Business Analysis: How Brown bent his Golden Rule to keep the public finances in line

Here, we look for a way through the maze of issues surrounding the UK's public finances and the Government's rules for its own fiscal policy.

What did the Chancellor do yesterday?

He announced that after a major revision to past economic data - which showed that economic growth between 1997 and 2000 had averaged 3.5 per cent rather than 2.6 per cent as first thought - it was now clear the latest economic cycle began in the middle of 1997 rather than its provisional judgement of 1999.

We all know that economies go through cycles - why is this so important?

When Labour won power in 1997 it was keen to establish a reputation for credibility on public finances - something it had squandered in the 1970s. It set up two fiscal rules, one relating to the economic cycle.

The first said the stock of public debt should be at a "stable and prudent level", later clarified as being 40 per cent. The second rule, known colloquially as the Golden Rule, said that "over the economic cycle", the Government would borrow only to invest and not to fund current spending.

In other words, while the Government should be able to invest for the long term, it must ensure the money it raises during the "up" times pay for its extra needs on day-to-day spending needs during the "down" period.

That sounds eminently sensible and straightforward. Why the fuss?

The problem is that despite the connotations of permanence and value that the phrase Golden Rule conjures up, the reality is far removed from that. As Professor Peter Spencer, a respected economist, points out, the Chancellor is "judge, jury and executioner" when it comes to the rule. In particular he can decide when the economic cycle starts and when it ends.

How does that impact on the rule, precisely?

As the cycle starts when the economy is moving upwards, the early years are usually characterised by surpluses. Originally the short 1997-1999 period ended with a surplus of £9bn that can be added to the £50bn surplus that had already been banked from the 1999 to 2001 upturn. The change in effect gives the Chancellor a £9bn cushion to count against the deficits racked up after 2000.

So has the cycle ended yet? Who will tell us when it has?

In Budget in March, the Government said it expected the cycle to end "towards the end" of this year. It did not want to talk about that yesterday, but the new graphs it published showed the economy if anything is moving further away from hitting the line of trend output that would mark the closure of the cycle. The Government says it will be possible to say only in hindsight the cycle had ended so as to judge the rule- and it warns that further revisions could change that view anyway.

What do other people say about this system? I read that the Liberal Democrats want the National Audit Office to have an independent role in deciding the cycle's start and end dates.

Yes. The two main opposition parties are united in wanting an independent authority to make the key judgements on the fiscal rules. Independent think-tanks such as the Institute for Fiscal Studies and the National Institute of Economic and Social Research agree. In the case of the NIESR it would like to be given the job.

Mr Brown said he would ask the NAO to audit his new view on the start of his cycle and said he expected them to make their views known. When pressed on this, his press officials declined to say whether the Treasury would change its mind if the NAO disagreed. Analysts believe that will be unlikely.

Is that the only change that the Treasury has made to the Golden Rule?

Far from it. Last year it clarified the way the rule should be judged. The rule says the current budget must balance over the economic cycle. Most commentators assessed the progress of the rule by adding up the surpluses and subtracting the deficits. Last year the NIESR said this showed Mr Brown was on track to break the rule. The Treasury has insisted the rule should be calculated by taking the average of the surpluses and deficit measured as a percentage of GDP.

Why does that make a difference?

In the early years of the cycle when the Government was running a surplus, the economy was smaller, so the surpluses were magnified as a percentage of GDP. Likewise the more recent deficits are measured against a much larger economy. Of course as the UK enters the new cycle with deficits, these initial shortfalls will be magnified while later surpluses will appear smaller as a percentage of GDP. Unless, of course, the rules are changed again.

Hasn't the Office for National Statistics made some helpful changes to the way it sees the public finances?

The ONS has made two key decisions over the way that Railtrack and the Government's road programme are viewed in terms of the public finances, although it insists these are purely technical judgements.

The first was the continued classifying the £21bn debt held by Railtrack as a private debt even after the decision by Stephen Byers, to make Railtrack insolvent and form Network Rail, a not-for profit company. Separately it admitted it had incorrectly allocated £3bn of spending on the UK's road infrastructure as current, not capital, spending.

Why does this all matter? Surely it's no more important than deciding how many angels one can balance on the head of a pin?

To an extent this does look like politicians, statisticians and economists playing a mathematical version of Grandmother's Footsteps. Even the NIESR says a small breach of the rule would have no economic consequence. But it is important for two reasons. The first is that this whole process acts to undermine the Government's reputation on fiscal policy it was meant to underpin. As Ian McCafferty, the CBI's chief economist put it, the Government's fiscal policy lacks the credibility the Bank of England has on interest rates.

The second is that yesterday's decisions could be used as a way of delaying the tax rises that economists believe are inevitable until a more politically convenient time. Separately Mr Brown delayed the next three-year spending review by a year to 2007, giving more room to make the numbers add up.

So what is the bottom line?

When the cycle now ends - probably later than this year - the next one will begin with a current budget deficit. At some point, barring an economic miracle, taxes will have to rise. Most economists believe the rise will be about £12bn a year - the equivalent of 3.5p on the basic rate of income tax.