Labour Party Fiscal Credibility Rule: McDonnell’s Mainstream Mantra

"To this end, and with my Fabian cap on, it would appear Labour’s fiscal credibility rule is nothing more than a timid mainstream step in the right direction, gradual it may be, progressive and radical - it certainly is not."

Fabianism champions the belief that radical long-term goals are best advanced through empirical, practical, and gradual reform. Thus, you would be forgiven if you’d have thought, as most on the left advocate fiscal policy, it would be easy to get behind Labour’s ‘Fiscal Credibility Rule’ given its clear endorsement of borrowing to invest.

On the face of it such a step to include fiscal policy seems radical. However, this halfway house keeps ‘mainstream consensus’ at its very heart. Labour is missing an opportunity to see another golden age of economic growth due to inertia around adopting new economic models. For the authors of this rule (Simon Wren-Lewis and Jonathan Portes) favour the retention of an independent central bank, while independent from democratic accountability, many would argue less so from corporate interests.

The ‘mainstream consensus’ assignment of monetary policy favours setting interest rates to control inflation. Fiscal policy is a separate tool that can also control inflation. However, the ‘mainstream consensus’ argues that between these two inflation controlling instruments (interest rates or borrowing to invest) only one should be used or ‘assigned’. Primarily the reason for assignment rests on the prima facie rational belief that having two levers controlled by different people, who may have conflicting opinions over the state of the economy, may lead to serious economic issues. The ‘mainstream consensus’ believes (when interest rates are not at the ZLB) a goal independent monetary policy focused on targeting inflation should respond to a rise in inflation expectations. One would argue an accommodative approach to monetary policy, in response to the use of fiscal policy (IE using both), could achieve much more. A point I shall revisit later.

Notwithstanding the above, the fiscal credibility rule dips its toe in the water for such accommodation, but only at the Zero Lower Bound (ZLB). IE when the Bank of England cannot cut rates any further, e.g. at zero. There is empirical evidence (Woodford, 2011) to suggest that the use of fiscal policy under conditions of the ZLB will produce output in excess of unity (e.g. if I put £1 into construction you get £2 of economic output). It is only under these conditions do Wren-Lewis and Portes believe fiscal policy is appropriate for such coordination, which is why they argue that in all other cases monetary policy decided at the behest of independent central bankers should take precedence.

So if the authors can empirically acknowledge an accommodative use of fiscal policy at the ZLB through discretionary coordination, my question is why not at all levels?

Well Wren-Lewis moots, in a claim bannered “Labour’s fiscal rule is progressive”, his concerns around in doing so would lead to a deficit bias, which would result in more taxes needing to be raised to pay the interest on the debt. He also asserts the need for assignment (either the use of fiscal policy or monetary policy) to control inflation. Furthermore, it is evident he believes in the ‘mainstream consensus’ that inflation should be targeted, albeit with output rates set independently by the Office for Budget Responsibility.

This is where the ‘mainstream consensus’ falls over. Blindly following a simple objective that ignores and is light touch on financial stability, cannot be something we still advocate given what we know now. Namely, that low inflation and price stability do not always lead to macroeconomic stability.

Firstly, what is preventing a coordinated approach to the use of fiscal and monetary policy used to accommodate one another, with objectives focused on financial stability and the maximisation of social welfare?

We have seen Japan after decades of sluggish growth adopt a coordinated approach back in 2013 under Shinzo Abe. What has been witnessed since then. Record levels of growth unseen in a generation with eight consecutive quarters of economic growth. Its longest streak for 28 years. Although some may argue not coordinated far enough. Nevertheless, such coordination is not beyond the wit of man (or woman). Empirically, a coordinated approach that utilizes both fiscal and monetary policy levers have been found to be more effective on both the fiscal multiplier and the deficit spending multiplier, with the latter empirically found to be nil under the ‘goal independent’ mantra of Wren-Lewis and Portes. Monetary and fiscal policies should be consistent so that the impact on aggregate demand is cumulative and not offsetting, as sometimes has been the case in Japan. To note, this is not an argument to implement fiscal policy in isolation to monetary policy. If coordinated with monetary policy fiscal expansion can reduce the real rate of interest and lead to further increases in consumption and investment.

I for one would call myself an Arestisian or a Pettiforian, who both advocate a stronger macroeconomic role for fiscal policy. This is the approach to economic policy I believe McDonnell should be pursuing. Professor Philip Arestis of Cambridge University has called for more than a decade, such a role for fiscal policy. He argues that this should be coordinated with monetary policy and adopt a focus on financial stability, with income distribution and the maximisation of social welfare as key objectives of such coordination. The latter focusing on reducing income inequality, particularly due to the huge economic benefits empirically evidenced would happen as a result. The coordination of fiscal and monetary policy used together to stimulate aggregate demand can be found to produce stronger results than otherwise achievable without such coordination. IE coordination will produce better economic results than the ‘mainstream consensus’ view of conventional assignment, which focuses on monetary policy rather than the coordination with fiscal policy to control inflation. See Arestis, 2012; Eggertsson, 2006; Freedman et al, 2009; Davig and Leeper, 2009; Coenen et al, 2012; Cogan et al, 2010 and Sawyer, 2010 for empirical evidence.

Arestis has also demonstrated how many countries who have not followed the dogmatic ‘mainstream consensus’ of inflation targeting can achieve as good as, if not better, economic growth with discretionary accommodation utilising fiscal policy. Often the ‘mainstream consensus’ has resulted in a preference to play fiscal policy in a role subordinate to monetary policy. We need the use of fiscal policy to build more council houses, schools, hospitals, and necessary infrastructure. The fiscal credibility rule does permit this, although as argued above, most likely to a much lesser effect on economic growth due to the ‘mainstream consensus’ rules that result in offsetting, or fiscal contraction.

Ann Pettifor, who called the financial crash ahead of its occurrence, challenges the very notion of how government debt is understood and attacks head on the fallacy of ‘tax-to-spend’. Pettifor argues tax revenues are not the source of government spending, and reaffirms it goes without saying it is important that the government repays its borrowing through increased tax revenues. While some noddily argue it should pay for it through directly raising tax levels, others argue it can take a more logical approach after the investment provides an increase in income owing to greater tax collection from a larger economy. The notion of money is misunderstood as often journalists’ and politicians’ alike call for a “budgeted” plan that is paid by taxes to then spend. You do not go to the bank to borrow money to pay for a car and agree to pay it out of funds already in your bank account, you promise to pay it from future earnings. The ‘mainstream consensus’ viewpoint cuts across to what happens in the real world and is merely used by conservatives to impose austerity purporting an over-zealous simplification of government debt, as if it were a household. Newsflash - it is not.  For example how many households have an ATM? Governments have the ability to create new money just as private banks do.

This is what must be acknowledged by the ‘mainstream consensus’, how money is in fact created.

The creation of debt, whether this is in the form of government or private debt, creates new money in the system. Without borrowing GDP cannot grow, on the flip side if everybody saved there would be no money put to work, and would be a kin to taking money out of the system. Dead money if you will. The government controls the amount of money in the system through taxation, and the central bank plays an important role in stimulating the economy through setting interest rates. Taxation, like savings, removes money from the economy. In turn, governments can control an overheating economy through reducing fiscal policy or increasing taxation, or can stimulate an economy in recession by injecting new money into the system through directing it to productive means. Right now, the private sector has a glut of savings that are not being put to work in the economy, while huge amounts of household debt is expected to be repaid to the private sector from falling incomes. This sounds like a recipe for disaster, at the expense of indebting the British public through unfettered extraction of as much of their future income as the private sector can get away with.

Is that really where all our best interests are held?

Right now citizens of the UK are at the behest of the debunked medicine that is austerity, endorsed by George Osborne who quoted in his Mais lecture back in 2013 the discredited works of Reinhart and Rogoff.  This obfuscation of the ‘mainstream consensus’ has put our economy on the rocks, with real wages remaining below their pre-recession peak.

While Wren-Lewis and the rest of his cohort appear to be on the sounder side of the central bank independency slate, as he is after all anti-austerity, they have still drunk the alleged “tried and tested” Kool Aid of unaccommodating monetary policy at the discretion of unaccountable central bankers. Coordinating monetary policy with government discretion over the fiscal stance can spur private sector investment. I for one, who has invested tens of millions of pounds on behalf of a New York based real estate private equity firm off of the back of government led projects such as Crossrail, can safely say that well placed government investment spurns private sector investment. Ha Joon Chang demonstrates in his book ‘23 Things They Don’t Tell You About Capitalism’ governments can indeed pick winners, with South Korea’s steel industry as a prime example.

We must not forget, it was the ‘mainstream consensus’ who led us down the path of austerity, of swinging cuts, of unabated privatisation of our core services. Hell bent on removing the state from as much of the market at every turn. This has led to significant housing affordability issues, discontent, and polarisation of our politics. We can build a ‘Progressive Consensus’ underpinned with true social democratic values, through adopting the recommendations made by the likes of Arestis and Pettifor, while at the same time throwing the old targeting inflation adage of ‘mainstream consensus’ out of the window.

The foundation of this ‘Progressive Consensus’ can be built on practical tried and tested empirically evidenced economic policy. This means a coordinated accommodating approach to fiscal and monetary policy, focused on the maximisation of social welfare, financial stability, and reducing income inequality through appropriate redistribution of income from the top two deciles to the bottom four. The latter reduction key to addressing the budget deficit problem.

My first foray into Labour Party economic policy was brought about by a debate held by John McDonnell himself at a People’s Parliament event. There I was inspired at the challenges made to the ‘mainstream consensus’ economic mantra of the day by the likes of the highly esteemed Ann Pettifor. However, I am disappointed to see what is in effect a trepid approach to shaking up economics by McDonnell now he is on the cusp of power. Japan has evidenced coordination is possible between government and a central bank, and it cannot be ignored that it has resulted in unemployment halving over the last five years through such endeavours. Despite this Japan still targets inflation. Who is to say this is not the reason why it hasn’t seen inflation and its growth potential move in a more significant manner.

While across the globe international governments lose their policy co-ordinating capabilities, Labour should lead by example focus on the boring predictable stability business needs. Through broadening the objective of the central bank and not bowing to the strong deflationary monetary policy objectives that goal independent central banks seek, Labour can reform economic policy and make it democratically accountable. The deflationary bias of the ‘mainstream consensus’ destroys the deficit spending multiplier that would otherwise be expected from fiscal expansion. Back to Pettifor’s point. New money in the system needs to be put to work before it can be used to pay back. It doesn’t come out our wallet straight away, we invest with borrowing to create more money, more value than we originally started with. Thus, new money creation must be permanent and invested in productive means to achieve this end. Not taken out straight away with interest rate rises just so the private banks can capture the upside.

Coordination does not need to mean a loss of so-called independence. With common objectives such as a maximisation of social welfare, set and agreed at outset, alongside the necessary parameters and trade-offs associated with adhesion to a democratic fiscal stance, a Labour government can restore faith in putting power back to the people, and not just corporate interests.

In conclusion, I do believe McDonnell has bottled it when it comes to setting truly radical progressive economic policy. One might have been led to believe he had the nous to acknowledge the true impotence downgrading fiscal policy to a passive instrument results in, and instead led with an avant-garde radical ‘Progressive Consensus’ that strengthens its role through coordination. Furthermore, he has failed to challenge its use just to balance the government budget, as if government coffers were no different to that of a household. All contrary to the economic revolution we may have been led to expect back when he was noisy backbencher advocating pluralism in economic debate. To this end, and with my Fabian cap on, it would appear Labour’s fiscal credibility rule is nothing more than a timid mainstream step in the right direction, gradual it may be, progressive and radical - it certainly is not.


Chris Worrall is a Young Fabian member. Follow him on Twitter at @itsEUchris.

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