February 8, 2008 | posted by Michael Baxter in UK economy |

Yesterday, the Office for National Statistics dug out the biggest spanner it could find, and hurled it right into the midst of the government’s fiscal workings. As a result, one of the two central planks of Gordon Brown’s approach to government borrowing was left in tatters.

Is it time for our Gordon to sip on the hemlock? Well, maybe not. Maybe, it is all just down to an accountancy quirk, and it doesn’t really matter. Mind you, while we are being asked to look kindly on this apparently meaningless breaking of one of Gordon’s rules, we might equally ask, if this is just an accountancy quirk we are talking about, why does it exist in the first place? In any case, surely, the government should be subjected to the same measures and constraints that are applied to business.

But, even after taking that into account, Gordon’s cunning might in any case come to the rescue. It appears he could just about stretch logic, and claim that the existing definition of his fiscal rule no longer applies.

You may recall, Gordon Brown defines his prudency by two yardsticks. First there is his golden rule, this is the one which says government spending on current account items must balance over the course of an economic cycle. So, it’s okay to go out and spend, providing it is paid back before the cycle ends.

Now, Gordon, as is his wont, played around with this, so that he has always been able to show the rule had been adhered to.

He played around with the timing of the economic cycle, for example.

Also, at one point, when some analysts were saying the rule was about to be broken, he took one of those sharp intakes of breath of his, and said “No”; spending should be balanced over the course of a cycle as a percentage of GDP – not in absolute terms. This was a subtle but important point, as in an economy which is growing, GDP will be much greater at the end of an economic cycle – therefore, borrowing at the end of the cycle which recently ended might have been greater in terms of pounds, shillings and pence than savings at the cycle’s beginning, but as a percentage of GDP, it was the other way round.

The Office for National Statistics also reclassified spending on road maintenance as a capital item, thus removing this from the current account.

Put all that together, and yippee, the golden rule stayed golden.

Moving forward, it seems a much bigger problem exists with this rule. After all, we have been enjoying the fruits of an impressive economic boom – unemployment has been down, corporate profits, and therefore corporation tax, has been high, and thanks to the consumer boom, VAT receipts have risen sharply.

Despite all this, year-in year-out, government borrowing to pay for current account items has been greater than the government originally predicted.

If the economy is now set to go through a sharp slowdown, then just at the time when the economy needs a boost from government spending, it appears government finances will be looking terribly stretched.

So that’s bad news for the golden rule.

Fort that reason, a number of economists have been calling for the golden rule to be scrapped altogether.

It does seem that the Dubya Bush government has the right idea, with its $146bn tax rebate. When a country’s consumers are highly indebted, slashing the rate of interest may not be an effective way to kick-start the economy. It is what Keynes once called “pushing on string.” Instead, goes the argument, the government needs to boost the economy with a fiscal stimulus.

So that seems to mean the UK needs a boost from the government, just at the time when its finances are tight.

But, and here is the really bad news, Gordon has his second rule: the sustainable investment rule. This is supposed to mean that overall government debt must never be more than 40 per cent of GDP.

Well, this has now gone horribly wrong, thanks to Northern Rock and Gordon’s erstwhile friends at the Office for National Statistics (ONS). For yesterday, our official compiler of statistics announced that Northern Rock is now a part of the public sector.

Gordon and Alistair might have been able to avoid using the “n” word, but as far as the ONS is concerned, Northern Rock’s mountain of debt has been nationalised.

The finances did, however, get a boost though, with the ONS’s  inclusion of the Bank of England debt within the public sector too.

In fact, as the Institute of Fiscal Studies (IFS) explained this morning, “The ONS and the Government agreed as long ago as 2003 that the Bank of England should be classified as part of the public sector, but this had not yet been done. The ONS has decided to do so now to avoid ‘an unnecessarily complicated and potentially misleading’ presentation of the transactions between Northern Rock and the Bank.”

So what does it all mean? The IFS put it this way: “The reclassification decisions mean that the debts of Northern Rock and the Bank of England (minus their short-term financial assets) will be added to public sector net debt. The latest available data suggest that reclassifying Northern Rock will increase public sector net debt by roughly £100 billion (around 7 per cent of national income), while reclassifying the Bank of England will reduce public sector net debt by around £2 billion (0.1 per cent of national income).

“Public sector net debt stood at £536.5 billion (37.7 per cent of national income) in December, so the reclassification will probably increase public sector net debt to around 45 per cent of national income. “

Public sector net debt rises sharply in the short term because the measure of debt used for the fiscal rules is net of short-term financial assets, but not long-term financial assets. Crucially this means that the increase in debt is not offset by the value of Northern Rock’s mortgage book. When Northern Rock or its mortgage book is sold, this should offset a large part of the increase in public sector debt. It is even conceivable that the net debt will end up lower than it started.

So does it matter? The IFS put it this way: “Taxpayers have provided a direct loan of around £25 billion (via the Bank of England) and guaranteed some other creditors of Northern Rock, estimated at around £30 billion, to ensure that savings deposited at Northern Rock remain risk-free from the point of view of savers. Therefore in principle the total potential exposure of the taxpayer is around £55 billion (or 4 per cent of national income). But in practice all or most of this exposure should be recoverable from the sale of Northern Rock’s assets, in particular its mortgage book.”

In other words, sure, the statistics say the sustainable rule has been broken, but the reality is different.

And yet, it seems to us that if we can dismiss this idea of including short-term debts but excluding long-term assets from the analysis, why divide the accounts in that way in the first place? Investors are used to comparing a company’s short term assets with debts – that is considered the prudent way. Why should the government be different?

But fear not, it turns out that Gordon once said the definition of the sustainable investment rule will be re-examined in the next economic cycle – a cycle that has now begun. So all our Gordon has to do is re-arrange his mirrors, pump out some smoke, and all is well anyway.