Introduction
Although the Labour Party’s Economic Advisory Council only met a few times, it did help produce one important result: Labour’s fiscal credibility rule (FCR). (The Council discussed rather than created policy, and the rule was devised by the Shadow Chancellor’s office after a discussion with the Council in consultation with some of the Council’s members.) In this chapter I want to place the rule in the context of both mainstream theory, and also a more modern school of thought called modern monetary theory, or MMT for short. I also want to talk about how the media almost unanimously failed to understand what made the new rule unique and radically different from earlier fiscal rules. To understand all this it is helpful to start with a bit of history on the macroeconomics of fiscal policy.
Historical Background
When I first studied economics as an undergraduate in the early 1970s, there was a huge debate going on between Keynesian and monetarist economists. In an important sense these labels were misleading, because both schools accepted the basic idea that the economy needed to be regulated to moderate booms and recessions. Monetarists accepted broadly the same intellectual framework as Keynesians in understanding how the economy worked: the framework developed from that outlined in Keynes’s General Theory published in 1936.
The key difference between the two schools was over which instrument was better at regulating the economy: monetary or fiscal policy. In this sense it is more accurate to describe the two schools as monetarists and fiscalists. Monetarists had an additional belief, which was that policy was best conducted by setting targets for the money supply. If this was done, they argued, the economy would largely regulate itself.
Monetarists both won and lost this battle. They won in the sense that macroeconomists began to believe that changing interest rates was a better way to regulate the economy than changing taxes or government spending. One of the reasons this happened was the collapse of the Bretton Woods system of fixed exchange rates in 1971. With the freely floating exchange rates that the UK now has, monetary policy can exert a strong and immediate influence on the economy through its impact on exchange rates. Monetarists lost, however, in the sense that money supply targets were tried in both the UK and the US in the early 1980s, and in both cases these experiments failed dramatically.
From the mid-1980s until the Global Financial Crisis (GFC), a new international consensus emerged about how to regulate the macroeconomy. I’ve called it a ‘Consensus Assignment’ because it assigns each instrument of policy to a specific task.1 Independent central banks should control inflation and aggregate demand by varying short-term interest rates. Governments were charged with using fiscal policy to manage the amount of government debt. It was believed that central banks were better at monetary policy than politicians because politicians would be tempted to change interest rates for political as well as economic advantage.
This Consensus Assignment endured for so long because, on the monetary policy side, it appeared to be very successful. The inflation rate, which had reached double figures in the 1970s, now stabilised at the target set by most central banks of 2 per cent. The business cycle, booms and recessions, also seemed to become more moderate. The fiscal part of the consensus fared less well, however. In many countries (not all, and in particular not the UK) government debt rose steadily over time. Governments seemed less good at controlling their own debt than independent central banks were at controlling the macro-economy. This problem became known as ‘deficit bias’.
It might seem intuitive that steadily rising government debt as a proportion of GDP is a problem, but in many cases this intuition is based on an erroneous belief that a government is like a household. One obvious difference is that governments ‘live forever’, so there is not the same necessity to run down debts at some point as there is with households. Another difference is that the government’s debt, if it is domestically owned, is money the country owes itself. If government debt increases, someone (or some institution like a pension fund) that holds this debt has an asset that is part of their wealth.
Nevertheless, mainstream economists have identified three main problems with ever-rising government debt. First, it could represent the current generation taking income from later generations. Second, to the extent that governments had to raise long-term interest rates to sell this extra debt, this could crowd out private capital and reduce the supply of output. Finally, higher debt requires higher taxes to service it, and these taxes would discourage labour supply, and therefore also reduce output. (It could, in extreme circumstances, encourage a government to default.) A key point to note is that all these problems are long-term, influencing future generations and supply rather than short-term output and demand.
The response of governments to deficit bias was twofold. First, fiscal rules were set up to try and avoid ever-increasing government debt to GDP. Second and rather later, fiscal councils (independent fiscal institutions) like the Office for Budget Responsibility (OBR) were established to provide an independent check on what the government was doing. Together rules and institutions were designed to eliminate deficit bias.
The Global Financial Crisis
You will often hear people say that the GFC was a consequence of this Consensus Assignment. I do not buy this story. In my view the GFC was the result of excessive exuberance in the financial sector, which in the US and the UK lent more and more relative to the capital in the sector. As this capital was the buffer for banks when things went wrong, it made the whole sector vulnerable to any shocks. The GFC was the result of inadequate regulation, not successful macroeconomic policy. It is true that the relatively calm period before the GFC may have encouraged excessive risk taking, but we should not have to suffer a volatile economy for the sake of inhibiting the banking sector.
However, the GFC did expose what turned out to be the Achilles heel in the Consensus Assignment. If the economy was hit by a large negative shock like a financial crisis, nominal interest rates hit what is sometimes called the zero lower bound (ZLB): a level that central banks think is as low as they can go. Any lower and people would start having to pay to hold money in a bank, and they might react by holding cash instead rather than spending more. The ZLB problem is very similar to the ‘liquidity trap’ problem discussed by Keynes.
This blows the Consensus Assignment out of the water. If rates are stuck at the ZLB and the economy is in recession, monetary policy can do little to encourage a quick recovery. Governments in the US, the UK and even Germany realised what this meant in 2009. Fiscal policy had to take monetary policy’s place in stabilising the economy. We had fiscal stimulus in all three countries, and this stimulus was also backed by the IMF.
However, this use of fiscal stimulus was opposed by two important groups. The first, which included the then governor of the Bank of England, Mervyn King, wanted to cling to the Consensus Assignment. They argued that new instruments of monetary policy, like quantitative easing (QE), could stand in for lower short-term interest rates. This was patently absurd once we recognise that reliability of impact is a key feature of a good instrument. QE was completely untested, and therefore not reliable at all. The Bank of England had little idea what impact it would have.
The second group were politicians from the right. In both the UK and the US they opposed fiscal stimulus in 2009, and when they came to power in 2010 (in the US in terms of dominating Congress, in the UK as the main party in a coalition) they started imposing the opposite policy: austerity. I have talked about their motives for doing this, and the considerable harm they caused in pursuing an austerity policy, elsewhere.2 I also talk there about how the Eurozone crisis was something that would always be limited to that area: we could never ‘become like Greece’, and the arguments that the markets forced austerity on us are a complete myth. (More discussion of this below.)
The result was that from 2010 onwards, policy reverted to the Consensus Assignment. In particular the media quickly adopted old habits, believing that the goal of fiscal policy was to do nothing more than reduce the government’s budget deficit. It seems likely that a majority of academic economists always opposed austerity, and that this majority increased over time, but they were rarely heard in the media.3 I coined the term ‘mediamacro’ for, among other things, the persuasive belief that the government was just like a household and should tighten its belt in a recession. Mediamacro is the opposite of what both first-year textbooks and state-of-the-art macroeconomics tell governments to do.
Fiscal Rules
Before the GFC, fiscal rules had been crafted to conform to the Consensus Assignment, and so were about how to adjust spending or taxes depending on the size of the government’s deficit. The ZLB problem that we experienced after the GFC, and which in the UK we continue to experience after the Brexit shock, means that fiscal rules have to adapt so that fiscal stimulus can be used when we are at the ZLB. This is what Labour’s FCR does, and as far as I am aware this is the first fiscal rule to take into account the Achilles heel in the Consensus Assignment.
The FCR is based on a target for the deficit, but it contains a crucial ‘knockout’. If interest rates hit their lower bound, or if the central bank says this is likely to happen, the goal of fiscal policy changes from meeting a deficit target to stimulating the economy. The aim of fiscal policy when interest rates are at their ZLB is to help the economy recover as rapidly as possible, which in effect means providing enough stimulus so that interest rates can rise above the ZLB.
This knockout will, of course, mean that the deficit increases substantially, but this is never a problem in a recession. If a country has its own currency and central bank, the markets can never force it to default by not buying its debt because the central bank can buy that debt (as has happened in large quantities as part of the QE programme). The priority in a recession is to achieve a recovery as soon as possible. If that leads to an increase in government debt which is judged too high, then that can be dealt with once the recovery has been achieved. As I noted earlier, high government debt is a problem in the long term, so dealing with it can and should wait until the economy has recovered.
This dichotomy – of dealing with the recession in the short term and debt in the longer term – is what basic macroeconomic theory suggests you should do. The key mistake the Labour government made in its last year in power and in opposition before 2015 was to suggest that policy should somehow aim to help the recovery and tackle the deficit at the same time. (Remember, ‘too far, too fast’.) The mistake should be obvious: dealing with the deficit stops you helping the recovery, and indeed can make a recession worse.
If the FCR had been in operation in 2010, we would have seen further stimulus in this and perhaps subsequent years, leading to a much quicker recovery from the GFC. Instead, under austerity we had the slowest recovery for at least a century. If the FCR had been in place this would have meant a higher deficit, but it is less clear that the debt-to-GDP ratio would have increased relative to what actually happened, because GDP growth would have been much stronger. However, it does not matter whether the debt-to-GDP ratio increases or not in the short term: the increase in debt can be dealt with once interest rates move above their ZLB.
Once the recovery is assured and interest rates begin to rise, the knockout for the FCR ends and we go back to a deficit target. That target may need to be modified in the light of the increase in debt, but even if this means a tight, contractionary fiscal policy, it will not mean an increase in unemployment because interest rates can be cut to offset its impact. This is the key reason why austerity (fiscal consolidation at the ZLB) is such a foolish thing to do: you are taking demand out of the economy at the exact time that monetary policy cannot offset the impact on output.
There are other laudable features of the FCR, but the ZLB knockout is what makes it unique, and brings it up to date with current macroeconomic thinking. Yet for those who are stuck with a Consensus Assignment view, it seems unimportant: I heard one journalist describe the knockout as a ‘loophole’. That is a strange way to describe a mechanism that would have ensured a rapid recovery from the GFC, but I fear it is typical of mediamacro.
Modern Monetary Theory
MMT is a new macroeconomic school of thought. It is quite rich in its scope, so I cannot do justice to it here. Instead I want to give my own interpretation of how its views on fiscal policy relate to mainstream macroeconomic thought, and in particular to the Consensus Assignment.
One of the merits of MMT is that it stresses that, for an economy like the UK with its own currency and central bank (and where the government borrows in its own currency), a government can always fund its spending by creating its own currency. It does not need to borrow from the markets, so the markets cannot exert some kind of veto power on the size of the government’s deficit.
The euro crisis happened because individual member countries did not have their own currency or central bank, and in addition the European Central Bank (ECB) initially refused to fill the gap when markets failed to lend more to Greece and other periphery countries. The crisis ended in September 2012 when the ECB changed its policy through its OMT programme. In this vital sense, the UK could never become like Greece.
So what stops a government increasing its spending by creating more money? MMT acknowledges that there is a constraint, which is inflation. If you create too much money during a recession, demand will exceed supply and prices will rise. But that will not happen when supply is greater than demand, as it is in a recession. In that situation there is no need to worry about printing too much money.4
My first problem with MMT is that these ideas are not new. They have, in fact, been a basic part of mainstream theory since Keynes. It is why no economics textbook will tell you to embark on austerity when the economy needs to recover from a recession. In particular, Keynes talked about why an expansionary fiscal policy was necessary in what he called a liquidity trap, which is very similar to being at the ZLB. I have already argued that the majority of mainstream academic economists were against austerity, and this is one reason why.
I suspect the real reason MMT gained so much popularity is that the majority opinion of academic economists was rarely heard in the media. Instead the media often looked to economists in the City, who tend to be more politically oriented and had a vested interest in talking up any threat from the markets. Unfortunately, this often included governors of central banks. In addition, too many political commentators with no economics background assumed that governments were just like a household, and could, in Cameron’s words, ‘max out their credit cards’. Mediamacro was crucial in reinforcing the need for austerity in the popular imagination.
There is, however, an important difference between MMT and mainstream macro, and that concerns the Consensus Assignment. MMT does not advocate using interest rates to control demand and inflation, stating that fiscal policy should be used instead. In that sense it is a throwback to the 1950s and 1960s, and the Keynesians who used to battle the monetarists.5
If governments were using fiscal policy rather than monetary policy to regulate demand, there would be no need for fiscal rules related to the deficit, and no deficit bias. Fiscal policy would be whatever it needed to be to regulate demand and ensure inflation reached its target. To say that MMT opposes fiscal rules is rather to miss the point. MMT opposes the whole Consensus Assignment even when interest rates are nowhere near the ZLB, which includes opposing independent central banks varying interest rates to manage demand. Fiscal rules are just one part of the Consensus Assignment that they oppose.
For better or worse, Labour and the Shadow Chancellor John McDonnell have chosen to work within the Consensus Assignment framework. What they have done is deal with its Achilles heel by bringing fiscal rules up to date.
Mediamacro and the FCR
Labour’s 2017 election manifesto involved a balanced budget increase in current government spending, which means that all its non-investment spending increases were matched by tax increases. (Investment spending is not part of the main FCR target, and substantial increases in public investment were also part of the manifesto.) At the time of the election, the UK had returned to interest rates being at their ZLB as a result of the Brexit vote. That meant that, according to the FCR, in theory Labour’s spending increases did not need to be matched by tax increases, as the priority should be a fiscal stimulus to get interest rates above the ZLB.
That the Labour team chose not to present a manifesto that increased the current deficit was a sensible choice, even though they could have done otherwise and stayed within their FCR. As I have already noted, the media generally has a blind spot on this issue, and a few weeks was not time for a serious re-education programme. On a more practical level, interest rates could easily rise above the ZLB in the five years after 2017, and covering this would have been too much for the media to handle.
Nevertheless the Labour manifesto was strongly criticised, based on Institute for Fiscal Studies (IFS) analysis which said that their calculations did not add up. The political impact of this criticism was completely blunted, however, by the fact that the Conservative manifesto was completely uncosted. However, the overall reaction still reflected what I have called mediamacro: a focus on the role of fiscal policy in terms of the impact on the deficit, even though this would have been (initially at least) completely inappropriate because interest rates are at their lower bound.
Let us suppose the IFS was correct, and the tax measures outlined by Labour were insufficient to match their proposed spending increases. There were two possibilities. First, and the most likely given the Brexit slowdown, interest rates would have remained at their lower bound. In that case the FCR would have said that the resulting fiscal stimulus was entirely appropriate and welcome. The fact that the numbers ‘did not add up’ would have been a welcome feature of Labour’s manifesto, because it would add to the fiscal stimulus. Second, if despite everything the economy suddenly recovered strongly, the deficit would fall as a result and Labour may well have been able to fund all the spending increases and still stay within the FCR. As a result, the fact that the numbers might not have added up was largely irrelevant, and yet it was a central theme for mediamacro.
At some point in the next five years there will be a general election which Labour have an excellent chance of winning. Their fiscal decisions will be guided by a fiscal rule that would not have given us 2010 austerity, and represents state-of-the-art macro-economic thinking. But if Brexit goes ahead and we leave the single market, the UK is likely to remain a depressed economy with low interest rates, and highly vulnerable to negative shocks. As if that were not bad enough, Labour will also face a media that seems incapable of thinking of fiscal policy as anything more than just good housekeeping, and which has not understood how large a mistake austerity was.