Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 18 June 2013

Bold macroeconomic policy changes for a new government

One of the features of the incoming 1997 Labour government was that it undertook significant and progressive changes in macroeconomic policy. Not only was it right to give independence to the Bank of England [1], but the institutional framework they created for this was innovative and effective. As I have written recently, the fiscal framework established a year later was also clear and progressive compared to past practice and what was being done elsewhere.

So could the government that gets elected in 2015 be equally bold? I think it could be. Furthermore, the suggestions I make below apply to many advanced economies. Yet why look two years ahead now, when recovery from recession is either far from complete, or for many countries has not begun? One reason is that the lags in policy making can be quite long. A new government will not have spent the year before an election working out its policies - it will have been too busy campaigning. Policies get decided much earlier. To have a chance in that decision making process, ideas need to be bounced around earlier still.

On monetary policy, the new government needs to acknowledge that the recession has indicated clear problems with the inflation targeting regime. Three things need to change. First, the medium term inflation objective should be accompanied by an objective of minimising the output gap - in other words the UK should have a dual mandate like the US. Second, nominal GDP should be adopted as an intermediate target, to guide the MPC as to how best achieve these two objectives. Third, the inflation target of 2% is too low, because it increases the risk that we will soon suffer another Zero Lower Bound (ZLB) recession. In the UK the government fixes this target (which is one reason why the 1997 decision was progressive), and it should raise it. All of these changes will assist the process of recovery as well as help in the longer term.

On fiscal policy, we have to distinguish between policies pre and post recovery. If the government inherits an economy where the interest rate set by the Monetary Policy Committee is still at 0.5%, then its priority should be fiscal policies that promote recovery. I agree 100% with Paul Krugman that governments around the world have needlessly confused long term issues involving debt with this short run priority: here is one of many posts I have written arguing this. Yet the incoming government should also have a fiscal strategy post recovery.

This should involve both rules and institutions. Whatever fiscal rule is adopted, it should make three things clear. First, it does not apply at the ZLB. [2] Second, it should focus on a long term objective of reducing the debt to GDP ratio. Third, deficits have to be flexible in response to shocks in the short term. Now how you square these three things is tricky, and I still have an open mind on this, but for the moment you should read this very interesting proposal from Tony Dolphin at the IPPR as to how it might be done. That proposal utilises an enhanced UK fiscal council (OBR), which is the institutional leg of the reform.

Before discussing that, however, I want to say a bit more about why the policy goal should be to gradually reduce debt to GDP. I would give four main reasons. First, it allows room for fiscal policy to support monetary policy if it again hits the ZLB, without worrying about the bond markets. Second, it reduces real interest rates, which should encourage private investment (although the more open the economy the smaller this effect will be). Third, it reduces future distortionary taxation. Finally, future generations will need all the resources we can give them to help cope with their inheritance of hugely disruptive climate change.[3]

In the context of similar proposals from Hopi Sen [4], Chris Dillow recently raised some doubts. Some of these relate to the short term position: yes, investment probably responds more to expected future growth than the cost of capital, but with an active monetary policy, reducing debt to GDP should not inhibit growth. A more serious concern is that reducing real interest rates might increase the risk of hitting the ZLB, which is one reason why I propose raising the inflation target. [5]

The current government should be credited with setting up the OBR, but it did so with a very restricted remit. The OBR is not allowed to crunch the numbers on alternative policies, so it cannot even produce the raw material on which others can propose advice. Perhaps this made sense to avoid throwing a new institution into the middle of a fierce political debate in 2010, but it does not make sense in the longer term. At the very least the OBR should be given the freedom to look at alternative fiscal policies, but its role could go further still, as the IPPR proposal suggests.

[1] I should confess that before 1997 I was very dubious about central bank independence. In retrospect that was because I did not have the imagination to see how that the institutional set-up could be crucial. Despite my recent criticisms, I think the MPC has done much better than elected governments would have done. However my fears were that we would get something more like the ECB, so they were not groundless. I also worried that an independent central bank might be too conservative in the Rogoff sense, and that concern has also been realised

[2] Or equivalently, there should be a rule that directs policy in very different ways at the ZLB.

[3] In an ideal world, we would be dealing with climate change now, and perhaps - as I discussed here - using higher government debt to help pay for it. However we are not, and it does not look like this is going to change any time soon.
Postscript 24/6/13: As well as leaving capacity for fiscal stimulus after a large negative demand shock, Obstfeld argues that we need low debt to leave capacity for a (partial) bail out of the financial sector.

[4] I obviously disagree with Hopi on how the Labour party should respond to the myth that their fiscal mismanagement was responsible for the UK’s current plight. If you want to get into the apology idea, then it seems reasonable that governments should only apologise for major errors rather than every particular thing they could have done better. As I have argued before, there is no comparison between Labour’s fiscal errors and the current government’s mistakes. Governments that commit errors that go against expert opinion at the time bear a particular responsibility. Few (myself included) raised objections to the constant 40% debt to GDP ratio when it was adopted in 1998.

[5] In the UK I suspect that the main short term impact of a tighter fiscal regime will be a depreciation in the exchange rate rather than lower interest rates. In the context of the last Labour government, I think that would have been helpful.


  1. Simon you presume debt to GDP is a good measure of debt sustinability - it isnt. First of all GDP is a flow and debt is a stock - so the ratio is dimensionless. Secondly the appropriate measure is a flow measure which measures the cost of servicing debt - and would therefore include interest costs as well as the costs of exchange rate variations of any debt not held in the currency of issue. Would be interesting to see RR remodelled using such a debt sustinability measure. Note: Ratings agencies all use some varient of debt sustinability in their models.

    1. Agree with Simon.

      The method that you use requires future data that are notoriously hard to predict.
      Why use a complicated model (that is inaccurate nevertheless) iso a much simpler one that is as inaccurate. Keep things as simple as possible if you want to manage things.

      Seen from a slightly different angle the market determines if something is sustainable and market conceptions also move all over the place as we have seen lately.

      Debtlevel will differ per country and situation (basically on the presumed fundamentals) but like P/E if you start with that and keep a critical mind and your eyes open and make small adjustments it works as good as more complicated stuff.
      I personally prefer using several different models and look at the differences in outcome. Preferably here say with calculating interest rates at which the thing would drive into the wall. Usually these give a good indication where strange things are happening. But for more daily stuff use the simpler method (slightly adjusted when necesary), if the complicated method is inaccurate as well.

  2. You might not want to hear it but this is written under the assumption that Labour wins the next election. The polls give them a rather stable and considerable lead. That is true.
    However elections are 2 years away and Europe is full of examples that candidates went through the ice even very close to election date.

    And Labour present leader fits perfectly the profile of such a candidate. The guy, like Brown, pure on voterappeal, is simply crap. With Brown having at least the expertise which 'Ed' has not.

    Cameron on policies not only economic (but also EU-file and Scotland for instance) basically has considerable support. His main problem is simply he is not able to sell it properly. And under IP pressure his party looks like a mess.
    It might not be your views but it is the general public's. And they are the ultimate judge (at least short and medium time, God and historians after that).
    Which is in this media driven world a huge disadvantage, but also something that can be repaired.
    It might not be your view but it is the general public's. Eg the public is for austerity (whatever that might be) only as long as it doesnot concern themselves. That much for intellectually incoherent and illogical, but that is the way it is.

    'Ed' however appeals as much or possibly even less to the general voter than 'Dave'. And his policies are constantly moving all over the place. If somebody is inconsistent and incoherent he is.
    'Ed's' main advantage very likely has been that he hasnot come under attack yet. And even now he looks considerably crappier as PM than 'Dave' in the eyes of the general public. Seen his policy u-turns it is very unlikely that he will not come under attack (in a similar way that 'Dave' is now or even worse). And my bet would be that he cracks.

  3. On dual mandate politically.
    The main issue probably to get it accepted or not.
    Imho it should be packaged according the political climate to maximise that chance.

    However the main problem is we simply donot know what the political climate in say 2015 will be.
    In a nutshell basically a transfer of political power as that is what it is might be benificial for politicians. As they can put the responsability for the economy for a large part with somebody else. However as well they lose a mechanism with which they can benefit their voters and not those of other parties. And anyway the elctorate might hold them responsible if something goes wrong.

    EU being the best example. Politics in general like the deniability it has given them (Brussels tells us ..). However with the EU that simply doesnot seem to work. The electorate simply blames national politics and let them figure it out. Same trend with the economy it always costs a few % in the polls even if the government is not too blame.
    The outcome of this all will likely determine if a dual mandate will be possible politically. My guess is that it will be very difficult. All over Europe countries will see a lot of European political problems. PR simply sucks and for years to come (news in all sorts and measures, but nearly always bad and not only on the economy and the forced attepts to save things usually make things worse). Important as an issue itself, but also to have other CBs do the same or being forced by markets to do things (like with independence).

    Imho the preliminary discussion goes into the wrong direction. People like yourself keep connecting it with welfare and anti-poverty stuff even if not necessary. Which will frighten one half of the spectrum. And QE Ben-style clearly mainly benefits the rich, very little dropping through there.
    So my guess would be that if sellable at all i is better sellable if implicit political decisions are cut to an absolute minimum.

    Also from a more philosophical pov (that democracy thingy) political decisions like on transfer of income or wealth should be taken in the political arena.


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