Yet another call for governments to abandon debt limits and focus instead on net worth! This time it’s in the United Kingdom, where an influential think tank, the Resolution Foundation, has proposed the replacement of the country’s debt rules with “a target to see net worth improving.” This is a bad idea that must be resisted.
The Foundation’s intentions are noble. It is, with reason, deeply concerned with the problem of serious long-term government underinvestment. To understand the relationship between the Foundation’s proposal and the problem of insufficient public investment, let’s remind ourselves that net worth equals non-financial assets minus debt* – so that if a government has, say, debt equal to 90 percent of GDP and non-financial assets valued at 90 percent of GDP, the assets would offset the debt and its net worth would be zero. Using debt to finance public investment thus has no effect on net worth, which means that shifting to a net worth target would remove any barriers to a major increase in debt-funded government investment. Hence the Resolution Foundation’s proposal for what it describes as a “fiscal rule that would value the asset acquired by an investment rather than treating the cost of doing so identically to consumption.”
The Foundation is not alone – either in Britain or elsewhere – in calling for fiscal policy to be refocused on net worth. Interestingly, another country where this idea has been vigorously advocated over recent years is New Zealand. It is relevant then to note that, in its recent review of the country’s fiscal rules, the New Zealand Labor government considered – and rejected – a shift from debt to net worth.
The core reason why net worth cannot replace debt in fiscal policy formulation is that debt limits serve the crucial objective of fiscal sustainability. In a past blog piece, I outlined the reasons why net worth cannot be regarded as a fiscal sustainability indicator, and should therefore not be allowed to dethrone debt when setting targets and rules to assure fiscal sustainability. (I subsequently presented these in greater technical detail in a paper prepared for the OECD.) The key points are
- Nonfinancial assets cannot be treated as offsets against debt because the balance sheet values of these assets in many cases provide little information about the extent to which they generate income or savings to service and repay debt, or could be sold to repay debt. This is particularly true of social and defense assets – e.g. hospitals and tanks. This means that the total value of non-financial assets in government balance sheets greatly exceeds their realistic financial value.
- It would therefore be possible for government to respect a net worth rule while seriously weakening fiscal sustainability by engaging in large-scale debt-financed capital expenditure in areas which add little to government’s capacity to service and repay debt.
These are pretty much the reasons that led New Zealand to reject the net worth rule option. As the New Zealand Treasury puts it, “social assets generally do not directly generate revenue; instead, the public services they provide are funded by various forms of taxation. Increases in the value of social assets (for example the land under state highways) do not necessarily impact on the quantity or quality of public services and may not be easily realized. Increases in asset values may indicate increases in the costs of providing similar services in the future …” Treasury advised the government that by rejecting a net worth fiscal rule New Zealand would avoid the error of offsetting against debt the value of “roads, schools and hospitals that could not be used to repay debt.”
The Resolution Foundation backs its proposal with another line of argument – the claim that government investment is more or less self-financing. More precisely, what it says is that increasing public investment would do so much to boost GDP growth that, even if it were fully debt-financed, debt/GDP would not appreciably increase in the long term. Since what is important for fiscal sustainability is not the absolute level of debt but debt in relation to GDP, this line of argument suggests that any government shifting to a focus on net worth could have confidence that, in doing so, it would not undermine debt sustainability over the long term.
Nobody sensible would deny that the right type of public investment plays an important role in promoting long-term economic growth. Nevertheless, the Resolution Foundation is engaging in wishful thinking here, because the impact of public investment on growth depends entirely upon the type of investment we are talking about. There are many types of public investment which have a very limited impact on growth. We’re not just talking here about the propensity of some governments to waste huge amounts of money on symbolic “white elephant” projects. More important is the fact that capital expenditure on social or defense assets is typically not greatly growth-enhancing. This doesn’t make such capital expenditure illegitimate or unimportant. Good public health infrastructure is essential, and Russian aggression in Ukraine has reminded us all of the vital importance of investment in defense. But boosting GDP growth is not the only objective of public investment, or of public expenditure more generally.
There are, moreover, many forms of government current expenditure which are more growth-enhancing than investment in social and defense assets. This is true, for example, of funding for scientific research and a good deal of spending on human capital formation. If the idea is to exempt from debt limits government spending which is growth-enhancing, it doesn’t make a lot of sense to rely on the accounting distinction between capital and current expenditure. And while it might seem like a good idea to re-define capital expenditure to include this type of spending, to do so would potentially open the door to massive abuse by governments which inappropriately redefine other types of current expenditure as investment in order to be able to escape the constraints of the fiscal rules.
We must therefore continue to reject the proposition that net worth should replace debt when setting rules and targets to assure fiscal sustainability. The problem of underinvestment needs to be tackled by other means. My impression is that in the UK’s case, higher taxes are required — to tackle not only the problem of inadequate public investment, but the related problem of serious underfunding of the National Health Service. (At the PFM systems level, however, one idea I like is protecting investment spending by setting, within aggregate expenditure ceilings, a sub-ceiling for capital expenditure.)
Does all this mean that there is no role for net worth? Well, that’s another issue. A respectable argument can be made for using net worth as an indicator of the fiscal stance with respect to a completely different policy objective – intergenerational equity, as conceived of in “golden rule” terms. In fact, it seems to me intergenerational equity is the only possible justification for using net worth as a fiscal policy indicator. However I would argue that even here net worth is not the best indicator – that is better to focus on its “flow” counterpart, the operating balance. In other words, the “golden rule” is better captured through a rule that the budget should be balanced as measured by the accrual operating balance than by a rule that net worth should be maintained constant. I expect to return to that point in a later blog piece.
*More precisely, NW = non-financial assets + net financial worth (see the earlier blog piece). Net financial worth is a broader debt measure, but the difference between it and other more widely-used debt measures (e.g. net debt) is irrelevant to the issues addressed here.