emergencies.

4. Save for retirement in ways that require little self-control.

5. Borrow only on the security of a real asset.

These rules are heuristic but they are near enough to optimal for practical purposes and are understandable and relatively easy to follow. You probably usually follow them.

The Golden Rule of fiscal management is also a near-optimal heuristic with the merit that it can be readily understood by the public. There are lots of nuances in its implementation which I have set them aside for this exposition.

Fiscal conservatism is not (neoliberal) Austerianism. It accepts that a country may want to spend a lot on public consumption – which Austerians may deplore – but argues that such spending must be offset by comparably high taxation (and other revenue), which Austerians deplore even more. It argues that the government can (and should) borrow, but only for investment which will benefit future generations, like on infrastructure for educational and healthcare buildings, storm, fresh and waste water and transport. Austerians think that such investment should be provided by the private sector. The record of the last four decades shows that strategy results in underinvestment.

The Golden Rule says that the current public debt target of the government is a muddle because it does not distinguish between debt arising from borrowing for consumption and debt matched by capital assets. Just suppose the government took the underinvestment in infrastructure seriously, deciding to address it by a major capital works program. Currently it would be thwarted by the public debt target even if the program met every criterion that commonsense advanced.

This is not an argument against the current accounting conventions, although the public accounts could be rearranged to present the fiscal situation in a more understandable way to the public. The government is required to present an Investment Statement at the end of the year. Hopefully it will be more transparent than last year’s.

What the Golden Rule approach is objecting to is the way the government states its debt track (as it is required to do by the Public Finance Act). Rather than state a debt target, it should state it was committed to the Golden Rule and that any necessary temporary borrowing to deal with a crisis (such as an earthquake) would be repaid in five years (say). Infrastructural investment program would go ahead as much as available resources allow.

It may be tinkering with this idea already. Last year’s Fiscal Strategy report said the government had a ‘net worth’ target. (It was 40 percent of GDP.) Net worth is the aggregate of public assets less public debt. Unfortunately, the statement has little explanation or analysis.

In particular, if the government’s net worth target is 40% of GDP and its debt target is 30% then it has a gross public asset target of 70%. (be warned; definitions are tricky here.) There is no exploration of what that currently means or whether the 70% target makes sense. But observe that if the government were to borrow more for infrastructure, both its gross assets and gross debt would increase by the same amount, so that net worth would be the same, although providing the investment was effective, the economy would be better off. Perhaps the government should replace the net debt target with a net assets guideline.

Borrowing is not free. The resulting debt has still to be serviced and that would come out of the consumption budget. Historically we followed a similar practice when overseas borrowing went into a separate ‘works’ account which funded public works (which in the old days included building power stations). The debt was serviced from the rising government revenue generated by the economic growth and development stimulus to which the infrastructure contributed.

When the overseas borrowing ran out – as it did in 1929 – the government promptly closed down its public works program, dumping its workers into unemployment. I recall this event not as a warning – it is very unlikely to happen today for a number of reasons, including the benign vision of Keynes – but to remind you that the pursuit of the Golden Rule being proposed here is an evolution of a practice which worked pretty well in the past, and is likely to benefit Aotearoa New Zealand in the future.

*Brian Easton, an independent scholar, is an economist, social statistician, public policy analyst and historian. He was the Listener economic columnist from 1978 to 2014. This is a re-post of an article originally published on pundit.co.nz. It is here with permission.