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 (BoE) 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, often called the Great Moderation, when nearly all the advanced industrial 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 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, when it also introduced the first phase of what has become known as the quantitative easing (QE) programme. £200bn of new money was electronically created and added to the BoE balance sheet 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, reflecting the empirical reality that the UK has not had a proper recovery yet, nearly a decade on. Real gdp per head and average household income are barely above the level that they reached in 2007. The needed recovery in both growth and productivity is not currently on the horizon.
The macro-economic framework conceived during the Great Moderation – its application based on economic models that ignored the potential of liberalised financial markets to leverage debt – contributed to the GFC. It has been beached by the subsequent stagnation. In short, in its existing form, whether in design or operation, or both, it appears to be incapable of shifting the UK economy out of stagnation. It is thus unsurprising that policy attention is rotating back to the definition and ordering of the first-order principles of macro-economic policy, and to whether the BoE’s independent mandate should change.
The IPPR reform framework
A spring 2018 paper by Alfie Stirling, Just About Managing Demand, takes up that challenge. Produced as part of the centre-left Institute of Public Policy and Research (IPPR), Commission on Economic Justice , it reflects the view of the author, but follows the research and policy tramlines furrowed by the Commission; and no doubt will inform its final report.
Since 2010 monetary and fiscal policy has effectively pulled in opposite directions; monetary interventions injected demand into, while fiscal policy took it out of, the economy. The tendency of governments, with their short-term electoral horizons, to exhibit deficit bias, Stirling argues, has been supplemented by surplus bias: discretionary fiscal contraction or consolidation (fiscal austerity) is ostensibly used to reduce the deficit as a matter of economic necessity, but is effectively applied as a smokescreen to ‘shrink the state’ largely for ideological and political reasons.
The paper’s centrepiece proposal to overcome surplus bias, when interest rates are at their ELB, is to provide the BoE’s Monetary Policy Committee (MPC) with added independent powers to decide whether fiscal policy is ‘overly restrictive’ and in that event to set and quantify a rectification stimulus sufficient to substitute for the cut(s) in base rate cuts that the MPC would have otherwise made.
The operational implementation of that surrogate stimulus would then be delegated to National Investment Bank (NIB) – an institution presumably based on Labour Party proposals to establish a new National Investment Bank . The MPC to achieve its primary inflation target (as may be amended, as discussed below) would, in effect, align monetary and fiscal policy in default of the government.
A reformed and comprehensive set of fiscal rules, echoing and extending Labour’s Fiscal Credibility Rule, is also 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 linked to a longer-term target level for debt.
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. This minimum investment rule, however, would be subject to the proposed debt target; however when interest rates reach and remain at their ELB the zero-current balance and debt rules would be suspended, leaving the investment rule in place and operative.
The long-term debt target (which could be higher, lower, or the same, compared to a set baseline level) would no longer require the debt/gdp ratio to be lower at the end of each five-year Parliament. Rather it would be based on an assessment of the UK’s fiscal space – that is the scope available for increased public spending and/or lower taxes without threatening long-term fiscal sustainability and market confidence.
That assessment would be undertaken by 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), remit. It would involve, a macro-economic ‘cost benefit analysis (comparing) lower levels of debt against higher taxes or lower levels of spending’. The OBR would also be given the independent authority to assess the long-term impacts of different investment projects on gdp in line with methodologies agreed with government and independent economists at different levels of debt.
It would also be mandated to conduct a review of accountancy classifications of investment, identifying areas where revenue spend on human capital, on software, or other sources of innovation and growth, in addition to capital expenditure on physical assets, should be counted as investment for expenditure control purposes. Borrowing that adds to future productive capacity of the economy or provides a revenue stream would not be subject to the zero-current balance rule. Borrowing by ‘independent’ public corporations – as defined internationally – for investment purposes would no longer be scored as government borrowing or debt.
Stirling highlights that recessions tend to recur on average every 10-15 years, with the next one expected before long. To prepare for that inevitable – although time-uncertain – eventuality, Stirling moots some more radical revisions to the BoE independent mandate.
The BoE’s primary inflation target could be increased by up to two per cent. This would be 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’. Unemployment and nominal (money) gdp targets, acting alongside, or as intermediate guides to, that target, could also be put in place.
These revisions would serve dual but related aims: pushing up interest rates above their ELB would enable the MPC once again to use interest rates management as an effective policy instrument to prevent or forestall a future recession; they could also prevent monetary policy being prematurely over-tightened during a period of above-target inflation, driven, say, by an external price shock, such as an oil price hike induced by international political instability.
In sum, changes to the BoE mandate could involve the toleration of higher future actual and expected inflation levels to get interest rates above their ELB and hence to provide reserve monetary firepower to counteract the next recession; but if they remain or reach their ELB, an activist fiscal policy of a path and magnitude determined by the MPC could then be deployed to overcome government surplus bias, as a more effective fiscal alternative to QE. Changes to the fiscal rule framework and to the classification of expenditures for deficit accounting and control purposes, if implemented in their entirety, could institutionally prevent the cutting of economically productive expenditures during a recession, while providing a target for their expansion across the economic cycle, subject to a long-term debt target, which, however would only apply when interest rates are above their ELB. Borrowing for investment by public corporations defined as independent in any case would not count against the deficit or debt total.
Political timing and feasibility
The package covers a lot of policy reform ground. It does come across a bit as a future strategic policy primer for the Shadow Chancellor, John McDonnell and his team; providing, perhaps, both its strength and weakness.
The next government would need to wrestle with the impact of Brexit on the economy and the public finances. Where not already ceded by the May government, fiscal demands on the current budget on ever-rising health and social care demands, local education quality and effectiveness, on training and apprenticeships, and manifesto commitments would have to be faced.
An incoming Corbyn administration would raise borrowing to finance its re-nationalisation, affordable housing, and industrial policy programmes, including the establishment of the NIB, where not shuffled off-balance-sheet. The political context can only be expected to be febrile in the first place – whether related to a Brexit-related hiatus and/or a media-hyping of the first ‘marxist’ Labour government – however unfair and politically-motivated that charge may be.
Making substantive changes to the BoE inflation, to the OBR fiscal mandates, and to the fiscal rules, all in parallel, could risk political over-load. And, to work and to stick, substantive changes to certainly the BoE and OBR remits could not simply be foisted on, but rather would require extensive consultation with, and the support of, the key institutional stakeholders involved. That would take time; as would the establishment of the NIB.
Although a Brexit-hiatus could precipitate a general election before 2022, it remains the due date. A freestanding NIB that relied upon the election of a Labour government in 2022 would be hard pressed to be operationally ready to expand lending on a scale sufficient to counteract any future recession much before 2025; that is unless the present Conservative minority administration decided to develop its own prototype, which it should, but probably won’t.
Changing the fiscal rules – and changing the BoE mandate even more so, as discussed below – would in themselves be political acts. The 1997 new Labour reforms to the fiscal rules and its establishment of BoE independence and were made on back of an already emerging strong technocratic and political consensus in their favour and were introduced within a supporting economic environment. The new economic settlement it represented – along with Gordon Brown’s self- denying ordinance to keep within Conservative spending limits – a tilt towards the centre ground and the assumption of the mantle of economic competence.
This time round, one can almost already hear the crescendo din already that would envelop the new government; that it only wants to change the fiscal rules to pass on the consequent debt burden to its successors for its own political purposes etc. Although is unlikely that Labour would be elected in the first place without a compelling economic and political narrative that underscored the necessity and desirability of substantially increased levels of public productive investment to spearhead the economy’s escape from stagnation, it is far from certain, however, that narrative would be sufficient to persuade the OBR to sign-off the government’s spending plans, whether in terms of the ‘fiscal space’ available for increased investment or their long-term fiscal sustainability.
Economically beneficial public investment also not only needs to be sufficient in volume, but efficient in selection, in composition, and in execution. Varying public investment levels for counter-cyclical stabilisation purposes could, however, risk a return to fluctuating famine and feast conditions, unconducive to such efficiency. http://www.asocialdemocraticfuture.org/investing-productive-infrastructure/ in that regard it proposes remedial reforms to the public expenditure and planning system that are designed to better reflect the long-term economic benefit of efficiently selected and executed infrastructural investment.
They include providing the National Infrastructure Commission (NIC) with a statutory remit to assist each government department to publish an annual Departmental Investment Plan (DIP). Each DIP should prioritise projects, according to their estimated economic and social return, incorporating auditable information on the methodology that it has applied to rank projects with reference to their expected economic return.
Such reforms could tie-in with changes to the fiscal rule framework that provide the OBR an added remit to assess the fiscal space available for increased public borrowing and debt. Splitting the function of assessing the micro-efficiency of individual projects from the more macro-task of assessing the overall fiscal space available for increased borrowing appears to align better with the respective roles and remits of the NIC and the OBR.
The point and sequencing of the proposed fiscal reforms referenced to likely future political and economic scenarios is not wholly clear. If Labour came to power in the aftermath of a Brexit hiatus it is almost certain that the economy would be in such a state that interest rates remained at their ELB. In that case, the new government could simply rescind the existing rules, and proceed to inject a fiscal stimulus financed by borrowing and begin to implement its industrial policy, including the establishment of the NIB. The OBR-brokered interaction between the investment and long-term debt rule in terms of assessing available fiscal space would come into play only when interest rates escape their ELB again.
The government would be able to call upon some substantive technocratic support to use fiscal policy as its primary instrument to escape recession. Prominent New Keynesian economists, such as Paul Krugman in the US, and Simon Wren Lewis in the UK, consistently made the case that monetary policy (MP) should have been complemented post-GFC, at the very least, by a fiscal stimulus, not contraction – a position that many mainstream other economists and organisations, including the IMF and the OECD have subsequently endorsed.
It could also point to empirical experience: the results of the Coalition’s conjoint reliance upon QE and fiscal austerity support the case that QE should have been, at the very least, combined instead with a conventional Keynesian fiscal expansion in public investment. Such an expansion where it utilised and safeguarded unused capacity within the economy could have protected and extended its future productive capacity, helping to lift the economic drag of falling and stagnant productivity.
A new Chancellor could also loosen fiscal policy in tune with the government’s own assessment of economic circumstances and requirements, without recourse to the MPC, as he could change the fiscal rules. In any case it would be unlikely that a newly-established NIB would be ready to spearhead the counter-cyclical response through expanding its ‘lending for business growth, housing, innovation, and social and physical infrastructure’ on sufficient scale to bring the economy back to a sustainable growth path.
For a new Labour Chancellor to press for a change in the BoE mandate, providing the MPC a power to initiate a fiscal stimulus, even though the BoE on number of occasions has disclaimed any wish to intervene in the direction and composition of fiscal policy, appears superfluous, save that it could provide an obstacle to future surplus bias if exhibited by a future government; that same government could then change the mandate again, however. Such a yo-ho would do little to bolster the credibility and purpose of an independent mandate.
Designing policy architecture to better prepare for the ‘next recession’ rather than escaping systemic stagnation now or, even worse, the prospect a Brexit-induced recession could therefore possibly put the cart before the horse. Without a period of economic expansion accompanied by rising pressure on wages and competition for loanable fund, neither interest rates nor inflation are likely to rise above their ELB to a point where rate reductions could be made to respond to a recession. The immediate policy reform priority is to escape stagnation in a sustainable way.
How necessary is (are) a BoE mandate change(s)?
A 2022 election could offer at least a time window for macro-economic framework reform to be considered and anchored to some semblance of a supporting cross-cutting and over-lapping political and technical consensus. On that score, the proposed reforms to the BoE’s mandate appear a rather tentative shopping list or one of possibilities. Many of the issues attached to raising the inflation target rate and/or providing it with a greater output and employment focus are not evidentially justified or explored – more attention is given to the proposal to empower the MPC to specify and delegate a fiscal stimulus to a newly-established NIB, as discussed above. The references, however, do provide a starting point.
With respect to raising the inflation target, the MPC has so far has recoiled from raising base bate above 0.5% This is despite headline inflation even exceeding three per cent – more than one per cent above its medium-term target – thus triggering the requirement for the BoE Governor to write an explanatory letter to the Chancellor. The majority assessment of its members has been that above target-inflation is mainly owed to conditions or factors external or outside (exogenous) to the domestic labour market, including rising oil prices and sterling depreciation linked to Brexit.
The BoE’s May 2017 Inflation report, in line with that, highlighted that the post-2015 fall in sterling was likely to keep domestic inflation above the two per cent target throughout the next three years, (author italics), further noting that where inflation settles once that upward pressure fades will depend on domestic (wage-related) price pressures, concluding that these were expected to build by 2020.
The MPC hitherto has been careful to apply its constrained policy discretion in accordance with its current mandate, focused on the medium-term not the short-term headline CPI inflation figure, so as not to chock-off any nascent or uncertain recovery, at least while spare capacity exists within the economy.
Given that institutional monetary policy context, what would be the economic point of modifying the primary inflation target to accommodate higher inflation and/or giving employment and output a greater weight within the BoE mandate? A slightly different answer to that of simply an interest rate buffer to counteract the next recession, which Stirling emphasises.
The underlying key problem is that the UK economy has failed to recover its pre-GFC secular real productivity and growth trend of annual average c2.3%-2.5% growth. The result: an unrecoverable massive 15-20% loss of potential GDP calibrated to the level it would have reached if that historic trend had been interrupted and thrown off-course by the GFC, the Great Recession, and then counter-cyclical fiscal austerity.
That lost stock of output and income foregone will rise further inexorably, if growth and productivity remain stuck in stagnation mode. In technical economic jargon the economy has suffered hysteresis (a change – in this case on UK gdp, whose initial effects persist, even when its proximate causes or source no longer exist).
A fiscal expansion combined with falling immigration that causing the labour market to further tighten and thus trigger wage inflation, but without it accelerating, could usher-in a new expansionary economic environment that could allow the economy to break out of that circle. How and by what mechanism(s)?
As labour inputs become relatively more expensive, investment in the upskilling of the indigenous labour force, as well as on additional and improved physical capital stock, should be encouraged, in turn, inducing an associated shift in the employment structure towards the formal and away from the insecure gig economy, pushing-up both overall (total factor) and labour (per unit period) productivity.
Infrastructural investment should also increase both the capacity of the economy and its total factor productivity; for example, improved connectivity should lower costs and expand the pool of labour that is available to work in higher productivity and thus higher paid jobs.
But if the MPC references the likelihood of rising domestic wage pressure to the current supply side-capacity of the economy, it risks taking the current compressed productive potential of the economy (for the purposes of MP) as an immutable given. The associated output gap (the difference between aggregate demand and the capacity of the domestic economy to meet it without inducing above-target inflation), has been significantly revised downwards since the GFC by the OBR.
The latest May 2018 BoE Inflation report appears to fall into that stagnation trap. Striking a more hawkish tone than its predecessor a year earlier, it notes that ‘labour demand growth remains robust with a very limited degree of slack left in the economy’ with productivity growth remaining muted, limiting ‘the pace at which output can grow without generating inflationary pressures is likely to be modest’, before diagnosing that ‘ongoing tightening of monetary policy (up to 2020-21) would be appropriate’ albeit that any future increases in Bank Rate are likely to be ‘at a gradual pace and to a limited extent’.
It is not altogether clear what that could mean in practice. It does suggest, on one hand, however, that the BoE does not intend to raise interest rates at a speed and magnitude sufficient for the MPC to draw upon a four to five per cent interest rate buffer to counteract the next recession, assuming that a Brexit-related one is avoided. On the other hand, even modest and slow rate increases could impede or even reverse the productivity-enhancing economic expansion outlined above.
In that case desired increases in personal and household income and improvements in public services will not be possible. Given the existing linkage between consumption and confidence to house prices in the UK, if rates were raised more substantively, such increases could even precipitate a home-grown recession, especially in a post-Brexit environment, which can only be anticipated to be uncertain at best.
Is increasing the inflation target to, say, four per cent, the answer, then? Raising the inflation target by up to two per cent could allow the economy in Paul Krugman’s words to ‘adjust permanently to a higher rate of inflation’, offering space for rate cuts to be made in response to a future recession. The ghost of accelerating inflation continues to lurk in the background, however. Economic actors might well take a supposedly one-off increase in the medium-term inflation target to be the thin end of a wedge that they should grab while they have the chance, resulting in insufficient passage of time for any productivity-enhancing adjustments to take root before pressures to tighten to retard insipient accelerating inflation become difficult to resist. It would also entail a quite marked discontinuity in the BoE mandate that could suggest instability and further changes, undermining its credibility.
What is not open to doubt is that allowing inflation to rest at a higher level would require – if international competitiveness is to be maintained – a commensurate increase in productivity across the tradeable sections of the UK economy; relying on sterling to depreciate in compensation instead, itself would add to domestic inflationary pressures.
Also, the Chancellor, facing higher public-sector nominal wage claims from health and other public-sector workers could well be forced to resort to fiscal drag and/or additional taxes to protect the current budget balance, dampening the translation of real wage into real disposable income growth in the process. Such dampening might well be desirable in terms of securing a shift in resources within the economy towards investment, but such suppression of real wage growth by stealth taxes cannot be expected to hold for any extended period.
An alternative might be to suspend inflation target temporarily while the economy escapes stagnation. It cannot be expected that the BoE would instigate such a change itself. But if imposed by the Chancellor, the effect would be nearly akin to abolishing the independent mandate of the BoE altogether.
Yet another variant could include raising the inflation target explicitly only for a temporary or time-limited period, on the basis that the retention of two per cent medium term target would conserve continuity. The aim would be to influence wage-bargaining behaviour so that real wage inflation tracks productivity, rather than inducing beggar-my-neighbour escalating, rises. That desirable outcome would tend to depend on, however, not only on the credibility of the new temporary, and necessarily, contingent target rule, but also on other emergent factors that may affect the labour market and wider economy. Perfect alignment of real wage inflation and productivity remains a heroic assumption.
Besides the existing inflation target is a medium-term one, although its precise time-span can be open to definition. The same desired end-result of a productivity-enhancing expansion could therefore possibly be engineered by more informal and less disruptive institutional means. The annual Chancellor’s letter to the Governor could be used to adjust the weight balance accorded to price stability and real economic activity, for instance. The MPC could continue to operate within its existing 1997-set medium-term two per cent target but with reference to a political tilt for it to be administered it in future with greater regard to employment and output considerations, as new economic conditions and times require.
An imperfect analogy might be a judge instructing the jury to decide a case on the balance of probabilities rather than beyond reasonable doubt. The underlying and overarching importance accorded to price stability would necessarily be diluted, however, with attendant possible implications for the credibility and certainty of the target. That said, a case can be made that the advantages of price stability was overstated within the existing framework and that events have tended to suggest that in some conditions its strict adoption can retard rather than induce strong and sustainable growth.
In that regard, tilting the MPC mandate towards output and employment considerations could also be achieved by moving to a nominal annual gdp target of, say, five per cent. This would combine or mix real output and inflation into a single target; it could be achieved by various permutations of both: for example, two per cent real growth and three per cent inflation, and vice versa. Such variability could gnaw at its overall credibility and certainty, however.
Or the target could be split equally, 2.5% for each; reducing uncertainty but at the same time also the flexibility that may be needed to allow the economy to recover its historic secular growth and productivity path. When taken in the round, as a 2013 Deputy Governor Speech on nominal income targets, pointed out, insofar that the existing mandate does take cognizance of output and employment objectives, many proposed alternatives can appear more different than they are actually are.
The issue really boils down to the relative weight that should be accorded to employment and output relative to medium-term price stability, for what period, and in what circumstances. Incremental evidence-driven change in emphasis subject to continual review might ultimately prove the best friend of radical reform.