What does being an iron Chancellor actually mean?

 

Rachel Reeves in her conference speech (text version) only mentioned the word ‘iron’ twice (‘iron discipline’ and ‘iron-clad fiscal rules’) but that and the nature of her speech was enough for the headline writers to label her as a potential Iron Chancellor. Which, I suspect, is exactly the way she and her team would have wanted it.

Thanks to the combination of a Global Financial Crisis (GFC) and the right wing press with its influence on the mainstream media [1] the last Labour government ended with a reputation for being loose with the nation’s finances. That reputation is completely undeserved, as I have shown many times, but it is impressions that matter here. In contrast, because of austerity, the Conservatives get far too easy a ride. It is the Conservatives who have treated fiscal rules as something you change every other budget to suit the numbers or politics, yet it is Labour who have to say their fiscal rules will be iron-clad.

The reality is that the fiscal rules Reeves is proposing are almost exactly the same as adopted by John McDonnell when he was shadow Chancellor. Let me repeat that. The reality is that the fiscal rules Reeves is proposing are almost exactly the same as adopted by John McDonnell when he was shadow Chancellor. The big difference between the two shadow Chancellors is that McDonnell announced higher spending and taxes that satisfied those rules (in 2017 at least), but Reeves has been more cautious, so far. In addition, Reeves with Starmer’s support has exerted more discipline on other shadow ministers over what they commit to.

At the centre of these fiscal rules is the golden rule: aiming to match current spending with taxes. However no Chancellor would be foolish enough to try and do that year to year. Best practice for a government like the UK is to have a rolling five year ahead target. I talked about why the golden rule is a good fiscal rule recently here.

That rule is fine as long as the economy is doing OK. The catastrophic mistake George Osborne made was to try and follow it when the economy was just starting its recovery from the GFC recession. [2] Since then, fiscal rules have often had clauses of various kinds to deal with that situation. Labour’s proposed rules do that too, by saying that in a crisis or the recovery from it fiscal policy would be used to support the economy rather than meeting the golden rule. Whereas McDonnell suggested that the Bank define when that was necessary, Reeves has the OBR doing that job. So Labour’s fiscal rules will not repeat the disaster of 2010 austerity.

Crisis apart, the golden rule implies using borrowing to invest, and again Reeves has been very clear that this is what Labour will do. However, like McDonnell’s fiscal credibility rule, Reeves also has the commitment to reduce government debt as a share of GDP, probably as a rolling five years ahead objective. This was included by McDonnell’s team in their fiscal credibility rule against my advice, because it was thought to be politically necessary to do so.

As regular readers will know, my negative view on targeting debt to GDP (or any stock measure for that matter) has not changed since I wrote this with Jonathan Portes. That successive Shadow Chancellors feel the need to include a poor target because otherwise they would get a lot of flak from the media tells you all you need to know about the lack of economic expertise in our media. That expertise says that government debt is not a bad thing, sometimes it is good to let it increase, and we have no reason to believe that current levels of debt are in any way harmful or risky. To suggest that a government that follows the golden rule would be irresponsible if it failed to reduce its share of debt in GDP is just economic illiteracy.

Hopefully this particular target will disappear once Labour are elected. It probably needs to because the amount of additional public investment that is needed after years of underinvestment is immense, and it would be a crying shame if this didn’t happen because of a daft fiscal rule. Because public investment encourages growth it helps reduce debt to GDP in the longer term, so cutting back on such investment because it would in the short term raise debt to GDP is classic short-termism.

Turning back to current spending, it is clear that the next government, whatever its colour, will have to raise taxes and spending once they are in power. As Sam Freedman says here “Starmer’s holding position that he wishes to run “a reforming state, not a cheque-book state” is transparent nonsense”. As I suggested here, the only issue is whether a Labour government does the politically smart thing and acts boldly to increase a variety of taxes in its first budget, or whether tax increases are reluctantly spread out over its first term. The public’s desire for more tax and spend is clear from the latest British Social Attitudes survey, although not quite as strong as it was in the nineties.

Reeves’s line that money for additional spending will come from growth is also at best a holding position. Spending on the NHS, social care, education and so on as a share of GDP needs to rise, which means higher taxes as a share of GDP. Once again, those who criticise these fictions of reform or spending through growth really should focus their attention on a media that makes such fictions a sensible political strategy for a Labour opposition that wants power.

Will Labour be constrained by the macroeconomic situation it finds itself in? We can consider two possibilities, even though reality will probably be somewhere between the two. The first is that inflationary pressure and high (by recent standards) interest rates continue. As long as Labour follow the golden rule, any extra current government spending should not be too inflationary because they are funded by permanent increases in taxes. [3] The shift from private sector to public sector spending will happen through higher taxes.

The same is not true for additional public investment, however. In this case the shift from consumption to investment will come through higher than otherwise interest rates. However the impact on interest rates is likely to be small, as public investment can increase substantially in proportionate terms without rising very much as a share of GDP. Perhaps more of a concern will be getting the resources for the projects (e.g. construction workers).

The second possibility at the other extreme is that UK inflationary pressure disappears very quickly, as the lagged effects of recent rises in interest rates begin to be felt. At worst, the UK may be in recession when the general election is finally called, and by the time Labour takes power interest rates could be back to their lower bound. In some ways this reduces Labour’s problems, because they can in the short run use increases in public investment and current spending to boost the economy. However, one big advantage of rolling five year ahead targets is that the recession will be forecast to be over in five years, so the tax implications of permanently higher current government spending cannot be avoided.

One final point that Reeves’s speech brought home was that Labour will be fighting the 2024 election not just its traditional ground of public services but also on the economy. To Reeves’s credit, she has been persistent at putting better growth at the centre of her message. While I agreed with that, if only because the Conservative’s record has been so poor, many others thought otherwise, because of the structural reasons why the Conservatives tend to perform better in polls about ‘the economy’. Reeves was correct, and not just because of Truss: Labour were level with the Conservatives on the economy six months earlier. What the Truss disaster ensures is that even if growth picks up next year, the Conservatives are unlikely to get much credit for it. [4]

[1] Also to some extent due to the failure of Labour to counteract this message, in part because they had an extended leadership campaign.

[2] The centrepiece of Osborne’s fiscal rules was also a 5 year rolling target for the current deficit. That rule was adopted because it was suggested by the IFS, who Osborne’s advisor Rupert Harrison had worked for. Unfortunately the IFS do not do macro, so their thinking ignored the problem of recessions where interest rates hit their lower bound.

[3] In theory a permanent increase in taxes should lead to an equal decline in consumption. There are two reasons why there might nevertheless be a positive impact on GDP. First, consumers may not regard the tax increases as permanent. Second, private consumption tends to be more import intensive than government spending.

[4] Before the 1997 election, the economy had been recovering well for a few years, but it wasn’t enough to help the Conservatives, in part because the forced exit from the ERM had blown their reputation for economic competence.