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Macroeconomic Strategy and Prospects

2.1 Over the past three decades, the UK economy has exhibited high volatility in output and inflation. Instability has made it hard for individuals and firms to plan and invest and has damaged the long-term growth of the economy.

2.2 The Government has reformed the framework for macroeconomic policy to promote economic stability. Greater stability will help people and businesses to plan for the long term. This should improve the quantity and quality of long-term investment - both in physical and human capital - and help raise productivity. Making the economy more stable will also raise employment and living standards.

2.3 The Government's reforms to the macroeconomic framework involve both monetary and fiscal policy. These reforms have both domestic and international relevance. The first part of this chapter discusses the reforms; the second part sets out the medium-term outlook for fiscal policy in light of the latest forecast of the UK economy, and illustrates how the framework is delivering sound public finances while supporting monetary policy during the below trend phase of the cycle.

A MODERN MACROECONOMIC FRAMEWORK

The monetary policy framework

Why low inflation is important

2.4 Stability is essential for high levels of growth and employment. Maintaining low and stable inflation is the best contribution monetary policy can make to long-term economic and social prosperity. High and variable inflation damages the real economy. It leads to an inefficient allocation of resources because people find it difficult to distinguish price movements associated with changes in the demand and supply for particular goods and services from general increases in the price level due to excessive demand across the economy. More generally, planning for the future becomes much more difficult. Costs are also incurred as people seek to protect themselves from the effects of inflation rather than concentrating on the creation of new wealth. This damages productivity and growth.

2.5 High and variable inflation also involves social costs that are likely to fall particularly hard on those people on lower incomes. By damaging growth, high inflation leads to lower average incomes than otherwise. High inflation and macroeconomic instability can also affect those on low incomes through their impact on the distribution of income. This can occur, for example, from arbitrary changes in wealth caused by unexpected movements in inflation; through the impact of uncertainty on decisions to invest in human capital (which is an important mechanism by which people can raise their earning potential); and because of the deterioration in the skills of low income workers who tend to be those most affected by boom and bust cycles.

2.6 Low and stable inflation plays a central role in creating the stable macroeconomic environment which individuals and businesses need to make sound investment and saving decisions. By ensuring that monetary policy focuses on maintaining low inflation, both sharp slowdowns and runaway booms can be avoided. It is now widely accepted that tolerating more inflation does not lead to higher growth or lower unemployment in the long term. Indeed, it is increasingly accepted that high inflation adversely affects long-term growth and is unfair (see Box 2.2).

The new monetary framework

2.7 The Government reformed the monetary framework immediately upon coming to office to ensure that monetary policy makes the best possible contribution to achieving high and stable levels of growth and employment. The primary objective of monetary policy is price stability. But, subject to that, the Bank of England must also support the Government's economic policy objectives, including those for growth and employment. The Government's inflation target - reaffirmed in this Budget - is 2½ per cent for the 12-month increase in the Retail Price Index excluding mortgage interest payments (RPIX).

2.8 The new monetary policy framework, set out in the Bank of England Act 1998, has several features that ensure the benefits of low inflation are realised fully:

• transparency and accountability are central to the framework:
  • the roles of those concerned and what they are responsible for are clear. The Government sets, and is answerable for, the inflation target consistent with the goals of its economic policy. The role of the Bank of England's Monetary Policy Committee (MPC) is to set interest rates to meet the inflation target; and
    
  • in discharging its responsibility, the MPC is subject to Parliamentary scrutiny, for example, by the House of Commons Treasury Select Committee and a House of Lords Select Committee. The MPC is also required to publish the minutes of its meetings, which now occurs within two weeks.
• the inflation target is symmetrical. Inflation outcomes below target are viewed just as seriously as outcomes above the target;
  
• the target for inflation applies at all times and the MPC is accountable for any deviations from it. It is required to justify any such deviation on its merits. For example, following a supply shock, regaining the target immediately might require such a severe policy response as to cause unwarranted damage to the economy. The onus is on the MPC to explain how it proposes to return inflation back to its target level; and
  

• furthermore, if inflation is more than 1 percentage point higher or lower than the target, the 'open letter' system requires that the Governor of the Bank of England write to the Chancellor, explaining why the divergence has occurred, the policy action being taken to deal with it, the period within which inflation is expected to return to the target and how this approach meets the Government's economic policy objectives, including those for growth and employment. Any such letter must be published so as to facilitate public scrutiny.
  
  

  Box 2.3: The Harmonised Index of Consumer Prices (HICP) The Government's inflation target is expressed in terms of the Retail Price Index excluding mortgage interest payments (RPIX). This measure is familiar in Britain - an important factor underpinning the credibility of the new framework. Within the European Monetary Union, the European Central Bank uses the Harmonised Index of Consumer Prices (HICP) for assessing compliance with its price stability objective. A paper outlining the differences between the HICP and the RPIX was published with the Pre-Budget Report in November 1998. The Government believes it is important to establish a record of sticking to the RPIX target, but it is monitoring the HICP since this index is useful for comparing Britain's inflation performance with other European countries. Starting with the figures for January 1999, the Office for National Statistics (ONS) began publishing the UK's HICP and RPIX together for the first time.

Assessing the new framework

2.9 The new monetary policy framework has been in place for less than two years but there are already signs that it is yielding significant benefits:

• inflation has remained very close to target since last summer, with monthly outturns for RPIX inflation at or around 2.5 per cent;
  
• financial market inflation expectations have fallen towards the target level. Inflation expectations 10 years ahead, derived from index-linked and conventional gilts yields, have fallen from 4.3 per cent in April 1997 to 2.6 per cent in February 1999;
  
• base rates peaked at 7½ per cent for 4 months in 1998 compared with a peak of 15 per cent for a year in the last economic cycle, and have since fallen to 5½ per cent. Long-term interest rates have recently been at their lowest level for over 40 years and the differential between the yields on 10-year government bonds in the UK and Germany has fallen from 1.7 percentage points in April 1997 to 0.5 percentage points in February 1999; and
  
• debt interest payments by the Government are falling due to lower long-term interest rates and inflation.

2.10 The forward-looking and transparent nature of the new monetary policy framework means interest rates have been changed when necessary in a more timely fashion than in the past. This has helped to keep output closer to trend, preventing a repeat of the large boom seen in the late 1980s. With inflation close to target, the UK is now in a better position to steer a course of stability and respond to the current global economic slowdown.

2.11 Macroeconomic policies aimed at achieving sustained growth, sound public finances and low inflation should also promote exchange rate stability, consistent with the Government's objective of a stable and competitive pound in the medium term. The strength of sterling during 1997 caused difficulties for some firms, especially manufacturers trading within Europe. Most of sterling's appreciation took place before the new monetary framework was introduced. Over recent months, however, sterling has fallen back close to its level at the time of the last General Election.

The fiscal policy framework

2.12 The Government's new fiscal policy framework constitutes the second key element of its strategy to promote economic stability. The framework also serves to support some of the Government's other important goals, notably the more efficient use of resources in the public sector, thus contributing directly to raising productivity in the economy.

Problems with the previous approach

2.13 The new framework has been designed to tackle head-on a number of key deficiencies associated with the previous approach:

• fiscal policy objectives were not precise and were subject to change. Observers found it difficult to tell whether the objectives were being met. Consequently, structural deficits were not identified sufficiently quickly to be tackled without significant costs;
  
• the framework promoted neither the economic stability nor long-term focus vital to economic success. Output and inflation in Britain were more variable than in most other major industrial countries;
  
• current spending often took precedence over capital, even if the latter offered better value for money. In particular, capital spending - the benefits of which tend to accrue primarily in the future - was an easy target for cutbacks when the fiscal position deteriorated; and
  
• fiscal decisions did not accurately reflect the impact of current public spending on future generations.

The new fiscal policy framework

2.14 The Code for Fiscal Stability sets out the new fiscal policy framework and gives it a statutory basis. It was approved by the House of Commons on 9 December 1998, in accordance with the requirements of the Finance Act 1998.

2.15 Five principles lie at the heart of the Code - transparency, stability, responsibility, fairness and efficiency. The Government is required to conduct fiscal (and debt management) policy in accordance with these principles. In particular, it must state explicitly its fiscal rules and objectives. These must be consistent with the principles.

2.16 The Government has set two strict fiscal rules to deliver sound public finances:

• the golden rule - on average over the economic cycle, the Government will borrow only to invest and not to fund current spending; and
  
• the sustainable investment rule - public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level.

2.17 The golden rule ensures that the Government does not pass on the costs of services consumed today to the taxpayers of the future - each generation is expected to meet the current costs of the public services from which they benefit. This approach is consistent with achieving fairness between generations.[1] The golden rule, supported by the new regime for planning and controlling spending (discussed further below), also removes any bias against capital spending by providing for separate current and capital budgets. Now both types of spending are treated equally on a value for money basis.

2.18 Although the golden rule means that, over the economic cycle as a whole, the Government should not borrow to meet current spending, borrowing is permitted to finance public investment. This is because capital spending generates assets that confer benefits to both current and future generations. It is fair, therefore, that future generations should help pay for the benefits they receive, including servicing the associated borrowing.

2.19 High levels of public debt, however, can reduce the Government's ability to buffer the economy against major shocks. Debt may also impose other costs, such as higher interest rates and efficiency losses due to the higher tax rates needed to service the debt. The Government has, therefore, set the sustainable investment rule to ensure that public debt (net of financial assets) remains at prudent levels. The current level of net public debt is not high by historical or international standards. Nonetheless, the Government believes that a modest reduction is desirable, other things equal, to below 40 per cent of GDP over the economic cycle.

2.20 Transparency is an integral and pervasive feature of the new framework, so ensuring that Parliament and the public can scrutinise the economic and fiscal plans. This should encourage a longer-term approach to government decision-making. The Code for Fiscal Stability provides for a number of reports, of which the EFSR is one, that together set out a comprehensive account of the Government's economic and fiscal strategy and the state of the public finances. In order to ensure that the public is fully informed about Budget decisions, the Government will propose an amendment to the Code for Fiscal Stability, requiring that, in future, a leaflet be sent to every household informing them of tax and spending decisions.

2.21 The Budget includes some technical changes to allow the Debt Management Office (DMO) to take over the Government's cash management from the Bank of England as intended in last year's Finance Act. The transfer of cash management will complete the separation of monetary policy and debt management operations announced by the Chancellor in May 1997. These changes improve the transparency and efficiency of the Government's debt management operations.

2.22 It is important that information is of high quality and presented in a form which provides the basis for good policy-making. The Government is in the process of implementing a major new initiative in the public sector - Resource Accounting and Budgeting (RAB). RAB will put the Government's accounts on a similar footing to those found in the private sector (see Box 2.4). In addition, the Office for National Statistics is undertaking a number of improvements to key economic statistics, relating to both economic activity and the public finances (see Box A2 in FSBR Annex A and Box B2 in FSBR Annex B).

Planning and controlling spending

2.23 The new fiscal policy framework is supported by a new regime for planning and controlling public spending, first announced in the 1998 EFSR. This regime anticipates the planned introduction of RAB, and will play an integral part in allowing the Government to deliver on its wider economic and fiscal strategy.

2.24 The previous control regime - like the fiscal policy framework with which it was associated - encouraged short-term planning and favoured spending on consumption rather than investment. It led to planning on an incremental basis and a failure to coordinate and integrate new spending so as to maximise its effectiveness.

2.25 The new regime addresses these shortcomings. All public sector spending (excluding financial transactions) is contained under the heading Total Managed Expenditure (TME). Within TME, current and capital expenditures are planned and managed separately, consistent with the distinction made in the fiscal rules.

2.26 Around half of TME is managed through Departmental Expenditure Limits (DEL). Spending within DEL is subject to firm multi-year limits covering a three-year period. These limits, set in cash terms, provide departments with a solid basis for planning and a strong incentive to manage their own costs. The Government is now allowing departments the freedom to carry over any part of their spending within DEL from one financial year to the next, a major new flexibility which should greatly improve value for money.

2.27 The other half of TME, expenditure which cannot reasonably be subject to firm multi-year limits, is known as Annually Managed Expenditure (AME). AME - a large part of which is social security spending - is subject to tough annual scrutiny as part of the Budget process. The scrutiny is to ensure that spending within AME is consistent with achievement of the fiscal rules.

2.28 Controlling the quantity of spending is just one aspect of the new regime. It is equally important to control the quality of spending. The Government made clear that the increased public investment announced in last year's Comprehensive Spending Review (CSR) would be linked to modernisation and reform to deliver enhanced efficiency and effectiveness in public spending.

2.29 The Government is delivering on that commitment. It is publishing for the first time measurable targets for the full range of the Government's objectives for public services in the form of ground-breaking Public Service Agreements. Departments' performance against their targets is being scrutinised by a high level Cabinet committee (PSX), chaired by the Chancellor, and supported by a Public Services Productivity Panel of outside experts from business, consultancy and audit. Each department will publish a Departmental Investment Strategy, and this will inform decisions by the Government on the allocation of resources from the Capital Modernisation Fund.

Benefits of the new approach

2.30 The Government is well on track to meet both its fiscal rules. A full assessment of the performance of the new fiscal policy framework is set out in detail later in this chapter.

Stability in the international context

2.31 The UK is an open economy, and therefore events in the world economy and financial markets have a substantial impact. Reform of the domestic macroeconomic policy framework has improved the UK's ability to respond to external events. But the UK has also taken the lead in promoting macroeconomic stability across the world, so as to reduce the likelihood of future global shocks. It has also been at the forefront of proposals to improve the international community's ability to respond to shocks when they occur.

Stability abroad

2.32 Recent world events, especially those in Asia, Russia and Brazil, have served to emphasise the importance of taking steps to improve crisis prevention and resolution. Lessons learned include the need for: an open and transparent international financial system; co-operation and co-ordination between international and national bodies; prevention of moral hazard (where investors take on undue risk in anticipation of being 'bailed out' if a crisis occurs); official financing able to stem contagion; and mechanisms to protect vulnerable groups in crisis countries. Transparency and accountability have just as powerful a role to play in avoiding poor policy making and poor outcomes internationally as they have in the domestic economy.

2.33 Responding to these events, the UK led the G7 in a Declaration on 30 October 1998, which committed G7 countries to:

• introduce codes of good practice on fiscal policy, monetary and financial policy, corporate governance, and accounting, to ensure public and private sector transparency;
  
• establish a mechanism for co-ordination and co-operation between international financial institutions, international regulatory bodies and key national authorities. This should improve surveillance of financial supervision and regulation, thus fostering stability and reducing systemic risk. The President of the Bundesbank, Hans Tietmeyer, was tasked with consulting on how to bring this about;
  
• involve the private sector in crisis prevention and resolution, for instance, through collective action clauses in bond issues;
  
• establish a new, contingent IMF financing facility to prevent contagion, backed up by private sector involvement and bilateral financing as appropriate; and
  
• ask the World Bank to draw up principles of good practice in social policy, to reduce the impact of economic adjustment on vulnerable groups and ensure that development goals were taken fully into account in programme design, especially during crises.

2.34 Good progress has already been made in implementing this reform agenda. At their 20 February meeting this year, G7 Finance Ministers and Central Bank Governors endorsed Herr Tietmeyer's proposal for a Financial Stability Forum, to co-ordinate the identification of systemic risk, the implementation of codes of good practice, and promotion of international financial stability. They noted the completion by the International Accounting Standards Committee of its core set of internationally-agreed accounting standards, and the agreement of a new format for the IMFs Special Data Dissemination Standard - both to increase transparency. They welcomed the implementation of the agreed increase in the IMF's quotas, including the New Arrangements to Borrow. They also published a detailed timetable for the implementation of all the remaining reforms agreed in the October Declaration.

2.35 As they are progressively implemented, these reforms should help to reduce the volatility of financial markets and increase the prospects for economic stability and prosperity, both in Britain and abroad.

Economic stability in Europe

2.36 The UK has a strong interest in economic stability in Europe, irrespective of whether or not it chooses to join the single currency. Around half of the UK's trade and 40 per cent of overseas investment is with the euro area.

2.37 Along with other Member States, the Government submitted its Convergence Programme to the European Community in December 1998, in line with the requirements of the Stability and Growth Pact. The Convergence Programme shows how the new stability-oriented policy framework provides an essential platform for closer convergence of the economic performance of the UK and other Member States.

2.38 The first outline National Changeover Plan for possible entry to the European single currency was published by the Treasury in February 1999. This is a consultative document which sets out the practical steps which would be needed for the UK to join the euro - if that is what Parliament and the British people decide. Government policy on UK entry to the single currency was set out in the Chancellor of the Exchequer's Statement to Parliament on 27 October 1997. This makes it clear that the determining factor as to whether the UK joins should be the national economic interest, and whether the economic case for doing so is clear and unambiguous

2.39 In a statement to Parliament on 23 February 1999, the Prime Minister explained that preparations need to be made now so that, should the economic tests be met, a decision to join a successful single currency could be made early in the next Parliament. The public sector has given a clear signal of its commitment to prepare, involving some spending to give Britain the flexibility it would need to make the changeover as quickly and cost-efficiently as possible.

MACROECONOMIC PROSPECTS: MEETING THE FISCAL RULES

Summary of the economic forecast

2.40 Developments in the economy since the Pre-Budget Report (PBR) have been broadly in line with expectations. Growth slowed a little further in the fourth quarter of 1998 and RPIX inflation has remained very close to its target level of 2½ per cent. Survey measures of confidence have shown signs of improvement following reductions in interest rates.

As a result, there is little change to the economic forecast, or in the assumptions underpinning the fiscal projections. A summary of the forecasts for output and inflation is presented in Table 2.1. (A detailed assessment is set out in FSBR Annex A.)

Table 2.1:Summary of the economic forecast

2.41 The forecasts for GDP growth are presented in the form of opportunity ranges. The upper end illustrates the potential for higher sustainable growth based on improved supply side performance of the UK economy. As in the PBR and previous forecasts, the public finances projections are based on the lower end of the GDP opportunity ranges. They are consistent with a deliberately cautious assumption for trend economic growth of 2¼ per cent a year over the medium term.

2.42 GDP grew by 2¼ per cent in 1998, a little lower than forecast in the PBR, but in line with the forecast made a year ago in the last Budget. Growth in the fourth quarter of 1998 showed a further slowing, but was in line with the PBR projection. Manufacturing output fell, but this was more than offset by continued robust growth in the service sector. This was accompanied by strong labour market activity during the second half of 1998, with growth in employment showing a marked upturn compared with the first half of the year.

2.43 RPIX inflation averaged 2½ per cent in the fourth quarter, as projected in the PBR. The latest evidence, including a slowing of earnings growth, lower pay settlements and historically low rates of producer output price inflation, supports the view that RPIX inflation may move marginally, and temporarily, below 2½ per cent during 1999, returning to target later in the year. The fall in average earnings growth over the past six months, as revealed in the newly reinstated series, is encouraging. As the Chancellor has said on a number of occasions, including last year's Budget, stability requires wage responsibility across the public and private sectors.

2.44 Growth in the United States remains strong and wider financial market contagion as a result of the Brazilian devaluation has been relatively limited. However, prospects for growth in Europe have deteriorated and, overall, the outlook for UK export markets is weaker than previously expected. This is balanced by the marked easing in domestic monetary policy in recent months and firm domestic consumer confidence.

2.45 Growth is expected to be slower this year than last at 1 to 1½ per cent. The fiscal projections are based on GDP growth of 1 per cent in 1999-2000. However, the factors necessary for stronger growth in 2000 and beyond are expected to build during the course of this year:

• prompt monetary policy action to tackle earlier pressures on inflation - supported by fiscal policy action to restore the public finances to a sound structural position - has allowed interest rates to fall at an early stage. With world financial market turbulence receding, survey measures of business confidence appear to be improving;
  
• as the impact of past policy tightening wears off, healthy private sector fundamentals should begin to dominate once more. Both companies and households are in better shape than at the beginning of the decade: neither sector appears over-borrowed and balance sheets are relatively strong; and
  
• the Budget continues to lock in sound public finances, while providing some £6 billion of support for the economy during its below trend phase.

2.46 Overall, there is no reason to alter the assessment that this cycle is likely to be much more moderate than those in recent decades. The independent consensus remains one of moderate growth in 1999, followed by higher growth thereafter. Uncertainties remain, including ongoing risks to the world economic outlook. Nonetheless, around two-thirds of independent growth forecasts lie in a relatively narrow band of ½ percentage point either side of the low end of the forecast opportunity ranges for both 1999 and 2000.

Recent fiscal trends and short-term outlook

2.47 The public finances improved further in 1998-99. The current budget moved into surplus for the first time in eight years, and public sector net debt has fallen to around 40 per cent of GDP.

2.48 Chart 2.1 below shows the improvement in the fiscal position from a longer-term perspective. From the early 1970s, the current budget was continuously in deficit apart from three years during the late 1980s boom. The deficits in the early 1990s were the largest since the Second World War. Although net investment was falling as a share of GDP, net borrowing also reached its highest post-war level in the early 1990s. As a result, public sector net debt doubled over the first half of the 1990s.

Chart 2.1: Surplus on current budget and public sector net borrowing

2.49 Table 2.2 compares the latest outturns and short-term forecasts with the forecasts in the PBR. The estimate for net borrowing in 1998-99 is a net repayment of £1 billion. This compares with a £1½ billion repayment forecast in the PBR. The current budget surplus in 1998-99 is estimated to be about £1½ billion lower than forecast in the PBR.

Table 2.2: Comparison of updated forecasts with 1998 PBR

2.50 These differences are small. They largely reflect lower than expected receipts, particularly for corporation tax and VAT. Public sector current receipts in 1998-99 are estimated to be about £1¾ billion lower than forecast in November. The Control Total - which under the new spending control regime will cease to exist after the current financial year - is £¾ billion lower than forecast in the PBR, mainly reflecting lower expenditure on social security benefits. The Government is set to meet its objective of working within the previous Government's spending plans in its first two years in office.

2.51 Forecasts of receipts for 1999-2000 on a pre-Budget basis have been revised downwards by £3 billion. In part, this reflects some of the estimated shortfall in receipts in 1998-99 (especially of VAT) carrying forward. In addition, the forecast of tobacco receipts has been revised down by over £½ billion and national insurance contributions are now expected to grow less strongly next year. This partly reflects the effect on receipts of the 1998 Budget reforms. Total Managed Expenditure for 1999-2000 is over £4½ billion lower than forecast in the CSR, largely reflecting lower than expected spending on debt interest and on social security (even after adjusting for the effects of the economic cycle).

2.52 These changes result in a higher forecast of the surplus on current budget in 1999-2000 of £2 billion, compared with the PBR projection of £1 billion, whilst net borrowing is £3 billion - £1 billion lower than projected in the PBR.

Medium-term fiscal projections

Fiscal policy and economic activity

2.53 The key requirement of fiscal policy is that it delivers sound public finances, and thus prevents government itself being a source of adverse shocks to the economy.

2.54 Fiscal policy can also play an important role in supporting monetary policy. The substantial tightening of the fiscal stance during 1997-98 supported monetary policy in containing the pressures on inflation that were emerging when the economy was above trend, as well as restoring the public finances to a sound position.

2.55 More recently, the economy has slowed as the world economy has weakened. In these circumstances, the Government judges it appropriate that the Budget measures should continue to lock in the structural improvement in the public finances. At the same time, it is appropriate and sensible to continue to allow fiscal policy to support monetary policy in the below trend phase of the cycle. The Budget measures provide a £6 billion discretionary boost to the economy over the next 3 years, safeguarding stability, while continuing to meet the fiscal rules.

Medium-term fiscal projections

2.56 The Government's latest medium-term projections for the public finances are summarised in Table 2.3 (£ billion) and Table 2.4 (per cent of GDP) below. A more detailed breakdown can be found in Annex B of the FSBR.

Table 2.3: Summary of public sector finances

Table 2.4: Summary of public sector finances

2.57 Over the three-year planning period from 1999-2000, Departmental Expenditure Limits are essentially unchanged from those set out in the CSR in July 1998[2]. However, the components of AME have been reviewed since the CSR, leading to downward revisions to the forecasts of spending on debt interest and on social security benefits (even after adjusting for the effects of the economic cycle).[3] The AME margin has been set at the same level as in the CSR.

2.58 Public sector net investment is set to double to 1 per cent of GDP by 2001-02. For later years, it is assumed that current spending continues to grow at 2¼ per cent per year in real terms while net investment rises to 1½ per cent of GDP.

2.59 It is assumed that there are no further tax changes other than those announced in the Budget, which include the annual real increases in fuel and tobacco duties and the indexation of rates and allowances.

2.60 Actual public borrowing is expected to become positive again during the below trend phase of the economic cycle. But the underlying position remains strong. Net debt continues to fall as a percentage of GDP and the current budget remains in surplus.

2.61 Chart 2.2 shows public sector net debt is projected to fall below 35 per cent of GDP in 2003-04. The improvement in the debt ratio reflects sustained strength in the structural position of the public finances. The chart also shows that net wealth is projected to stabilise broadly as a proportion of GDP, in marked contrast to the experience during most of the 1990s.

Chart 2.2: Public sector net debt and net wealth

2.62 Table 2.5 reconciles the revised medium-term projections of the surplus on current budget and public sector net borrowing with those published in the PBR, with the difference split between those accounted for by Budget initiatives and those due to forecasting and other changes. Before Budget measures are taken into account, tax revenues are slightly lower than projected previously over the period, but spending - notably on debt interest and social security - has fallen faster still.

Table 2.5:Changes in surplus on current budget and public sector net borrowing since the PBR

Taking account of the cycle

2.63 For the purposes of assessing the underlying strength and therefore sustainability of the public finances, it is necessary to take account of the impact of the economic cycle. The method used to produce estimates of the impact of the economic cycle on the public finances is discussed in Box 2.5.

2.64 Based on the judgement that the economy was on trend, on average, in the first half of 1997, Table 2.6 below presents cyclically-adjusted estimates of the key budget balances. With the economy projected to undergo a fairly modest cycle by historical standards, the difference in the paths of actual and cyclically-adjusted measures of borrowing is less than it has been in the past.

Table 2.6: Cyclically-adjusted budget balances 1

2.65 The Budget continues to lock in the sound structural position of the public finances, while allowing fiscal policy to play its role in supporting the economy during its below trend
phase of the cycle. As Chart 2.3 shows, cyclically-adjusted public sector net borrowing remains close to balance over the period covered by the projections and is very similar to that set out in the PBR. This conclusion is reinforced in Table 2.7 which shows the cumulative fiscal tightening since 1996-97.

Chart 2.3: Cyclically-adjusted public sector net borrowing

Table 2.7:The fiscal tightening - cumulative change since 1996-97

Fiscal policy in an uncertain world

2.66 Projections of the public finances necessarily involve a significant element of uncertainty. This is because public revenue and spending projections depend heavily on economic growth and, in particular, on assumptions made about the position of the economy in relation to its sustainable long-term trend. The demand for public spending can also vary unpredictably in response to evolving needs and opportunities.

2.67 The medium-term projections discussed above are based on deliberately cautious assumptions audited by the National Audit Office. In addition, they imply a small surplus on the current budget over the economic cycle, providing a safety margin over what would strictly be necessary to meet the golden rule.

2.68 Chart 2.4 illustrates a still more cautious case in which trend output is assumed to be 1 per cent lower than in the central projection (the same degree of caution as in the PBR). This scenario would imply that a greater proportion of the projected surplus on current budget was due to cyclical strength in the economy. Nonetheless, even under this scenario, the Government would still remain on track to meet the golden rule, while the sustainable investment rule would be met comfortably.

Chart 2.4: Cyclically-adjusted surplus on current budget

Assessment against the fiscal rules and European commitments

2.69 Table 2.8 illustrates the Government's progress in meeting its fiscal rules and against the criteria set out in the Maastricht Treaty. As the table shows:

the surplus on current budget is expected to average 0.4 per cent of GDP over the economic cycle, thus meeting the golden rule;
public sector net debt is projected to decline to well below 40 per cent of GDP by 2003-04, an outcome consistent with the sustainable investment rule; and
the Maastricht Treaty and Stability and Growth Pact requirements - reference values for general government net borrowing below 3 per cent and general government gross debt less than 60 per cent of GDP - are met comfortably.

Table 2.8: Progress against the fiscal rules and Maastricht Treaty criteria 1

Long-term fiscal projections

2.70 Illustrative long-term projections of the public finances are presented in EFSR Annex A, as required by the Code for Fiscal Stability. These projections show a sound fiscal position, broadly in line with the results of a recent study by the National Institute of Economic and Social Research which constructed a first set of generational accounts for the UK. They show that, unlike in many countries, Britain does not have long-term fiscal problems in store. In addition, even a small rise in trend productivity growth could strengthen the long-term sustainability of the public finances considerably.

Conclusion

2.71 The modern macroeconomic policy framework described above is set to deliver the economic stability that Britain needs to achieve its goal of high and stable levels of growth and employment. But while economic stability is a necessary condition for prosperity, it is not sufficient - policies aimed at encouraging work, raising productivity, and promoting fairness and opportunity are also needed. The next three chapters consider the Government's strategy on each of these fronts.

1 As Discussed in EFSR Annex A, current fiscal policy settings in Britain do not appear to result in significant generational imbalance, in contrast to many industrial countries.

2 £250 million of the Capital Modernisation Fund has been brought forward from 2001-02 to 1999-2000.

3 The reduction in forecast AME spending on social security occurs despite the adoption of a new, more cautious planning assumption underpinning the public finances. It has been decided to base the projections of social security expenditure in this Budget on the average of outside forecasts of unemployment compiled in Forecasts of the UK Economy (latest edition, HM Treasury, February 1999). This approach does not reflect the Governments views on the prospects for unemployment. When unemployment is projected to fall by outside forecasters, the flat assumption will again by be used. This approach has been endorsed by the National Audit Office (see their report, HC 294).

Prepared 9 March 1999

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