A (much) better fiscal rule

Today the Labour Shadow Chancellor John McDonnell will give a speech where he puts forward an alternative fiscal rule to George Osborne’s fiscal charter. It involves a rolling target for the government’s current balance: within 5 years taxes must cover current spending. It leaves the government free to borrow to invest. Investment cannot be unbounded, as there is a commitment to reduce debt relative to trend GDP over the course of a parliament.

No doubt we will hear the usual cries from the opponents of sensible fiscal rules: Labour plan to borrow billions more than George Osborne and they plan to go on borrowing forever. The simple response to that should be that it is right to borrow to invest in the country’s future, just as firms borrow to invest in capital and individuals borrow to invest in a house. Indeed, with so many good projects for the government to choose from, and with interest rates at virtually zero, it is absolute madness not to investment substantially in the coming years.

This part of the rule is similar to the main fiscal rule Osborne himself adopted under the Coalition, which in turn is not unlike previous rules adopted by Labour. What is new is that McDonnell’s rule involves what could be termed a ‘zero lower bound knockout’: if interest rates hit their lower bound following a recession, the focus of fiscal policy shifts from deficit targets to helping monetary policy support the economy. It reflects the knowledge we have gained since the global financial crisis.

Again critics will claim that the knockout would have meant building up even more debt after the last recession. But what matters with debt is its relationship to GDP, and it is far from clear whether more stimulus in 2009 and 2010 would have increased the debt to GDP ratio, because you are increasing GDP as well as debt. But even if debt to GDP did rise, this reflects the right choice. It means prioritising the real economy - jobs and wages - over an obsession with government debt.

We will no doubt be told by government supporters that this would have led to financial disaster, just as we are also told that the coalition saved us from disaster. We will be told this by some economists working in the financial sector - a sector that created the Great Recession. But there is no evidence for this impending disaster, and plenty of evidence that it is a complete myth. As Paul Krugman might say, in a country with its own central bank the bond vigilantes just keep failing to turn up.

Recessions come and go, you might respond, but higher debt will always be with us. That ignores two key points. First, prolonged and deep recessions cause lasting damage. UK GDP per head is currently over 15% below pre-recession trends. Does none of that have anything to do with the slowest UK recovery from a recession in centuries? Second using fiscal policy to end recessions quickly does not mean higher debt forever. The key point is that debt can be reduced once the recession is over and interest rates are safely above their lower bound. Doing that will be no cost to the economy as a whole, as monetary policy can offset the impact on demand. Obsessing about debt during a recession, by contrast, costs jobs and reduces incomes, as every economics student knows and as the OBR have shown.

The rule happens to mean that pretty well all of the additional austerity Osborne has detailed since the election is unnecessary. But that is a byproduct of adopting a sensible rule. If there is any ‘reverse engineering’ going on, it is with the fiscal charter, which some argue was adopted with the political purpose of making Labour look less prudent before the election. As McDonnell notes, no economist has attempted to defend Osborne’s fiscal charter.

Yet I know this point worries some Labour MPs and commentators. They say, quite rightly, that one of the main reasons the 2015 election was lost was because Labour were not trusted on fiscal policy. But the basic truth is that you do not enhance your fiscal credibility by signing up to a stupid fiscal rule. Apart from getting attacked for doing so by people like me, your collective heart is not really in it and it shows. You get trapped into proposing to shrink the state as Osborne is doing, or hitting the poor as Osborne is doing, or raising taxes which makes you unpopular. And if by chance it ever looks like you might be getting that trust back, Osborne or his successor will move the goalposts again.

The far more convincing way to get trust back is to adopt a fiscal rule that makes sense to both economists and the public (‘only borrowing to invest’), and actively talking about it. When the Conservatives accuse you of borrowing, you do not try and change the subject, but remind people that is what firms and consumers do. Borrowing is not a dirty word, particularly when it is on vital investment and you can do it for almost nothing! Indeed borrowing to invest shows you are optimistic about the future and are prepared to do things to make it better. In contrast those who would turn down these investment projects in order to reduce debt as fast as possible have a negative outlook that fears the future.

The Conservatives know they are vulnerable on public investment. Osborne tries to give the impression that he is doing a lot of it, but the figures do not lie. In the last five years of the Labour government the average share of net public investment in GDP was over 2.5%. During the coalition years it fell to 2.2%, and for the five years from 2015 it is planned to average just 1.6%. That is not building for the future, but putting it in jeopardy, as those whose homes have been flooded have found to their cost.[1]

[1] Besides cutting spending on flood prevention while part of the coalition, Damian Carrington revealed yesterday that UK funding for research on flooding has been cut by 62%! There can be no better indication of the madness of George Osborne’s deficit obsession.