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.

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