Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 2 November 2021

The danger of imprecise exceptions from fiscal rules


If you think fiscal rules are a waste of time, tell me how you would conduct fiscal policy. Your answer is an implicit fiscal rule. Fiscal rules are a useful way of talking about good and bad fiscal policy in this very imperfect world.  

The Chancellor’s new fiscal rule contains a statement that the rule will no longer apply after “significant negative shocks”. In a twitter thread I called this ‘dangerously imprecise’, and in this short post I will explain why it is imprecise and why the Autumn Statement is an example of why it is dangerous.

I fear too many non-economists think this kind of exception from a fiscal rules is because a large negative shock will blow any fiscal rule out of the water as a result of the automatic stabilisers operating in a severe recession [1]. A far more important reason is that in a significant recession monetary policy will quickly become unreliable and ineffective because interest rates will hit the lower bound.

Macroeconomists and policymakers generally prefer using interest rate changes set by an independent central bank (usually following some form of inflation target) as the primary method of macroeconomic stabilisation. This is why hitting the lower bound for interest rates is so significant.

Quantitative Easing, or other forms of unconventional monetary policy, are not a substitute for interest rate changes for a number of unavoidable reasons, including the lack of an extensive evidence base for evaluating them. Fiscal policy is far more effective and reliable than unconventional monetary policy as a method of stimulating the economy in a recession.

It follows automatically that once interest rates look like they may hit their lower bound, deficit based fiscal rules should be replaced by whatever fiscal stimulus is required to quickly end the recession, whatever this means for government debt and deficits. Moreover that policy of stimulus rather than hitting some deficit target should remain as long as interest rates remain at their lower bound.

Saying that a deficit based fiscal rule should be suspended following a significant negative shock is entirely passive. Unlike normal fiscal rules, it doesn’t tell policy makers what they should do. By contrast, ‘fiscal stimulus once interest rates are likely to hit their lower bound’ is an active instruction to policy makers. The former is dangerous because it does not specify what the policy maker should do after a large negative shock, or how long the exception should last.

We can see that danger being realised in the recent Autumn Statement. Interest rates are still at their lower bound, and economic activity is not forecast to reach its previous trend. [2] So a good fiscal rule would prescribe some form of fiscal stimulus. Instead Sunak is giving us a fiscal contraction over the next few years. Bad fiscal rules (including those that are dangerously imprecise) lead to bad outcomes.

The worst thing a Chancellor can do is to facilitate, or be passive to, permanent losses in average incomes. Chancellors since WWII have strived to avoid such outcomes, until a decade ago. A permanent loss happened to a large extent after the Global Financial Crisis because of austerity, it happened through Brexit, and it looks like happening in a more minor but still significant way after the pandemic. Bad fiscal rules can enable such disasters, and a good fiscal rule can help stop it happening.

[1] Here I’m using ‘recession’ to mean a significant downturn, rather than two quarters of negative growth.

[2] The OBR says that the pandemic has permanently reduced the level of sustainable activity in the UK. For the reasons I gave here, I don’t believe this is inevitable. Creating a strong economy would over a few years make up for what had been lost in the pandemic. We see no such fatalism in the US, and I don’t see why the UK should be different.

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