Since the mid-nineties, the prevailing macro-economic policy framework – or ‘consignment’ as it sometimes called – has relied upon monetary policy to smooth the business cycle at a sustainable level of output and employment. In the UK, in 1997, it was given institutional backing, when the Bank of England was given an independent mandate to achieve a medium-term set primary inflation target. The role of fiscal policy, in macro-economic terms, was relegated rather to the management of public deficits and debt. This framework seemed to work during a period, sometimes termed the Great Moderation, when the advanced economies, including the UK, enjoyed an unbroken period of steady sustained growth and low inflation. The business cycle appeared to have been all but neutered, if not banished.
That illusion was popped abruptly by the Great Financial Crash (GFC). The Bank of England (BoE), in response, reduced the base rate it charged for the use of its own funds – from 5.5% in February 2008 to 0.5% in March 2009. It also introduced the quantitative easing (QE) programme, electronically creating £200bn to purchase long-dated government debt (gilts). This was in recognition that its main conventional monetary policy lever of base rate management had been rendered ineffective by short–term interest rates reaching their effective lower bound (ELB) – the point where reducing them further has little or no, and insufficient, effect on economic activity.
Rates remain at their ELB nearly a decade later, reflecting the empirical reality that the UK has not had a proper recovery yet, nearly ten years later. Real gdp per head and average household income are barely above the level that they reached in 2007 . Unless the economy’s growth trajectory returns to average post-war levels, increases in real personal and household income combined with the higher funding needed to maintain, let alone improve, public services, will lack a strong enough economic source to draw-on. A crisis in political economy looms.
The IPPR proposals
The extent to which that the UK’s secular stagnation is the result of shortcomings in the design and the operation of the macro-economic policy framework is a key concern of a recent paper by Alfie Stirling, Just About Managing Demand, produced as part of the Institute of Public Policy and Research (IPPR), Commission on Economic Justice programme, within an environment where monetary and fiscal policy has since 2010 effectively pulled in opposite directions; monetary interventions has injected into, while fiscal policy has taken demand out of, the economy.
Its policy focus is to to map out an institutional framework better prepared to respond to future recessions within a medium-term economic environment that is likely to be characterized by interest rates remaining at their ELB, at least with unchanged policies.
The tendency of governments, with their short-term electoral horizons, to exhibit deficit bias has, Stirling argues, been joined by surplus bias. Discretionary fiscal contraction or consolidation (fiscal austerity) is ostensibly used to reduce the deficit as a matter of economic necessity, but effectively is applied as a smokescreen to ‘shrink the state’ for ideological and political reasons.
The paper’s centrepiece proposal to overcome such surplus bias is to provide the BoE’s Monetary Policy Committee (MPC), with an added independent power to decide, not only when interest rates are their ELB. but when government fiscal policy is ‘overly restrictive’, in which event a stimulus ‘estimated to equate to all or part of the base rate cut that the MPC would have made, if they were not at their ELB’ would be set, quantified, and its implementation then delegated to a newly established National Investment Bank (NIB).
A reformed and comprehensive set of fiscal rules, extending and refining Labour’s Fiscal Credibility Rule , are set out. The separation of current and investment public expenditure for control purposes (as New Labour’s Golden Rule did) would be reinstated. Five year rolling targets would be set for a zero current balance, and for an operational debt target, ‘aimed’ at achieving a longer term target level for debt. Both would be suspended when interest rates reach and remain at their ELB. Public investment (which supports long-term growth) would also be provided with a separate dedicated target, expressed as a minimum percentage of GDP over the same five-year rolling period.
The proposed debt target (which could be higher, lower, or the same, compared to a baseline level) would not require the debt/GDP ratio to be lower at the end of each five-year Parliament. It instead would be based on an assessment of the UK’s ‘fiscal space’, linked to a ‘cost benefit analysis (comparing) lower levels of debt against higher taxes or lower levels of spending’. Responsibility for that assessment would be delegated to the Office of Budget Responsibility (OBR), as a complement to its existing UK’s Fiscal Council (independent bodies set up by governments to evaluate fiscal policy, https://voxeu.org/article/what-are-fiscal-councils-and-what-do-they-do) remit.
The OBR would also be charged with a remit to review of accountancy classifications of expenditure to identify where revenue spend on human capital, software, and other sources of innovation and growth, on top of capital expenditure on physical assets, should be counted as investment for expenditure control purposes where they add to future productive capacity or provide a revenue stream. Borrowing by ‘independent’ public corporations – as defined internationally, would no longer be scored as government borrowing or debt.
Other radical revisions to the BoE independent mandate are also mooted. In order to allow the economy to ‘adjust permanently to a higher rate of inflation’, consistent with interest rates settling at a higher resting point above their ELB, the inflation target itself could be increased by up to two per cent. Unemployment and nominal GDP targets acting alongside, or as intermediate guides to, its primary inflation target are also proposed. This to reduce the risk of monetary policy being prematurely over-tightened during a period of above-target inflation driven by an external price shock, such as an oil price hike linked to international political instability.
In sum, when interest rates are at their ELB, activist fiscal policy would be preferred to QE as a more immediate and certain instrument to restore and maintain aggregate demand to a level consistent with the economy returning to a sustainable growth path. Other changes to the BoE mandate would involve the toleration of higher future and expected inflation levels. By pushing up interest rates above their ELB, could then allow them be cut in the future to prevent or forestall a future recession and to avoid unnecessary losses of output and employment.
Would these reforms work and are they feasible?
Certainly an expansionary monetary policy pulling in a different direction to a contractionary fiscal policy makes little sense; that is unless one believes that reducing public expenditure and debt (noting that the former does not necessarily result in the latter) has a direct positive impact on growth, even in times of recession. Such a preference is born of political choice, or preference, rather than of economic evidence.