Clarifying Labour’s fiscal rule

This post was prompted by a debate between Richard Murphy, a prolific blogger and tax accountant originally credited with some influence on Corbynomics, and James Meadway, an economic advisor to John McDonnell, over Labour’s fiscal rule, announced by John McDonnell in a March 2016 speech.

Murphy is generally wrong, as Chris Dillow points out. But what I want to talk about here is what the fiscal rule actually is, and in particular to point to ambiguities about how it has been expressed. The rule has several components, but the most important and innovative is that under certain circumstances the other parts of the rule may be suspended to allow fiscal policy to step in when monetary policy is out of ammunition. This is a very important and very good principle.

This part of the rule in McDonnell’s original speech was given as follows:

…if conventional monetary [policy] again becomes constrained by hitting a lower bound as it did after the global financial crisis, we understand when fiscal policy has to take some responsibility.
And that is why we will reserve the right, for as long as monetary policy is unable to undertake its usual role due to the lower bound, to suspend our targets so that monetary and fiscal policy can work together.
Rather than an arbitrary cut off for GDP forecasts, we will suspend our rule in the circumstances when it is clear that fiscal policy needs to work together with monetary policy to get the economy moving again.

Reading James’s post, I was struck by a formulation of the rule that I had not previously noticed:

… in a critical innovation, it grants a licence to the Monetary Policy Committee to determine that when conventional monetary policy no longer operates properly (at the “lower bound”), the MPC can decide to suspend the Rule.

There are two notable things about this:

1. In James’s formulation, the Bank of England’s independent Monetary Policy Committee is charged with determining when the remainder of the rule may be set aside. Yet this idea does not appear in John’s speech or, as far as I’m aware, in any other previous official Labour Party communication. Indeed, John’s formulation uses the phrase “we will reserve the right”, which implies that it would be up to government to determine when the conditions for suspending the rule were met.

2. James says this part of the rule is triggered “when conventional monetary policy no longer operates properly”, a point which he refers to as the “lower bound”. The more complete term and the more common one for this point is the “effective lower bound” (ELB), in order to distinguish it from the “zero lower bound” (ZLB), which is perhaps more commonly discussed, at least outside very specialist circles.

In retrospect, in the context of McDonnell’s speech, it does make sense that he meant the ELB, because he says the “lower bound” was reached “after the global financial crisis”. In the UK, the ZLB was not so hit, with interest rates not falling below 0.5% until today, so the ELB was implied.

At the time, however, some may have thought that he was referring, perhaps, to the United States, where the ZLB was reached. This might have been the impression of Paul Mason who, in a piece linked to approvingly by James, summarises the rule as referring to the ZLB.

This is furthermore understandable because Mason refers to a 2014 academic paper written by Jonathan Portes and Simon Wren-Lewis, an economist who participated in John McDonnell’s Economic Advisory Committee, which apparently developed Labour’s rule.

Portes and Wren-Lewis used this formulation:

This ZLB ‘knockout’ for the fiscal policy rule could well involve a substantial increase in government debt. As the ZLB is almost certainly likely to have been hit as a result of a large increase in private sector saving, this is not a problem in the short term. Interest rates on government debt should not rise as long as the fiscal authority has the appropriate monetary policy backing. (Of course the whole point of the policy is to allow the monetary authority to raise short term interest rates above zero, so there should be some increase in long term interest rates.) This increase in debt will almost certainly mean that previous fiscal targets will become outdated, and so it makes sense for the government to say at the same time how they think the fiscal rule will change once the ZLB constraint no longer operates.

The paper is clear that it should be the job of an independent central bank to determine when the rule is activated:

It would seem appropriate to involve the monetary authority (i.e. central bank) in this forecasting capacity for a number of reasons. First, they have the forecasting expertise. Although the fiscal council and government might be involved in fiscal forecasting, their focus will probably be on the longer term. Second, it ensures cooperation between monetary and fiscal policy. Third, if the central bank provides some detail about what impact it thinks each element of any fiscal package will have, it provides an incentive for the government to undertake policy changes that have a large impact on demand, rather than to focus on changes that might be politically popular.

But it is equally clear from the paper that it is the prospect of reaching the ZLB, not the actuality of reaching the ELB which ought to be basis of the rule’s knockout clause. In a world in which negative interest rates are thought by some central banks to be effective means of stimulation — or at least worth trying — this distinction really matters.

So, what’s it to be?

For what it’s worth, I think James’s formulation makes probably the most sense. Two points about that:

1. There is a debate amongst economists about the ELB: where exactly it is under different circumstances. For instance, it may be that the longer interest rates are held low, the less effective they are, and that hence the ELB would tend to rise. This is better than targeting the ZLB because there are several problems associated with very low interest rates just above zero that it would be preferable to avoid entirely if possible — these include a lack of safe, worthwhile financial assets and an overreliance on private debt, particularly borrowing against housing to stimulate the economy, which will tend to lead to socially disruptive house price inflation.

2. Under these circumstances, given the complex technical determination involved in ascertaining whether the ELB has been reached, it certainly makes sense for the Bank of England to undertake the task. However, I’d argue that once this immense power has been given to the central bank, we really should start talking about helicopter money, and about the overt monetary financing of public expenditure and investment. I posted about this idea recently, which would have inter alia the following two advantages: a) giving the markets and the public confidence in the amount of money created/borrowed, by virtue of the central bank’s independence and reputation for superior technical competence; b) avoiding the sort of arguments over the deficit that the Tories have made for the past six years — because the appropriate amount of money would simply be created, rather than borrowed. If such a rule were enshrined in law, it would be much more difficult for the Tories to under stimulate the economy and shrink the state for ideological reasons, as they have since 2010. This is because, were they to try to do so, the independent central bank could step into take up the slack.

However, this said, it would be preferable for Labour and McDonnell to clarify their position formally. This can happen as part of future official exposition of the rule, which is generally good.

A note on communications

Looking at the press coverage of the fiscal rule when it was announced, the reference to the Bank of England’s role in the knockout clause of the rule does not appear in most coverage (eg BBC), or in any quotations, but was asserted as a fact without citation by The Guardian (twice) and The Independent. Presumably they were briefed separately to the speech. Given that, as we know, the media are relentlessly unfair to Labour leaders, and to team Corbyn in particular, it is necessary to repeatedly and consistently stress key messages that explain why new policy is different and important.

Tangentially related notes on this morning’s Today programme

John McDonnell did a good job. However, he shouldn’t accept that “People’s QE” or similar would entail an end to central-bank independence, which is what the interviewer claimed. Obviously if you have an autonomous national investment bank, or network of regional banks, and an independent central bank, there is no reason that the latter would have to seek permission of the Treasury to capitalize the former.

The economist who spoke as part of the conversation with Marian Bell (I don’t recall his name and it isn’t in the programme schedule) said that helicopter money was unpredictable in its effects and we would have no idea what it would do. As I pointed out in my previous post, however, something very similar to this was carried out in Australia in 2008 and 2009, and evaluations of the results are available. The Bank would presumably be prudent enough to try the policy on a relatively small scale before being forced to use it in extremis.

Caveat: I’m not a professional economist, I’m an interested amateur with an undergraduate degree.