William Thompson explains why monetary theory can help explain why the UK Government’s fiscal rules grind down the poorest for no good economic reason.
Inaction in welfare reform and provision in Scotland was a central theme of issue 144. Jen Bell highlighted the DWP’s role as the enforcer of fiscal austerity and wrote that the Labour leadership “shows no intention of reversing course”. Iain Ferguson outlined the need for a “different kind of social care system.” Few would disagree with either statement.
The quest for action must start with understanding the deep-rooted institutional support for fiscal austerity in Westminster. The UK’s fiscal rules, and specifically the welfare cap, provide a self-made straightjacket for the UK and an externally imposed constraint for the Scottish Government.
Since the Labour Party came to power in July 2024, one phrase has dominated economic discussion in the UK: ‘fiscal headroom’. Covered in great detail in every media outlet, we hear that a lack of ‘fiscal headroom’ creates a ‘black hole’ in the public finances, something that is supposed to scare us all. This is the narrative for cutting government spending. ‘Fiscal headroom’ means the difference between expected government revenue and expenditure. If more net revenue is collected, the government has more headroom. If the government spends much more than it is predicted to collect, we will be in black hole territory. The level of fiscal headroom is detailed in the UK’s fiscal rules, introduced by Gordon Brown in 1997.
All fiscal rules are neoliberal in design. They ‘constrain day-to-day government spending’ to aid governments in achieving a surplus or at least balanced budgets. You won’t find any detailed argument or the case being made for these rules within publications from the Office for Budget Responsibility (OBR) and International Monetary Fund (IMF), as there is a shared assumption that government ‘day-to-day spending’ should be kept as low as possible, to allow the productive parts of the economy to expand. In addition, there is a belief that without rules, elected politicians would use their power to do things that please voters. So, for example, a rise in welfare spending may induce some voters to vote for the current administration. The underlying rationale is that it should be ‘markets’ that are appeased by spending decisions, not voters. This is explicit in both OBR and IMF publications. Already, we see the political economy sitting behind these rules. These opinions are claimed as economic facts. ‘Fiscal headroom’ and ‘fiscal black holes’ are products of neoliberal economic ideology.
The current UK Fiscal Rules
Since introducing the rules in the UK, various methods have been used to constrain spending, and the rules often change. The main target under this administration is that the day-to-day budget should be in surplus in 2029/30, according to the OBR forecast. Inserting the OBR here ensures that our elected politicians are reliably constrained. Politicians may have the purse strings, but the unelected technocrats have an ever-watchful eye. The Treasury must lay out a plan as to how the government will achieve a ‘budget surplus’ by the end of the decade. Additionally, since this is a long way off and not restrictive enough, the target will change in 2026, by which point the day-to-day budget surplus or deficit should be no more than 0.5% of GDP.
That these rules have been so quickly and easily consumed and regurgitated by policymakers and the media is evidence of the unquestioning power of neoliberal economics. As such, a short detour into macroeconomic theory is helpful. The end game is a budget surplus. A budget surplus means that over the given period, the tax-take was higher than government expenditure (since only around 0.1% of government revenue comes from other sources). A budget surplus ensures that the non-government sector (holding exports and imports constant) is in deficit. As a fact of accounting, this means that every extra pound the government collects comes from us. The government’s surplus is your deficit. This puts a slightly different hue on government deficits and surpluses.
Nothing is inherently unsustainable about a government spending more day-to-day than it collects. The deficit is the amount of public money in circulation that has not yet been taxed back. This is the view of many economists and can be traced back to John Meynard Keynes (1883 – 1946), the more recent work of Wynne Godley (1926 – 2010), and Modern Monetary Theory (MMT) economists such as Stephanie Kelton and Scott Fulwhiller. Fiscal rules seek to hardwire economic opinion into the heart of government policy. A more fitting name for them would be austerity rules.
The March of Fiscal Rules
You can chart the rise of fiscal rules on the IMF website. Generally, they appear after centrist governments take power, and their propagation can be viewed as a proxy for globalisation and other neoliberal economic ideas.
The need to constrain government spending has been popular with centre and centre-right policymakers for almost forty years. However, the idea that a government needed fiscal rules is fairly new. Until the Eurozone introduced restrictions on government spending in the 1992 Maastricht Treaty, rules that became the international benchmark, governments had operated with more fiscal flexibility. This didn’t mean the government spent with abandon. The Clinton administration ran a budget surplus between 1998 and 2001. Australia did in 1998. And Canada did for a decade fom 1997.
The EU’s core fiscal rule that annual public deficits should never creep above 3% of GDP had a significant impact on economic management worldwide as governments cut back on social security and other expenditures to land within this limit. Understanding the genesis of this 3% limit tells us much about the lack of economic rigor underpinning fiscal rules and provides more evidence of the ideological framing for these rules.
Dr. Dirk Ehnts, a Parliamentary Assistant at the European Parliament and leading academic on monetary operations, explains in an interview at the Scotonomics Festival of Economics in 2024, how the EU’s 3% figure was calculated; “At no point in time did they have some literature or paper [peer-reviewed academic paper] as a source,” he explains. Bureaucrats at the French Ministry of Finance, keen not to upset their bosses, suggested a number safely above France’s historical level, which was around 2%. “3% was a good number because it allowed the French government to be within the rules,” adds Dr Ehnts. Perhaps no casual backseat conversation has had a more negative impact on the poorest people in the 106 countries that use fiscal rules.
Fiscal rules are effective. Swiss researchers Brändle and Elsener conducted an analysis of fiscal rules in 2024 and stated that they were “associated with improved fiscal performance as approximated by improved budget balances.” In other words, they correlate with a reduction of net government spending. Which area experiences the greatest decline in spending? “Fiscal rules have the strongest limiting impact on social spending,” added Brändle and Elsener.
The UK’s unique welfare cap
Fiscal rules provide a window into the social values and ethical standards at the heart of successive UK governments. Many countries have embraced neoclassical fiscal rules, but none to such an extent as the UK. According to the IMF’s database, the UK is the only country in the world with a specific welfare spending cap. Reducing welfare spending may be the outcome of fiscal rules in most countries, but the UK is the only country which makes it part of the target.
The welfare cap was introduced in 2014 by the Liberal and Conservative coalition government. In the broadest sense, the welfare cap ensures that welfare spending is under a more detailed level of scrutiny than any other form of government spending. However, not all welfare spending is treated the same. The table below provides a list of what ‘benefits’ are fair game.
When Rachel Reeves took office, she increased the cap by 20% for total welfare spending over the parliament to £194.5bn by 2029/30 and increased the overspend margin from 2 to 5%. Despite these minor changes – the increase is only likely to track with inflation and must account for a growing and aging population – the fiscal rules’ design ensures that welfare spending either creates or destroys the ‘fiscal headroom’ for the following reason. Currently, the UK government is looking for more ‘fiscal headroom’ to expand defence spending. As only one area has a specific target, welfare becomes the first priority when looking for cuts. Finding the money and keeping within the welfare cap makes perfect financial sense. The welfare cap changes the rules of the game in prioritising government spending.
The Start of a Collective Response
This much was obvious to three parliamentarians, Kirsty Blackman, Jeremy Corbyn, and John McDonnell, during the debate on the welfare cap that took place at the end of January. Alison McGovern, the Minster for Employment, explained that the “welfare cap was intended to ensure that the cost of important parts of the social security system … remains predictable and affordable.” The SNP’s Kirsty Blackman said that the Minister “has not made the case for why they are putting in a welfare cap this year and why we parliamentarians should agree to it.” Jeremy Corbyn added that there “seems to be one approach to investment in major infrastructure projects that run way over budget, and another when it comes to a welfare budget.” John McDonnell’s call for a “focus on poverty, rather than a debate on the welfare cap” was ignored. Kirsty again: “People go to food banks because work does not pay, and the two-child cap, for example, means that they do not have enough money to live on or to support their families. Why is the Hon. Member supporting a welfare cap that bakes in the two-child limit?” The government’s response? “It is important that we have proper controls on public spending. Fantasy economics will do absolutely nothing to support family finances and the Government are determined that we will manage public finances in a responsible fashion.” This narrative justifies billions of pounds of cuts to disability benefits.
The Labour administration framed the welfare debate in terms of how they would stay within the welfare limit and why the previous Conservative government failed to keep spending within limits. There was no discussion on this cap’s impact on those receiving welfare payments, on any alternative route, or on the need for fiscal rules.
Fiscal rules with a welfare cap are among the most neoliberal of economic ideas. By design they restrict ‘wasteful’ government spending on a social safety net that removes the incentive to work and dilutes ‘personal responsibility’. Neoliberal doctrine suggests that a robust safety net creates an inefficient economy. Despite the obvious failings they remain at the heart of the UK government’s political economy and ensure that when the axe is swung, it first cleaves off chunks of support for the poorest in society. These cuts reduce the associated Block Grant Adjustment for Social Security, meaning that the Scottish Government must likewise cut, or mitigate those changes. Currently, it spends £272 per person on mitigating Westminster fiscal austerity.
To effectively challenge the constraints on welfare spending, we must first understand the system that upholds them. The welfare cap is a technical measure that changes the rules of the game. It deeply embeds institutional support for neoliberal economic thinking. We can strengthen and support calls to increase welfare spending by exposing and questioning these foundations.
William Thompson is a political economist and founder of Scotonomics.