ON my bookshelf there is a tome I have been meaning to dip back into for some time. It is called Reforming Britain’s Economic and Financial Policy.

Written by Ed Balls, then Treasury chief economic adviser, now in charge of what used to be the education department, and Gus O’Donnell, then head of the government’s economic service, now head of the civil service, it was intended to be the bible of new Labour macroeconomic policy.

The foreword was by Gordon Brown, who was inspired by his own achievement. The reforms of 1997 ranked alongside those of the 1940s, he suggested, as he traced the “intellectual journey” to “an institutional framework that commanded market credibility and public trust”.

The three pillars of this new framework were an independent Bank of England to deliver low inflation, “a fiscal policy framework which is delivering sound public finances” and a Financial Services Authority to ensure financial stability. The book was sold as suitable for students. Maybe it is now only appropriate for historians, particularly those interested in crumbling pillars.

What should we make of the fiscal policy pillar of which Brown was so proud when Treasury officials are busy working on a rewriting of his rules?

First, a little context. Two things happened on Friday. Stories appeared about an autumn rewriting of the fiscal rules hours ahead of figures showing a sharp deterioration in the public finances. I am assured the Treasury did not plant anything. Indeed, Alistair Darling, the chancellor, had to delay his trip to his Edinburgh constituency to deal with the fallout.

Why do the rules need rewriting? The two fiscal rules, to remind you, are the golden rule — only borrow to fund public investment over the cycle — and the sustainable investment rule: maintain government debt at a “stable and prudent” level, below 40% of gross domestic product.

The problem with the first is that it relies on a judgment, in practice the Treasury’s, on where the economic cycle begins and ends. This not only allows the Treasury to time the cycle but it means fiscal policy is essentially backward-looking.

The issue has come to a head now because official statisticians will in the next few months produce a thorough revision of the national accounts. These estimates, in what is known as the Blue Book, are expected to give a definitive answer to when the economic cycle that began as long ago as 1997-98 came to an end. The golden rule, or something very close to it, will be preserved, but the Treasury is keen for the new version to have a credibility that the old one lost some time ago, by making it more forward-looking and transparent.

The bigger issue, however, is over the other rule. Until the credit crunch broke a year ago, the chancellor could claim not only that debt was below 40% of GDP, but that it would stay there, each and every year, into the indefinite future.

Now, while the Treasury is maintaining the stance that Northern Rock and Bank of England debt should not count towards the calculations, the game is up for this rule. Even before Darling announced a £2.7 billion tax giveaway to compensate for the 10p income-tax fiasco, and last week’s decision to postpone the planned 2p increase in fuel duties, the Treasury had expected debt to rise to 39.8% of GDP.

Now debt, at 38.3% of GDP, is almost certain to rise above 40%. Adding in Northern Rock, it already has. At 44.2% of GDP, it is higher than the 43.5% level Kenneth Clarke bequeathed to Brown in 1997.

What the Treasury intends to do, it seems, is throw quite a few things more into the debt pot, including the government’s liabilities under the private finance initiative (PFI), though probably not those huge public-sector pension liabilities.

What does it mean in practice? Had 40% remained a rigid rule, the government would have had to raise taxes or cut public spending over the next couple of years, which was probably not sensible.

In fact, those figures on Friday showed that the Treasury has the makings of a crisis in the public finances on its hands. Public-sector net borrowing in the first three months of this fiscal year, £28.2 billion, was well up on the £20.1 billion in the corresponding period of last year. Extrapolating that overshoot forward would give net borrowing for the full year of nearly £73 billion, points out Philip Shaw of Investec.

If the Treasury is right and the figures have been boosted by public-spending increases that will not be sustained, it may not be sensible to extrapolate. But tax revenues are weak. Stamp duty is down sharply, Vat and National Insurance contributions are down on a year ago and corporate tax revenues are flat.

I have pointed out before how in the last recession the government went from a balanced budget to a deficit of 7% of GDP. That was when the all-time cash record for government borrowing, £46 billion in 1993-94, was set. It will soon be broken.

How serious will this rewriting of the rules be for the government’s credibility?

If the Treasury is smart and produces revisions to the rules that are sensible, forward-looking, transparent and all the other things beloved of independent experts, it is possible that fiscal policy will emerge stronger from this. Unfortunately, there is rather a better chance that this will be seen as a politically expedient response to a crisis in the public finances.

Meanwhile, there are two pressing issues and both involve 2%. If the rewriting of the fiscal rules provided the government with an excuse to relax the 2% limit on public-sector pay rises then, as Peter Spencer of the Ernst & Young Item club points out, all would be lost. In the City, public-sector pay is the only thing standing between Labour and an inflationary deluge.

If a redrafting of the fiscal rules was followed by a softening of the Bank’s 2% inflation target, that would also go down like a lead balloon. Some rules are definitely not meant to be broken.

PS: It is hard to recall what untroubled lives we led less than a year ago. In early August 2007, consumer price inflation was 1.8% and we had not heard of the credit crunch. Our biggest worry was that the Bank might nudge up interest rates a quarter-point. Happy days.

Last month inflation was 3.8%, more than double a year ago, with higher readings elsewhere, including 4.6% retail price inflation. We are not alone. US inflation is 5%, the eurozone’s 4%. Will we look back in 18 months to this as the point when inflation came back and stayed?

Much depends on oil. Last week saw the biggest fall in oil prices since January last year, when the price slipped below $50 a barrel. This time it dipped below $130. Good news, though there have been too many false dawns to conclude the great correction has begun.

What about the Bank’s monetary policy committee? Having cut Bank rate to 5% when inflation was rising, it stands accused of negligence.

Its members stress that they are treading a careful path between the credit crunch and the commodity surge. You get no sense that it wants to raise rates, but cuts are for the moment out of the question. The Bank has to hold its nerve.

The Bank’s next inflation report will show an even higher peak than last time. Central bankers as much as anybody would love a big oil-price fall.

david.smith@sunday-times.co.uk

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