Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 9 August 2018

Labour’s fiscal rule is progressive

I have seen a lot of things said about Labour’s fiscal credibility rule in the last few days which are simply wrong. I think the heart of the problem is that many heterodox economists do not believe in what I call the conventional or consensus assignment outwith the lower bound for interest rates. That conventional or consensus assignment [1] is that interest rates should be used to stabilise the economy rather than fiscal policy. The whole idea of independent central banks setting interest rates is predicated on this assignment.

The assignment will not work when interest rates hit a lower bound where central banks feel they cannot cut rates any further (obviously!), so fiscal policy has to become the stabilisation instrument in that situation. The innovative feature of Labour’s rule is the knockout that allows exactly that. I do not think there is any controversy here, so I will confine myself to situations where interest rates are not at their lower bound and set at a level central banks believe will stabilise the economy.

Just as independent central banks are a (not necessary) consequence of the conventional assignment, so are fiscal rules. Without them history suggests you are likely to get deficit bias: a gradual increase in the government debt to GDP ratio over time. For a country with its own currency a rising debt to GDP ratio is never catastrophic, because the markets cannot force such a country to default. There is no magic number for the debt to GDP ratio over which disaster happens. All that stuff is austerity propaganda.

However deficit bias is not good for a variety of reasons. The most straightforward is that more taxes need to be raised to pay the interest on that debt, and taxes discourage labour supply (as well as being politically unpopular). You get deficit bias because it is too tempting for politicians to cut taxes or increase spending by increased borrowing, because to the electorate it looks like you are getting something for nothing. (Trump’s tax cuts for the rich would have been even more unpopular if he had cut spending or raised other taxes to avoid increasing the deficit). A fiscal rule is a device to discourage deficit bias.

It is not the case that fiscal rules are inherently neoliberal. A fiscal rule does not limit the size of the state in any way, as long as you are prepared to pay for higher government spending by raising taxes. Labour’s fiscal rule does not ‘enforce austerity’. Austerity in my book is cutting government spending in a way that is bound to reduce demand and therefore hurt the economy as a whole. In a fiscal credibility rule world monetary policy stabilises the economy, and if rates hit the lower bound the rule’s knock-out applies. That is the crucial difference between Labour’s fiscal rule and the one used by the Coalition government in 2010. Labour’s fiscal rule makes austerity impossible. Let me repeat that: you cannot have austerity with Labour’s fiscal credibility rule.

One false charge is that Labour’s rule would prevent a Job Guarantee scheme being introduced. The idea seems to be that, if a negative shock hit the economy, JG spending would rise and the fiscal rule would stop that happening. Note this is conceptually no different to unemployment benefits. This is not true because Labour’s rule targets the current deficit in 5 years time. In five years time monetary policy will have dealt with the negative shock, so there is no reason to adjust fiscal policy as a result of the negative shock. If by chance monetary policy fails once the 5 years are up, it gets another 5 years to try because the fiscal rule has a rolling target - it always looks five years ahead. That means government spending is never cut because there is a temporary economic downturn.

What this means is that fiscal planning under Labour will in effect always assume output is at the level that keeps inflation constant. Who decides what that long run sustainable level of output is? The OBR, much as they do now. Not the central bank, but the independent OBR. The OBR’s main job is to work out what the medium term steady inflation level of output is, and they put a lot of effort into getting it right.

At the heart of many of the objections to Labour’s fiscal rule is a wish not to follow the conventional assignment, but instead have fiscal policy rather than interest rates stabilise the economy. That alternative assignment means that fiscal policy would be whatever is required to stabilise inflation, and no rule for the deficit is required. That happened in the UK when we had fixed exchange rates and capital controls, so it is not a stupid idea. But to suggest, as so many seem prepared to do, that this choice over assignments is something more than a rather technical debate about transmission mechanisms, institutional constraints and delegation [2] is deceitful..

Which brings me to Richard Murphy’s post. Richard says so many false things about this rule it is difficult to know where to start. It is not ‘neoclassical’, it does not ‘have its roots in microeconomics’. It does not assume ‘markets allocate resources efficiently’. It does not make any assumptions about how money is created. To say that Labour’s rule is based on a microeconomics perspective but MMT has a macro perspective is complete and utter nonsense. You can justify Labour’s rule on the basis of pretty well any macroeconomics you like, as long as you accept that interest rates are stabilising the economy rather than fiscal policy.

The bottom line is that Richard tries to suggest that you could have more public spending under an MMT type assignment compared to Labour’s fiscal rule. That is also completely wrong, and if anything the opposite would be true. Suppose Labour comes to power in 2022, and nominal interest rates by then are at 2%, and inflation is steady at target. Labour are pledged to substantially increase public investment spending (which is outside the rule), which will put upward pressure on demand, at least initially. That would mean under a conventional assignment interest rates would rise to prevent inflation. But in an MMT world that wouldn’t happen. So in an MMT world how do you stop inflation rising? Either current spending would have to be cut, or taxes increased.

There is only one way that public spending for given taxes could be higher in an MMT world compared to Labour’s fiscal rule, and that is if inflation was not controlled at all. That is not what serious MMT economists would recommend. So when Richard says Labour’s rule means a Labour government would be committed to austerity policies, by which I think he means low public spending, while his MMT alternative would allow more public spending without raising taxes, he is, once again, just wrong.

[1] The term assignment comes from the idea that you have two instruments that can control inflation, fiscal policy or interest rates, and an assignment is where only one instrument is used to do the job. You could use both, of course, but if each instrument is controlled by different people with different views about the economy obvious problems could arise. Also in simple New Keynesian models it is optimal just to use monetary policy. I use the term conventional or consensus because it is the assignment that pretty well all advanced countries use, and the one most mainstream academic macroeconomists would recommend.

[2] transmission mechanism: how quickly and reliably each instrument impacts demand. institutional constraints: how quickly you can change the instrument (here monetary policy easily wins without significant institutional change). Delegation: again without major institutional change, you cannot delegate fiscal policy, so if you think delegating stabilisation policy is a good idea this favours monetary policy. As I argue here, delegation is as much about making advice public as it is about devolving power.


  1. The point surely is that if you are using fiscal policy in an MMT sense i.e. building on Lerner's Functional Finance, you spend as much as is needed to ensure the economy is at or near full capacity. If you have a fiscal rule that has some arbitrary target for the deficit (even over 5 years) while most of the time the amount of spending allowed under the rule or under an MMT-type prescription will be similar, there will likely also be a time when the deficit hits a certain level even though there is still slack in the economy. At this point, spending for a given level of taxes would be lower under Labour's fiscal rule.

  2. MMT doesn't suggest that taxes never need to be raised, just that they are not needed to fund spending. MMT says that inflation and the availability of real resources are the limits to spending for a currency-issuing government, not tax revenue or the ability to "borrow" and makes clear that this "borrowing" is not really borrowing at all, merely a savings vehicle for investors that defends a target interest rate.

  3. "as long as you accept that interest rates are stabilising the economy rather than fiscal policy."

    If you look at a graph of interest rates (, you will notice that 8 out of twelve times when rates were increased, a recession immediately followed. Banks have no clue what they are doing with interest rates, and the distortions in currency swap markets leading to the significant long-term violation of Covered Interest Parity are probably the result of Central Banks paying interest on excess reserves to maintain their policy rates.

    It's all silly, anyway. Demand should not be controlled. If Central Bankers believe demand is too high, let them lead by example by reducing their own demand. Rising inflation is not a problem if you index incomes to price rises and redenominate prices in units of real income purchasing power. Nominal inflation can be made to disappear through indexation.

  4. If one argues that we are currently away from the equilibrium level of public/private good allocation (which seems reasonable to me given your view of austerity as an ideological reduction in the size of the state from the democratically-supported level) then does that change the answer with respect to the value of using Fiscal Policy to respond to a negative shock.

    Could your model in Eser,Leith & Wren-Lewis (2009) be used / extended to answer this question more formally and give the relevant optimality conditions?

  5. A good response and I am really enjoying this debate from all sides. It is informative and for positive reasons. And important.

    But. How much work is 'at least initially' doing here?

  6. «That conventional or consensus assignment is that interest rates should be used to stabilise the economy rather than fiscal policy. The whole idea of independent central banks setting interest rates is predicated on this assignment.»

    That “conventional or consensus assignment” is pure far-right propaganda, and G Osborne very candidly proved this when he said:
    «insisted that he had no intention of amending his tough deficit reduction plans. It was up to the Bank of England, he added, to support demand over the coming months.
    "A credible fiscal plan allows you to have a looser monetary policy than would otherwise be the case. My approach is to be fiscally conservative but monetarily active."

    Indeed central bank "independence" is just obfuscation, because given an "inflation" target fiscal policy dominates, as G Osborne implied.

    Also central banks "independence" is a myth pushed by rightist Economists as a decoy for the really important detail: that what matters is that the inflation ceiling is announced in advance, therefore governments and their central banks cannot use a surprise rise of inflation to reduce the real value of their debts, giving a massive gift to the "bond markets vigilantes" and every asset owner.
    Also government can use a "surprise" fall in "inflation" (e.g. by fiscal squeezing) below the ceiling announced in advance to increase the real value of debts for people who don't get the special near-zero interest rate reserved by central banks to friends of right-wing parties.

    «fiscal rules. Without them history suggests you are likely to get deficit bias: a gradual increase in the government debt to GDP ratio over time.»

    A more realistic view is that increasing government debt is (like "inflation") always and everywhere a political phenomenon, and it happens when a government is fighting a war, or is determined to redistribute income and wealth to its constituents from other sectors of society, e.g:

    In the UK the government has engineering a fantastic rise in quasi governmental ("privatized keynesianism" as C Crouch felicitously called it) yet formally private debt like mortgages, as in this telling graph from S Keen:

  7. «For a country with its own currency a rising debt to GDP ratio is never catastrophic, because the markets cannot force such a country to default.»

    That's the usual misleading absurdity, because plenty of currency issuing countries have effectively defaulted, e.g. see "UK, IMF, 1970s", or "UK, Suez, USA debt".
    In practice there are two stages in which the default happens:

    * Foreign suppliers stop accepting the currency issued as payment, because they demand to be paid in hard currency, whatever they consider as such.
    * The currency issuer cannot borrow abroad in their own currency, need to borrow in hard currency, and then cannot generate the export sales to repay that.

    The IMF routinely "supports" sovereign currency issuing governments that "default" either in practice or formally, and since this is public and common knowledge it is amazing that “because the markets cannot force such a country to default” gets written by anybody.

    Perhaps a more realistic statement is that: a country that borrows in its own currency and has a large enough trade surplus cannot be forced to default, but then why would it default? I mean, stating the obvious... :-)

  8. I don't get the deficit bias concern. If the private sector as a rule wants to net-save, wouldn't the government have to run a deficit indefinitely or see the economy tank? Moreover, as we've seen most countries with their own currency running government deficits for decades with no consequences whatsoever (except when they try to reduce them!), deficits appear to be a feature of a private enterprise economy, not a bug. Leakages need to be replaced.

  9. The logic behind interest rate adjustments, which are part of the “conventional assignment” baffle me. It is widely accepted that GDP is maximised where the free market determines prices (including the price of borrowed money) absent obvious social reasons for thinking otherwise. Thus there is no good reason for the state to artificially interfere with interest rates by keeping banks artificially short of reserves, which is what has happened most of the time since WWII.

    Milton Friedman and Warren Mosler (founder of MMT) advocate/d a permanent zero rate of interest (in the latter sense). I agree with them. I’ve set out more detailed reasons here:

  10. I'm sorry, but after reading your piece and the Murphy piece you very kindly link to, I can't help feeling that he has arguments and you have assertions. Examples:
    1) Labour's (your) fiscal rule allows capital spending but restricts current spending: the famous "we can build the hospitals but we can't staff them" paradox. Would it not be more sensible, if you must go this way, to discriminate between transfer spending and resource usage? A lot of the apparent deficits come from transfer spending which does not put a massive burden on the economy (and likewise does not stimulate the economy so directly).
    2) You seem to be determined to maintain the 'assignment' which makes appointed, and unremovable, officials responsible for inflation while making politicians responsible for taxation. It doesn't have to be this way round - Germany has run for years with a fiscal council that takes a strong role in determining allowable spending/deficits and the OBR is being encouraged, not least by you, to move in the same direction.
    3) You are very concerned about deficit bias, pointing at the Trump tax cuts. Arguably, that issue is based in the US' peculiar constitutional arrangements. Certainly, in Western Europe we have seen for the last eight years - and perhaps much longer - an austerity bias where claims of 'cutting the deficit' are used to attack government spending per se.

    In sum, the 'Fiscal rule' seems to me to be fighting the battles of the 60s and 70s. The issue now is to argue for a sensible role for Government in the face of the 'taxation is theft' alliance which has well-funded supporters in the US and elsewhere. I'm sure there are many problems with MMT but changing the focus of the argument to reflect today's circumstances, which it seems to me the approach is trying to do, is definitely worthwhile.

  11. Firstly, you appear to claim a direct causal link between public spending and inflation. I would hope that you know that it is not that simple. MMT states that it is a lack of real resources to utilise or things to buy in the government's currency that may cause inflation.
    Secondly, why do economic commentators such as yourself write about public spending causing inflation when it is bank lending that creates most of the money in our economy?

  12. Some observations:
    1. The ‘knock-out’ element of Labour’s Fiscal Credibility Rule, where fiscal policy takes over the role of monetary policy when interest rates reach their effective lower bound (ELB) may not be as straightforward in terms of its application as made out. The institutional mechanism as to when that occurs, and for how long, in practice, rather than intention, remains unclear.
    2. Currently the MPC is delegated the task of using its MP levers to prevent inflation to rising above its medium-term target of 2%, taking regard of the government’s economic objectives. In this post, SWL states that the OBR will decide the long-run sustainable level of output is; and o the medium-term steady-inflation level of output, something that ‘they put a lot of effort into getting right’. That begs more questions than answers, as to the relationship between the medium and long term, in terms of policy transmission. It is also problematic insofar that the MPC is currently assessing its monetary stance against measures of the output gap – produced by the OBR - that take for granted that the trend-growth line of the economy has been permanently reduced by the GFC. That risks institutionalizing stagnation within the operation of the macro-economic policy framework.
    3. The ‘consensus’ assignment seemed to work well enough during the Great Moderation, and suited a coalition of interests, including New Labour, as it appeared to de-politicise economic policy-making and reduce it to an issue largely of technocratic – whether neo-classical or new Keynesian in theoretical grounding – competence, something that the author sometimes seems to over-rely upon in this post. As hindsight painfully showed, of course, that success was to a large extent an illusion, based on economic models and assumptions that neglected the impact of money and banking and debt. In many ways it is refreshing that John McDonnell has pivoted back to a political economy (whether it is labelled as social democratic or Marxist) approach;
    4. Given the current stagnation, the appropriateness of not only a 2% inflation medium-term target, but the sanctity of its primacy within the assignment, is open to debate. Paul Krugman post-GFC that 4% inflation was desirable in the US context, and the IPPR can be expected be to consider that with reference to the UK in its forthcoming Commission on Economic Policy final report. A controlled partial return to the 70’s might be what the UK economy needs (or more realistically a disciplined return could do as well or better than other alternative options wrapped up in spurious technical justifications, invariably serving the particular political interests of the few that involve corresponding more distributional pain for the majority) as the third decade of the 21st century is approached.
    5. As Krugman also points out, deficit-based Keynesian stimulus doesn’t provide a sound basis for sustained growth: it rather provides a route out of unnecessary recession and depression when aggregate demand is too low. Public investment needs to increase to a sustained steady-state level that is economically conducive to productivity-gain within the wider economy for the medium- to long-term , rather than being used as a pump-priming short-term counter-cyclical tool, a role which, because of gestation, timing, delivery issues, that it is often not well designed to discharge. Public investment must be efficiently selected, planned, and delivered in terms of its overall macro-economic and distributional impact. That imperative would benefit form more policy and academic attention.

    These points are considered in a bit more detail in with reference to the contribution made by Stirling of the IPPR in the spring.

  13. Are MMTers Friends-of-the-People?
    Comment on Simon Wren-Lewis on ‘Labour’s fiscal rule is progressive’

    Bill Mitchell recounts: “The exchange [with Richard Murphy] took place on the social media page of a Labour Party insider who has long advocated a Land Tax, which McDonnell is on the public record as saying will ‘raise the funds we need’ to help local government. He called it a ‘radical solution’. An aside, but not an irrelevant one. It reflects the mindset of the inner economics camp in the British Labour Party, a mindset that is essentially in lockstep with the neoliberal narrative about fiscal policy.”

    Bill Mitchell has serious doubts about whether the present Labour leadership really has the people’s best interest in mind:

    • “The British Labour Party has not crowned itself in glory in the last few weeks by proposing to consider adding a UBI to its policy platform.”

    • “As many commentators have pointed out the problem with this proposal can be summarized by just considering the party’s own title – Labour Party. A party that is concerned for the welfare and aspirations of workers who work and their dependents.”

    • “Why would a progressive ‘Labour’ party want to introduce a UBI to solve unemployment when in government it could always ensure that all idle labour is productively employed?”

    • “Why would a progressive Labour Party want to surrender to the neoliberal idea that there will never be enough jobs to go round when there is patently millions of jobs that can be created to serve community and environment if the government funds them?”

    There is social policy and there is the funding of social policy. And these are TWO ENTIRELY DIFFERENT things. The economic stunt is that one can pull social policy out of the monetary cylinder that does NOT benefit WeThePeople but WeTheOligarchy. And one can call oneself a real Progressive and present oneself as true Friend-of-the-People and stab the elected party leadership in the back.

    Classical social policy is rather straightforward: increase social spending and balance the budget by increasing the taxes of the rich or, alternatively, increase social spending and balance the budget by lowering military spending while keeping taxes unchanged.

    Progressive social policy does not bother with either. As Bill Mitchell said elsewhere: “Do we need the rich’s money?” “No”.#1 Progressive social policy does not need taxes because, in a fiat money system, the sovereign government solves all problems by deficit-spending/money-creation. MMTers correctly point out that, historically, ever-growing public debt has posed no serious problems and has never caused inflation. And this should tell everybody that all arguments against MMT are scientific and political BS.

    In sum, MMTers argue that all available evidence confirms that Progressive social policy is superior to the obsolete social policy of the present Labour leadership.

    Fact is that Progressives/MMTers are NOT the true Friends-of-the-People. MMT is scientifically refuted on all counts.#2 Because of the macroeconomic Profit Law, i.e. Public Deficit = Private Profit, MMT policy ultimately benefits alone the Oligarchy. Politically speaking, MMT is Wall Street’s knife in the back of the present Labour leadership.

    Egmont Kakarot-Handtke

    #1 MMT: academic snake oil for the people

    #2 MMT, money printing, stealth taxation, and redistribution

  14. "There is only one way that public spending for given taxes could be higher in an MMT world compared to Labour’s fiscal rule, and that is if inflation was not controlled at all. That is not what serious MMT economists would recommend." I don't think this is what MMT champions like Bill Mitchell are arguing. Spending is limited to resources. Where shortage of resources will cause prices to rise, that is the true limit. As for the wonderful work of our Parliamentary Budget Office, Mitchell doesn't share your enthusiasm for all their fine work.

  15. Be prepared for a point by point refutation of your article, along with being called neoliberal and/or just plain wrong from "Professor" Murphy any day now. After all, he is one of the world's leading (self taught) economists.

  16. Simon, I would like you to answer my question here if you would be so kind. I have studied the work of Wynne Godley which is crucially central to MMT. The sectorial balances, used still by the OBR and ONS show that when government tries to real equilibrium or a surplus, there is a mirror image on the charts showing increases in private debt. At the moment we have such a situation. It causes a slow down a recession, hence the high number of high street failures. Without a constant expenditure of high powered government money which creates real savings in the economy and full employment, people go into private debt, as do businesses, or starve. The fiscal rule seems to me to just create a cycle of private debt/poverty with flimsy stimulus. Being subject to artificial rules seems to me to fight the real spirit of Keynes Abba Lerner and Godley, who realised that government money should be used to balance the economy, not the books. Please explain why this is wrong.

  17. "Taxes are needed to pay the interest on the debt." Government is a sovereign issuer of currency. Wynne Godley stated that "Money is created in two fundamentally different ways. On the one hand
    there is outside money, which is created whenever a government pays for
    something by making a draft on its central bank or by paying for something
    with banknotes, and which is extinguished when a payment is made by a
    member of the public to the government, typically in the form of taxes. This
    kind of money we may call government money, since it is issued by public
    institutions, namely the central bank or the Treasury department of central
    government. Government money is usually called central bank money or highpowered
    money in the literature. On the other hand there is inside money,
    which is created by commercial banks when they make loans, and which
    ceases to exist when loans are repaid." So if government creates high powered money when it spends, why should taxes be needed to pay interest? Why does government need to issue private debt? Interest,if created by the Central bank at the governments order to spend, is stimulus,like any other spending. Why not tax the bond holders only? Or not issue private debt?


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