Fiscal rules: a primer for the budget

Do you want to know why fiscal rules should never involve targets for the debt/GDP ratio, or debt interest, or any stock measure, and why public investment should not be part of a fiscal rule? Read on, but first we have to establish two key principles.

Principle 1: what are fiscal rules for?

The way some economists are tempted to think about fiscal rules is in terms of economic optimality. What is the optimum debt to GDP ratio and what is the best way to get there? This misunderstands what fiscal rules are for. If every government was benevolent (always did the right thing for society) they would follow the optimal policy without the need for fiscal rules. Governments would just consult experts and do the right thing. Why try and formulate the optimal policy into a rule?

Fiscal rules are there to restrain governments from not being benevolent. For many governments the attraction of fiscal giveaways just before an election (and letting monetary policy deal with the consequences for inflation and future generations the responsibility of servicing the extra debt) is too great. Before the GFC the OECD’s debt to GDP ratio was almost double what it was 30 years earlier. In addition right wing governments have discovered that austerity during a recession is a good way of shrinking the state while pretending to be responsible at the same time. When I talk about an irresponsible government below, austerity is the clearest example of a government behaving irresponsibly.

So fiscal rules are part of the apparatus to ensure the government does not give in to either temptation. Good fiscal rules are not overriding democracy but dealing with a negative externality of democracy that occurs because electorates can be fooled. The first best option would be to educate electorates so they could not be fooled, but in a society where the media makes that impossible fiscal rules and fiscal councils are a good second best. Fiscal rules do not override democracy because governments choose to follow them and have the option of ignoring them. No fiscal rule should ever be enshrined in a constitution.

Principle 2: rules should not ignore optimal policy

As my paper with Jonathan Portes explains, fiscal rules are a delicate balance between stopping a government being irresponsible and not stopping them behaving optimally. Too often rules seem designed mainly to constrain governments with little regard to what an optimal fiscal policy would be. Rules that force governments to enact a fiscal policy that harms the economy are bad rules, and are unlikely to be met for very long.

The clearest example of that is when fiscal rules stop a government stimulating economy when interest rates are stuck at their lower bound. Every fiscal rule before the one proposed in our paper had this fault. Every fiscal rule enacted in the UK has had this fault.

Five requirements for a good fiscal policy rule

1. The rule must mandate fiscal stimulus in a recession where interest rates hit (or might hit) their lower bound.
   
   
2. Debt and deficits are shock absorbers, and fiscal rules should interfere with that as little as possible while still discouraging irresponsible government behaviour. We discuss how to achieve that in detail below, but one clear implication is that fiscal rules should involve deficit targets and not debt targets [1].
   
   
3. Public investment should not be part of any deficit target. To abandon good investment projects to reduce the deficit is a cure worse than the disease. The best way to stop white elephant investment projects is not some arbitrary limits on the share of investment to GDP, but an infrastructure commission with some power.
   
   
4. A fiscal council with teeth is an essential complement to a fiscal rule. Such a fiscal council (which has more power than the OBR) can allow a more optimal fiscal rule.
   
   
5. A good fiscal rule should be designed to last. It should have a structure that can deal with all eventualities. But there is every reason to revisit the deficit target every five or ten years in conjunction with the fiscal council and an open debate.

Requirements (2) and (4) interact. A fiscal rule that allows the maximum discretion for governments to allow deficits to be a shock absorber is a rolling five year target. Future targets with a fixed date become problematic as that date approaches, because any shocks just before the date require damaging short term fiscal adjustments, violating (2). But a rolling target allows the government to cheat, because the target never arrives. A fiscal council that can call out such cheating (and which carries political clout) allows a more optimal policy.

How well have the Conservatives done since 2010?

The obvious point is that in 2010 the Conservatives became the most irresponsible government since the General Theory was written in 1936 by violating requirement (1) and giving us austerity. Ironically by adopting a five year rolling target for the current balance (the deficit less investment) the rule met requirements (2) and (3). They created the UK’s fiscal council, the OBR, but failed to give it a strong enough mandate to effectively call out cheating. Rupert Harrison brought with him the expertise of the IFS in formulating the rule, but perhaps because the IFS did not do macro or perhaps for other reasons requirement (1) was ignored, at the very point interest rates hit their lower bound.

That was the high point for fiscal rules under a Conservative Chancellor! Despite the fact that their main rule excluded public investment, the government cut it sharply anyway, which is why the recovery was delayed from 2010 to 2013. Later on the Chancellor decided to play with fiscal rules as if they were his own political plaything to embarrass the opposition with, and I have lost count of how many there have been. A lot of the blame here lies with the media. Gordon Brown was strongly attacked when he allegedly fiddled with the definition of the cycle, but he kept to his fiscal rule for 10 years and it was important at influencing policy. In contrast Osborne was allowed to change fiscal rules as he liked, with very little comeback.

Where do we now stand? We will see shortly, but I would be very surprised to see any rule that meets the first requirement. To do so would come too close to admitting austerity was a mistake. (Something in a rule that allows the automatic stabilisers to work does not meet requirement (1), because in a recession where interest rates are stuck we need a substantial fiscal stimulus.)

The fiscal rule at the time of the 2019 Tory manifesto was “to have the current budget in balance no later than the third year of the forecast period; to limit public sector net investment to 3% of GDP; and to reassess plans in the event of a pronounced rise in interest rates taking interest costs above 6% of government revenue.” This rule illustrates how far backwards we have come since Osborne’s first fiscal rule. The deficit target involves a fixed date rather than being rolling. The current balance is still the target, but there is an arbitrary limit on public investment. (Osborne went even further backwards for a time by targeting the whole deficit.)

What number should the deficit target (excluding investment) be?

Good fiscal rules should have a structure that is designed to last, and a good way of testing them is to see how they would have done over the past. Including a debt target in a fiscal rule is a sure way of making it not last: this was why Gordon Brown’s rules failed. However, as requirement (5) states, there is no reason why you shouldn’t change the deficit target within the rule every decade or so, to reflect changes to your views about long term interest rates and other factors. One possibility is to give the OBR the responsibility of reviewing the deficit target every five years, taking into account changing views about long term interest rates, trend growth rates and what the ultimate debt to GDP target should be.

This is where debt interest should come in. This issue is discussed in detail in a recent paper by the Tony Blair’s Institute, and here I will only make the key point. If you target, say, is to keep the debt to GDP ratio constant, what the primary deficit (the deficit excluding interest payments) should be depends on what interest rates on debt currently are expected to be and what the growth rate of nominal GDP is expected to be. Interest rates matter because they raise the stock of nominal debt for a given primary deficit, and the growth of GDP matters because it reduces the debt to GDP ratio.

Of course the difference between the actual deficit and the primary deficit are debt interest payments. So far governments have tended not to target the primary deficit. In that case the issue is whether current debt interest rates are different from what they are expected to be in the future. This is possible if interest rates on debt are falling and a lot of debt is long term. It is complicated, which is why a body like the OBR needs to be involved.

Why is a maxima (and perhaps minima) for debt interest payments, as proposed here for example, not a good idea for a fiscal rule? Debt interest is just the debt stock times the average interest cost of debt. As a result, it suffers from the same problems as a target for the debt stock alone. Although some positive shocks to debt are correlated with lower interest rates, not all are. And even if they are, why should the correlation be just what is required to smooth fiscal policy?

So far I have talked about long run targets for government debt to GDP rather than government net wealth. This is simply because it is a more familiar concept. In advising on what the deficit target should be, a fiscal council should look at government net worth as well as levels of debt. A government that sells off a profitable asset in order to reduce its debt is just pulling the wool over people's eyes, and schemes like PFI are in danger of falling into a similar trap. 

How should we define public investment?

Requirement (3) excludes public investment from the deficit target, because that investment benefits future generations. But some current spending has some benefits for future generations too, like education. So is the national accounts definition of pubic investment too limited for a fiscal rule? There are rumours the Chancellor is thinking along these lines.

First, it is important to clear up a common confusion. A bridge built with public money will hopefully benefit many generations to come. But a bridge requires constant servicing, and that cost is part of current spending. Does this make sense? Yes it does. You can think of that servicing cost as the price that every generation has to pay to keep the asset in place. There is no reason the current generation should be exempt from paying that. Equally a new hospital should last for many generations, but every generation needs to pay for the nurses to staff the hospital.

What about education? Education isn’t like a bridge. It is not like a one off expenditure that ends when the bridge is complete. If a government decides to reduce class sizes (say), that requires more sending now but more spending in the future as well. Like servicing a bridge, it is a constant commitment that requires constant resourcing to match it.

Public investment should be excluded from the deficit target not just because it helps future generations, but also because it is a one-off investment that will benefit future generations.

Financing a Green New Deal

This discussion is important in thinking about financing spending to combat climate change. Making energy production green is a clear example of a one-off investment to benefit future generations. For this reason some economists have understood why government debt should rise to pay for greening the economy. As I explain in the link, there is a limit to how much this should be done, because the polluter (the current generation) should pay. But as I said here, no fiscal rule should be used as a pretext to stop vital work to green the economy.

Why not run fiscal policy like monetary policy

Interest rates are decided by central banks, or committees including some outside experts as in the UK. No one is suggesting a similar committee of experts can enact budgets, but could they - as Jagjit Chadha suggests here - set the overall deficit any Chancellor has to achieve in their budget. This committee, perhaps part of an enhanced OBR, could work out what the optimal deficit path is to achieve some long term objective for the debt to GDP ratio. No need for fiscal rules.

Inflation targeting works because everyone wants low inflation, and crucially everyone should realise that how you get it is an issue that involves a great deal of expertise. You need to have a model of how the economy works. Aggregate fiscal policy is not like that. There is no analogy to low inflation. Stable debt to GDP might come close, but many would argue that after the GFC debt is too high, and others would disagree. These views are worlds apart.

The same is true about how you get to any long run target. As I suggested above, macroeconomic theory suggests you should do it slowly but does that mean 50 years or 100 years? We just do not know. As a result, I suspect that at the end of the day all the experts would be able to agree on is general virtues like fiscal smoothing. This virtue can be embodied in a good fiscal rule.

Let me put the same point in a slightly different way. You can have rules for good monetary policy, but I suspect the majority would agree that a committee of experts could do better than this rule. I’m not sure the same applies to fiscal policy if the rule is good.

There is also a political economy issue. I doubt that a committee of experts setting the deficit Chancellors had to achieve would last very long. For that reason I don’t think it would ever be established. Maybe if academics devoted as much time and energy to fiscal policy as they do to monetary policy then in twenty years maybe, but it is not a viable proposition right now.

[1] To see why, think about the impact of coronavirus on deficits and debt. Hopefully the virus will lead to a sharp but short-lived recession, which will at least reduce taxes and raise the deficit and debt. The impact on the deficit in future years will be minimal, so requiring little or no adjustment to fiscal policy in future years. This is the optimal policy response. However the debt/DGP ratio will be permanently higher because of the short term deficit, so a debt target would require a (suboptimally) rapid fiscal response. Deficit targets are better than debt targets at preserving shock absorbers.

Monetary and fiscal cooperation: the case for a state dependent assignment

In December last year Mark Carney said

“In a global liquidity trap, central banks cannot be the only policy makers who do “whatever it takes.” There are clear gains from coordination, with other policies – particularly fiscal policy”

I of course agree, as would most academic macroeconomists. So would any sensible informed fiscal policy maker. But of course this didn’t happen in the Global Financial Crisis from 2010 onwards in some key major economies, including the UK.

Carney’s statement, which follows similar statements by the central bank governors of the Fed and ECB, goes against what I have called the ‘consensus assignment’. The consensus assignment has monetary policy looking after the stability of aggregate demand and inflation, while the fiscal authority looks after government debt. In the UK at least this consensus assignment is deeply embedded in the way the media thinks about policy.

In 2009 George Osborne gave a speech in which he said

“[New Keynesian] Models of this kind underpin our whole macroeconomic policy framework – in particular the idea that by using monetary policy to manage demand and control inflation you can keep unemployment low and stable. And they underpinned the argument David Cameron and I advanced last autumn – that monetary policy should bear the strain of stimulating demand….”

This is a statement of the consensus assignment. The irony of it was that shortly before the speech was given UK interest rates hit their lower bound.

Is the consensus assignment still the best way to run policy after short interest rates hit their lower bound? In 2010, in Europe and the UK at least, central banks acted as if it was. Indeed they went as far as to advise fiscal policymakers to embark on austerity. Carney’s statement is an implicit acknowledgement that central banks had been wrong to do that.

The trouble with unconventional monetary policy is not that it does not work, but it does not work reliably. The scandal in 2010 was that while the Bank of England was suggesting in public that unconventional monetary policy could replace conventional interest rate policy, in reality they had little clue how much effect any change in unconventional monetary policy would have. An unpredictable and unreliable instrument is not a good basis for a policy regime when a better instrument is available, and that better instrument is fiscal policy. I think negative interest rates fit into this category of unreliable instruments, simply because we cannot for obvious reasons assume linearity.

So how do we ensure as far as we can that fiscal policy makers will not repeat the mistakes of 2010 in the next recession? The first best would be to have better fiscal policy makers, but alas that is not always possible. There are three widely discussed possibilities.

1. The first is MMT. This in effect reverses the conventional assignment, with fiscal policy doing the demand and inflation stabilisation in all states of the world. If that happens debt looks after itself. I am not in favour of MMT, because I think independent central banks have been very successful at controlling inflation, and a government using fiscal policy would be less successful.
   
   
2. The second is Helicopter Money. If you are prepared to call Helicopter Money (HM) monetary policy, this preserves the consensus assignment by giving the central bank a new tool. HM is more reliable than unconventional monetary policy, because HM is just like a tax cut, and we have a lot of data on the impact of tax cuts on consumers. Like tax cuts, HM will not work if all consumers are Ricardian, but they are not.
   
   

HM is only possible with the agreement of the government, preferably well before it is actually needed. Two key things have to be agreed. The first is the distribution mechanism, where I suspect some governments would prefer something other than a reverse poll tax. The second is an agreement to back the central bank, by which I mean supply it with the assets it requires to claw back at least some of the HM when the economy recovers. The only difference between HM and a bond financed fiscal expansion is that probably some or all of the bond issuance is delayed until after the economy recovers.

Central banks worry that governments will renege on their commitment to back the central bank. My response is that any government that would not back their central bank so it can fight inflation is also a government that would be prepared to abolish its independent central bank, so the concern is of no interest. I suspect also central banks think HM looks like fiscal policy to most people, and they shouldn’t be doing fiscal policy.

I would add a further point on HM. It will not stop a government using what I call ‘deficit deceit’ in a recession: pretending the deficit is too high and requires spending cuts, because the government wants to scare people into accepting a smaller state than would be popular otherwise. HM would avoid this fiscal consolidation influencing output because its demand effects would be offset by the central bank. But a shrinking of the state beyond anything that is popular in normal times is also almost certainly sub-optimal, and can have devastating political as well as economic implications, like those we have seen in the UK, and you could argue HM encourages this.

3. The third, and most likely, is central bank advice. If the central bank thinks that a recession is coming where rates will hit the lower bound, it advises the fiscal authority that some fiscal expansion is required. This is fine if we are trying to combat a fiscal authority that is just ignorant on these matters. The central bank could also convince a fiscal authority that was worried about financing its debt, by for example agreeing to monetise the expansion needed by doing the corresponding amount of QE, or more simply to neutralise any failure by private agents to buy debt.
   
   

My concern here is with a government that said thanks for the advice, but we prefer to focus on reducing the deficit using spending cuts. Would the central bank be prepared to make its advice public? It might not do so if it was concerned that the government would reciprocate by starting to tell the central bank what do so. You could therefore argue that this strategy could be either ineffective, or may threaten central bank independence.

So how can you stop a government that is determined to use the rising deficit in a recession to shrink the state? Of course you cannot, but you can try and create the conditions that will put maximum political pressure on it not to. I suggest above that HM fails to do this, and central bank advice is unlikely to either.

What would be more effective is for macroeconomists and central banks to start being honest about the consensus assignment. As a near optimal policy regime that assignment is dead. Instead macroeconomics suggests what could be called a ‘state dependent assignment’. In most states of the world, central banks stabilise the macroeconomy just as they do now. However in an economic downturn of sufficient size (where ‘sufficient’ is to be defined) the assignment flips, and fiscal policy makers are in charge of stabilisation. In non-technical language, fighting recessions becomes the government’s job.

I think this is something that most academic macroeconomists and some central bankers have accepted implicitly but not explicitly. One reason is I think pedantic. Of course in the state dependent assignment the central bank does not stop trying to stimulate demand in a recession by at least keeping rates low, but there are compelling political economy reasons to highlight the responsibility of governments in this respect.

Those familiar with Jonathan and my paper on fiscal rules will recognise our knockout when rates hit their lower bound as one operationalisation of a state dependent consensus assignment. But it is not an ideal mechanism because switching the assignment should depend on forecast events. Others, like the IPPR and Resolution Foundation, have suggested alternative schemes that come under the umbrella of a state dependent assignment. There is a great deal of work required to figure out the best mechanisms, and also to think about who has control over when switches (both on and off) happen, and whether there is a role for the central bank and/or fiscal council in advising the government on effective stimulus packages.

To conclude, central banks are now recognising that fiscal stimulus is required in significant economic downturns. This is in contrast to the GFC, when many fiscal policy makers enacted austerity. One of the reasons they were able to enact austerity was the dominance of the traditional consensus assignment in the mind of the public. Our most effective way of preventing this happening again is to make a state dependent assignment the new consensus assignment.

The differences between Labour and the Conservatives on fiscal policy

The Conservatives have learnt the lesson of 2017, and have ditched austerity in order to offer higher spending to the electorate.They hope voters decide that there isn't much difference between the two parties on this score. But voters would be wrong to do so. In Labour's case the extra spending is sustainable, whereas for the Tories it will not be. There are two reasons for this.

The first is that the Tories are not proposing large tax increases, while Labour almost certainly will - in the last election corporation taxes and taxes on high earners. (In 2017 the IFS suggested their match between extra current spending and higher taxes wasn’t perfect, but they agreed Labour would keep within its fiscal rule, which is what matters.) That means for a given fiscal stance Labour should have more money to spend on non-investment public spending than the Conservatives. And, assuming there is no collapse in demand ahead, their fiscal stance is now similar. (If there is a collapse, see below).

The second reason is Brexit. The Tories have negotiated a very hard Brexit, leaving the Customs Union and Single Market. I have argued that Brexit will not happen under Labour, but even if it did a much softer Brexit means less economic damage. Soft or no Brexit means higher incomes under Labour which in turn means higher taxes, and so higher spending.

What the Tories are counting on is that analysis by the IFS and others of the two party's programmes will ignore the second difference, and use a common baseline (as the Resolution Foundation does here). Once you factor in Brexit, the Tories extra spending is unlikely to be sustainable. They willl be forced to raise taxes or cut spending to keep to their current balance target. It will be even worse if Johnson throws in some last minute tax cuts in a desparate attempt to ensure he gets a majority. The OBR might have shown all this in its budget forecast, but the budget was conveniently postponed.

Not only will Labour spend more on day to day government expenditure, but they also plan a much more radical increase in public investment spending. Whether you think that is a good idea will depend on how seriously you take the need for a Green New Deal, how much you want to reduce regional inequalities and how much social housing you want the government to build, among other things. That will mean more borrowing under Labour, but public investment of this kind should be financed by borrowing. No one should argue we cannot invest to reduce climate change because it means borrowing more!

Those are the headlines from yesterday. The rest is only of interest to those who worry about fiscal rules. For the details of what each party's new rules are I'm relying on this account by the Resolution Foundation.

1) Both Conservaives and Labour are now targeting the current balance: the deficit minus net public investment. The Tories have given up Osborne's foolish move to target the total deficit, and like Labour's Fiscal Credibility rule will not constrain investment in the deficit part of the rule. There are two differences. Labour targets the current balance five years ahead using a rolling target, whereas the Tories will target it three years ahead with no rolling target. I argue in my paper with Jonathan Portes that in a mature economy with a fiscal council like the OBR a rolling 5 year target makes more sense, because it is more robust to shocks just at the end of the target period.

2) Labour's Fiscal Credibility Rule departed from the suggestions in that paper by having a target for debt. The big change in this election is that this is replaced by a target that includes government assets as well as liabilities, a suggestion that both the Resolution Foundation, INET and the IFS’s Green Budget have made. If you are going to have a stock target (see below) this type of target makes more sense. The Tories have a weak and conventional 'falling debt/GDP' target.

3) Both rules appartently include limits for debt interest in relation to taxes. I'm even less keen on these than debt targets, but they have been suggested by others.

4) Labour’s Fiscal Credibility Rule has a knockout that occurs when interest rates hit their lower bound. This was a key proposal in my paper with Jonathan Portes, and as a result Labour's rule was ahead of its time. When interest rates hit their lower bound, the fiscal rule would be temporarily suspended and fiscal policy would focus on an economic recovery. When John McDonnell launched his rule in 2016 one BBC reporter called the knockout a loophole, despite the fact that it would have created a much faster and quicker recovery and avoided austerity! Other than that mediamacro hardly discussed the knockout.

Since 2016, however, first the IPPR, then INET and then the Resolution Foundation have suggested very similar knockouts, reflecting a growing consensus that fiscal stimulus will be needed for the next recession. In another post I might discuss the small differences between these different knockouts, but the principle is the same and kind of obvious - if conventional monetary policy can no longer do its job fiscal policy should take over. But as we are not yet at this lower bound, Labour were quite right in 2017 not to base policy on the knockout happening, and I suspect they will do the same again in this election. As far as I know there is no knockout in what the Conservatives' propose.

The difference between the rule suggested in Portes and Wren-Lewis and the Fiscal Credibility Rule is that the latter initially contained a target for total debt, and now contains a target for public sector net wealth. While the latter is a definite improvement on the former, I personally think targets for any kind of stock in a fiscal rule are a bad idea. The reason to target the deficit rather than debt is basic to fiscal rules. Adjustment of taxes and spending should as far as possible be done slowly.

Suppose some temporary fiscal shock raises both the deficit and debt. Because the shock is temporary, there will be no impact on future deficits. At most debt interest payments may rise slightly, requiring some very tiny increase in taxes or cut in spending. Debt will gradually fall back to its pre-shock level. That is smooth adjustment. However with a debt target you need a much bigger adjustment in taxes or spending to get the debt stock down within the target period. Exactly the same logic applies to permanent fiscal shocks.

This is the basic logic of preferring deficit target to debt targets This is not to say that the debt ratio or some other stock measure are not important, but they should guide what deficit targets should be, and not be targets themselves. An analogy is a road trip where you are delayed by some congestion. A sensible person does not start taking risks by driving very fast to make up for lost time as quickly as possible, but instead think how they can make up the time gradually over the entire journey. As no one has any good idea of what the optimum level of debt is, the journey in this case is decades not 5 years.

There is a technical argument that you should target both if your deficit target is the current balance, which excludes investment. If that is so, and it should be so, then in theory without some form of debt target the government could increase debt without limit by keeping investment very high. My response is that, if this really is a worry (has it ever happened in the UK over the last 50+ years?), have a target or limit for the investment to GDP ratio, as the new Conservative fiscal rule does. In this one respect I think their rule is better than Labour's, if you ignore their silly change in debt target! An investment target would avoid the dangers of having a stock target.

It would be much more sensible in my view to have just a current balance deficit target, which is occasionally revised after suggestions by the OBR in light of movements in various measures of government debt and wealth. In their recent Green Budget the IFS are very pessimistic, suggesting fiscal rules will never last a long time. I think there is a simple reason for this, and that is that rules generally contain some form of debt target. But they seem very popular with politcians in all countries, and many of those that advise them, which alas may mean fiscal rules may not be as robust as they could be.

Postscript (12/11/19)

I saw it suggested yesterday that you could ignore the points I make here because I once advised the Labour party (that role ended in 2016). Over the last decade I have advised all three of the main parties on various issues. I believe it is an economist's duty to give politicians their expertise if asked, with very mild conditions set out here. Giving that advice on technical issues should never be mistaken for being partisan, just as economists should never let their own political views influence the advice they give on these issues. 

Different kinds of fiscal stimulus

Newspaper day. In the Guardian I have a piece that looks at how we should regard any tax cuts that Boris Johnson may announce as part of the forthcoming election. And make no mistake tax cuts are coming (we already know they intend to cut the tax on petrol), because the spending review signalled that the governments rule will change, as Chris Giles discusses in a good article in today’s FT in which I among other economists are quoted. .

In the Guardian piece I argue that tax cuts are a bad idea because in the context of us leaving the EU they will almost certainly produce unsustainable increases in the deficit without much of a compensation in higher output. As I say in the Giles FT article, policies that if unchanged would lead to steady and permanent increases in debt to GDP are not a good idea. That in turn will mean that at some stage either taxes will have to rise or we will be back to austerity.

But why did I also imply that Wednesday’s spending review was to be welcomed? Are not spending increases and tax cuts not two sides of the same fiscal stimulus coin? There is the obvious point that in many areas public spending cuts have gone way too far. But there is a macroeconomic point as well. Spending increases directly raise aggregate demand by the same amount. Things like income tax cuts, particularly if they go to the better off, are largely saved. (A number of around a third is commonly found in empirically studies for the amount actually spent.) So you get less demand stimulus for your money.

According to calculations done in a separate article by the Financial Times, Labour’s likely plans will also raise the ratio of debt to GDP. But if you look beyond the ‘scare’ headline, the reasons are quite different. Labour will still meet its fiscal rule for current spending, but the amount of investment planned could lead to the ‘falling debt to trend GDP’ part of the rule being breached. These calculations need to be taken with a pinch of salt, because they assume the additional investment produces no increase in GDP, and therefore no higher tax take. Even the IFS when they evaluated Labour’s election plans in 2017 allowed additional public investment to boost GDP. Which is just one reason why the FT’s analysis annoyed the large number of economists, including me, who signed this letter published in the FT today.

I didn’t like the FT write up for another reason. It seemed to be designed simply to be one more fiscal scare story. If I had been writing this I would have asked whether, if the policy did in fact break the debt to trend GDP part of the rule because of more public investment, that part of the rule made sense. A company increasing investment would happily increase its debt to sales ratio if it did a lot of investment, as would an individual increase their debt to income ratio when buying a house. Perhaps that part of Labour’s fiscal rule is a hangover from the days when mediamacro thought government borrowing was a bad thing, even when it was additional investment?

That is the key difference between Labour and the Conservative policies. If the debt to GDP ratio rises because of supposedly permanent tax cuts, that leads to steadily increasing debt to GDP and so cannot be sustained. Running public investment at high levels because you are restoring the public capital stock and as part of a Green New Deal may be prolonged but it is not permanent, and temporary increases in debt to GDP to finance investment make sense.

Is Labour’s fiscal policy rule neoliberal?

That is the charge some on the left, particularly followers a movement called MMT, have laid against Labour's Fiscal Credibility Rule (FCR). MMT stands for nothing very informative, but it is a non-mainstream left-wing macroeconomic school of thought. Bill Mitchell, one of the leading lights of MMT, has run a relentless campaign against the FCR through his blog. As my own work with Jonathan Portes helped provide the intellectual foundation for the FCR, I will try and explain why I find the neoliberal charge nonsensical.

Although MMT has had its biggest impact in the US, it is increasingly discussed by those on Labour’s left (e.g. pro and con). Here I will give a lay person’s guide to only the aspects of MMT that lead to its dislike of Labour’s rule. MMT’s key idea is that fiscal policy (changing taxes and government spending) is better suited to stabilise the macroeconomy than a central bank setting interest rates.

Almost without exception, advanced economies use interest rates set by an independent central bank to control output and inflation. In the UK the Bank of England’s mandate (the inflation target and how quickly it has to be reached) is determined by the Chancellor. If the Chancellor wants to raise the inflation target or scrap it altogether they can do so. But the month to month task of actually choosing what interest rate is most likely to meet the Chancellors mandate is left to the Monetary Policy Committee (MPC), who are either Bank insiders or outsiders appointed by the Treasury.

Why is the choice of setting interest rates delegated to the MPC? Getting this choice right is a highly technical task, requiring detailed discussions of different forecasts and macroeconomic models. If the MPC is working well, they bring strong expertise to the table to help make a decision.

These experts could just give their advice in secret to the Chancellor, leaving the Chancellor to accept or reject their advice. The danger in doing that is the Chancellor will allow party political motives to influence what they do, to the detriment of the economy. As one Treasury insider once told me in the years before the Bank of England (BoE) became independent, the Chancellor recognised that rates had to rise but there is no way it was happening before the party conference.

A fundamental problem with today’s way of doing things occurred during the Global Financial Crisis. Interest rates fell to a level that became their lower bound. Central banks thought that cutting rates any further was ineffective and risky. When that happens, something else needs to step in to stimulate the economy. The BoE tried various measures (like Quantitative Easing), but they were all rather hit and miss because they had not been used much before.

Under the Labour government in 2009 fiscal policy was used to provide the stimulus that monetary policy could no longer reliably give. But in 2010 the Coalition government was elected and decided fiscal stimulus had to become austerity, with disastrous results in the UK and other countries that adopted it. Most macroeconomists rejected austerity in 2010, and their number increased steadily as the impact of austerity became clear.

It is now received wisdom among academic economists that when interest rates hit their lower bound, fiscal policy needs to provide a large stimulus to the economy. Labour’s fiscal credibility rule is the first in the world to formalise this. If interest rates hit their lower bound, the normal rule is suspended and a fiscal stimulus occurs that is sufficient to end the recession. Labour’s rule is therefore designed to prevent austerity happening again.

MMT wants to go one step further. It wants to use fiscal policy to stabilise the economy at all times, and not just when monetary policy is out of action. This is not a ridiculous proposal. The question is whether it would work as well as the current regime. Most macroeconomists prefer using interest rates when possible because rates can be moved quickly. It also allows this decision to be easily delegated to experts, which avoids party political influence getting in the way of macro stabilisation. However an obvious drawback of the current regime is that it cannot work when rates hit their lower bound, so in a bad recession you have to switch to fiscal policy. Labour’s fiscal rule hardwires that switch into policy.

If you are still reading you have probably decided by now that the debate between MMT and mainstream macro about whether to use fiscal policy all the time or just when interest rates hit their lower bound is pretty technical and best left to macroeconomists. I think that conclusion is correct. But why do many MMTers, as they are known, call Labour’s rule neoliberal? To understand this, you have to understand that MMT is far from just another school of macroeconomics.

MMT is also a political movement of the left. Mitchell himself supports Lexit. They are therefore naturally indignant that a Corbyn led government has adopted a rule that is derived from mainstream economics rather than adopting MMT. Their aim is to win a political as well as an economic battle. Pretty much anything is fair game in this political battle, including describing those like myself who defend Labour’s fiscal rule as neoliberal. (To see how ludicrous this charge is, see here.)

These attacks do however raise a legitimate issue. Why the need for a fiscal rule at all? Why not let the Chancellor choose the deficit depending on the economic circumstances? The answer is provided by something called deficit bias, which preoccupied economic policy before the global financial crisis (GFC). In the 30 years before this crisis, the ratio of OECD government debt to GDP almost doubled for no justifiable reason.

Deficit bias happens because politicians like cutting taxes or raising spending through borrowing, because it puts off any obvious economic pain. But if deficit bias does substantially raise the debt to GDP ratio, as it did before the GFC, then more debt requires paying more interest which in turn requires higher taxes or lower spending. Deficit bias does not avoid the downside of cutting taxes or increasing spending, it just puts it off until a later date. Deficit bias has not gone away. Donald Trump cut taxes for the rich, but he avoided a lot of political flack by doing this through borrowing.

Contrary to many alarmists in the City, the world does not come to an end if you have deficit bias. Deficit bias just makes life harder for future governments. So it is good practice, and a sign of fiscal responsibility, for governments to follow a fiscal rule. Nothing about this good practice need be neoliberal.

You can certainly make a fiscal rule neoliberal through asymmetry (deficits matter, but surpluses do not) and saying the only spending should be cut and not taxes raised to reduce an excessive deficit. Labour’s fiscal credibility rule does neither of these things. It targets the current deficit, leaving public investment free to meet public needs and benefit from low borrowing costs. The target only needs to be met in 5 years time and this period rolls forward. As a result the rule is compatible with the Chancellor enacting a modest stimulus during a mild recession. In a severe recession a fiscal stimulus is mandatory, making austerity impossible.

MMTers like to suggest that government spending could be higher under MMT than under the FCR. This is simply false if the MPC is doing its job. Indeed if higher interest rates reduce demand, as most empirical evidence suggests, for given taxes government spending will be higher under the FCR than under an MMT policy.

MMTers might argue that leaving interest rates decisions to a central bank is neoliberal. That charge has less force for the UK, where the Chancellor has complete control of the Bank’s mandate, than in the Eurozone for example. Delegation of decisions to experts is hardly neoliberal. Is the UK organisation that decides whether drugs are cost effective, NICE, a neoliberal organisation? There is a legitimate issue of what happens when experts fail to do their job, but that is an issue for UK monetary policy that has nothing to do with Labour’s fiscal rule.

MMTers over the top criticisms of Labour’s fiscal rule do however raise some serious questions about MMT. MMT has been important in the US in helping to counteract excessive concern among many Democrats about budget deficits, and in fighting nonsense that says we cannot afford to tackle climate change. However both points can be made using entirely conventional macroeconomics, as my article on the Green New Deal showed. Yet MMT also wants to be a revolutionary movement that overthrows mainstream macroeconomics.

There have been two revolutions in macroeconomics in the last 100 years, but both have brought major and radical new ideas to the table. As yet, MMT only offers ideas that can easily be expressed as part of the mainstream. For example using fiscal rather than monetary policy was a big debate when I was studying as an undergraduate more than 40 years ago. That does not make MMT’s ideas wrong, but they are certainly not revolutionary and they will certainly not replace the mainstream, even if MMTers call all their opponents neoliberal.

Is the German Debt Brake the worst fiscal rule ever?

The answer is probably not: a simple balance budget is worse. The German Schuldenbremse fixes the total cyclically adjusted deficit at 0.35% of GDP, which implies a gradually falling debt to GDP ratio. If actual outturns exceed this figure, there is a control mechanism which reduces the permitted deficit to get the path of debt back on target. So this debt brake improves on a simple balance budget by allowing a very modest deficit and cyclically adjusting. On the other hand it is worse than a simple balanced budget because it error corrects.

The fundamental mistake the rule makes is to make control of debt its central aim. Doing this only makes sense if you ignore macroeconomic common sense. The deficit and debt are macroeconomic shock absorbers. Running a variable deficit allows taxes and spending to be reasonably stable, which is beneficial for obvious and not so obvious reasons. Trying to tightly control the deficit and debt does the opposite. It makes sense to smooth taxes and government spending, but no sense whatsoever to smooth the deficit and debt.

The aim of a good fiscal rule is to eliminate deficit bias, which is the tendency of government debt to rise over time because, for example, politicians always want to spend more and tax less. The timescale for deficit bias is decades rather than years, so there is no need in principle to tightly constrain year to year deficits, or worse still to try and stay on some path for debt, and as I have already noted it is actually harmful from a macroeconomic point of view to do so.

Doesn’t the debt brake make some concession towards the macroeconomic stabilising role of the deficit by cyclical correction? There are two problems here. First, cyclical correction is a very imprecise art, and there is evidence the method used in the German debt brake and elsewhere does not work very well. Second, cyclical shocks are not the only thing that disturbs the government’s deficit. In practice all kinds of things can lead to erratic movements in the deficit, and it makes no sense to have to adjust tax rates or spending to exactly offset this erratic behaviour.

As Jonathan Portes and I explain in our paper on fiscal rules, a better way of keeping the stabilising role of deficits while still ensuring they do not steadily increase over time is to have a rolling target for the future deficit. Five years is the typical length of an economic cycle, so looking ahead five years makes sense, and also avoids the need for imperfect cyclical adjustment.

This kind of rolling future target is open to cheating, because the government can always promise but never intend to deliver on meeting the target. The problem here is that governments can cheat in so many ways when it comes to fiscal planning. No rule, even a draconian one like the debt brake, will stop all forms of cheating. The best way to avoid cheating is to establish a fiscal council with political weight that can distinguish between a government that fails to meet its targets through bad luck and one that fails because of cheating.

Do we need the debt error correction in the debt brake? A consistent result in academic research is that debt correction should be very slow, if it happens at all. That happens automatically with a deficit target, while the debt brake corrects too quickly. So the answer is no.

Another problem with the debt brake, alongside many other fiscal rules, is that it has a target for the overall deficit which includes public investment. Public investment should not be included in any deficit target, because there is no reason the current generation should pay for something that will benefit future generations. As investment is less painful to cut than current spending (or raising taxes), rules for the total deficit often lead to under investment, and we can see this in Germany. That only hurts future generations.

This is not about Anglo-Saxon economists telling Germany what to do. There are plenty of German economists who also see that the German debt brake makes no sense, and anyway economics is universal. The debt brake is a bad fiscal rule. It is doing the German people harm. It needs to change.

How to pay for the Green New Deal

The Green New Deal has recently been promoted by a group of Democrats including the inspirational Alexandria Ocasio-Cortez. I first came across it in a report in 2008 by the Green New Deal group, most of whom are pictured above a decade later (HT Andrew Simms). The view that we face a potentially existential climate change crisis, which politicians seem currently reluctant to sufficiently tackle, and which therefore requires a government led programme on the scale in each country of Roosevelt’s New Deal, is something I share.

Why a New Deal? What is wrong with treating climate change as we would any other kind of pollution, with a mixture of regulations, taxes and subsidies? I think the answer is put rather well at the end of an article in the Economist (HT Laurie Macfarlane) which seemingly complains about the Green New Deal’s departure from what it calls ‘economic orthodoxy’. They write

“In fact, the criticism of the economic approach to climate change implicit in the Green New Deal is not that it is flawed or politically unrealistic, but that it is a category error, like trying to defeat Hitler with a fascism tax.”

I would put it in the following way. Tackling climate change is resisted by powerful political forces that have in the past prevented the appropriate taxes, subsidies and regulations being applied. Which is a major reason why the world has failed to do enough to mitigate climate change despite decades of warnings from scientists. You need something like a Green New Deal to push aside those vested interests, and get the right taxes, subsidies and regulations into place. Just as proponents of a Green New Deal are savvy about the need to overcome the resistance of, for example, the oil and gas industry, they also realise that the Green New Deal needs to be politically popular. So the New Deal package has to include current benefits for the many, perhaps at the expense of the few.

What the most effective measures are to mitigate climate change, and perhaps other global environmental disasters, is a fascinating topic. We can learn a lot from the successes so far. Solar energy is now at least as cheap as coal, oil and gas, but this was not always so. It required substantial subsidies or state help for initial development, despite protests that solar energy would always be too expensive. Once a technology is widely used it tends to get cheaper to produce because innovations continue when a mass market emerges, and that is what happened with solar energy. It is impossible to pick winners in advance, so we need to try a number of things some of which will fail. Partly because of those failures a great deal of the required research and development must come from the public sector. No stone must be left unturned when the future of humanity is at stake.

Which all sounds rather expensive, and in particular will require large amounts of public money. An interesting and important issue is how this should be paid for. In the scheme proposed by among others Thomas Piketty, higher taxes on multinationals, millionaires and carbon emissions generate funds to tackle poverty, migration, and climate change. Others have suggested that this spending is better funded by borrowing or creating money. To examine who is right, I want to talk about some of the work of John Broome, an Oxford philosopher and economist.

John Broome was a key advisor to the Stern review on climate change. He argued, and Stern agreed, that we should not discount the welfare of future generations as much as market interest rates appear to do. The reason is ethical: the current generation had no justification for valuing the welfare of the unborn less than their own welfare. This helped Stern to recommend much more current action on climate change than other US based analysis. As Broome emphasised, the key argument here was ethical not economic.

In terms of the funding debate, ethical arguments are also critical. The polluter pays principle suggests that the current generation should pay to mitigate the impact of the pollution they cause. So we should all be paying more for energy, for example, so that the carbon used to produce that energy is priced to reflect its impact on climate change. The idea that the polluter should pay makes economic and ethical sense. It embodies an idea of fairness that most people would accept.

Unfortunately this does not work well enough in practice because those with an interest in selling more carbon and their political allies make people doubt that climate change is real. In addition the connections between the prices people pay and the emissions that cause climate change are often not transparent. So how do you deal with societies that for these reasons fail to pay enough to mitigate climate change?

The argument that Broome put forward (following work by Duncan Foley) is that measures to tackle climate change can be funded by issuing debt. This breaks the polluter pays principle, but it can still lead everyone to be better off (what economists call a Pareto improvement). If government debt rather than taxes are increased to pay for, for example, investment in greener infrastructure the current generation gets away with not having to pay. If future generations have to pay back the debt used to pay for these measures, that cost falls on them, but it is more than matched by the benefits to them because of the climate change avoided as a result. In other words if you cannot make the polluter pay, it is still better to take action to stop climate change even if future generations have to pay the cost of that action.

The case for using government debt to fund the Green New Deal has been strengthened by recent observations by Olivier Blanchard. He noted that interest rates on government debt have over the last half century been below the growth rate of GDP. What this means is that a one-off increase in debt may not require higher tax rates in the future, because that debt as a share of GDP will gradually shrink.

If both these reasons for using debt finance to partially pay for the Green New Deal fail to convince, just think of it this way. No one in a 100 years time who suffers the catastrophic and (for them) irreversible impact of climate change is going to console themselves that at least they did not increase the national debt. Humanity will not come to an end if we double debt to GDP ratios, but it could come to an end if we fail to combat climate change.

All this means that the question of how a measure is financed should never prevent that measure being implemented if it has a reasonable chance of reducing climate change. The whole point of the Green New Deal is that measures should be judged on how effective they will be at achieving their goal, and not on whether they can be afforded. Funding through taxes should be the first option because the polluter should pay, but if this is not politically possible then government debt should increase.

What are the chances of either of the two main political parties implementing a Green New Deal in the UK? It is hard to see a Tory government doing so because of its aversion to debt finance, its neoliberal reluctance to have government lead the way, and because the party contains many climate change deniers. The Labour party is much better placed, and has already set out plans to create its own Green New Deal. Crucially their fiscal credibility rule makes the distinction between current spending that does need to be covered by taxes in the medium term and investment spending that does not, because future generations benefit from that investment. The Green New Deal is all about investing now to improve the welfare of future generations.