Why the fiscal charter is not right

Ultimately I am against this charter for the same reason that I am against moves to legislate that the Fed should follow, or be monitored relative to a monetary policy rule.

Macroeconomic fiscal policy is, crudely, about weighing the demands of vigorous application of the stabilisers (automatic and otherwise) today, against the need to preserve room for doing the same at some point tomorrow.   Where this requires keeping the ratio of public debt to GDP from going above some limit beyond which the cost of debt finance might be expected to spiral, and inflation stability and the capacity to deficit finance to counter recessions would be undermined.

Most of the ingredients here are a matter of at least some controversy.  The likely safe limit for the debt-GDP ratio.  The size and frequency of recessions and financial crises.  The robustness of monetary policy objectives in the face of an otherwise necessary, extreme fiscal stimulus.  Crucially, the path of potential output – even the appropriate concept of potential output – about which the purpose of fiscal policy here regulated is to stabilise actual output.

For that reason, I don’t see how any sensible legislation could frame a fiscal rule like this.

The government have tried, but it falls down on many counts.  To give one example, the definition of ‘normal times’ when the surplus rule applies, is framed in terms of the annual growth rate of GDP of 1%.  Yet one thing almost all economists would surely agree on, is that the appropriate definition would be in terms of the difference between actual output and potential.  I can see why the legislation does not involve this concept, because it is such a conceptually and empirically elusive thing.  But I am not convinced that the solution to legislate in terms of growth rates is better than pure discretion.

Current circumstances seem to be exempt.  But imagine a repeat, 10 years hence.  After seven years more, interest rates are pressed against or close to the zero bound.  The economy is growing again, consistently, but many think that output is still below potential, and inflation is substantially below target.  A surplus in such times would be hazardous, to say the least.

To press on with this single example, its conceivable that a surplus might be needed even if the growth rate of output is less than 1%.  There is no economic law that potential output is an inevitable straight line process inexorably enriching us by 2% per year.  Sustained falls in output can be caused by falls in potential output, and during these times it may be necessary to have tight fiscal policy, where the loose fiscal policy allowed by this charter would be futile, inflationary and counter-productive.

As many others have pointed out, the shift from the previous version of the Charter to include public investment is perplexing.  It’s possible to sympathise with a political economy view that democracies, in which the unborn do not vote, may have a tendency to ‘invest’ without real expectation of future returns, simply as another form of covert, current spending.  But the Office for Budget Responsibility’s old terms of reference seemed adequate defence against that.  Likewise, it’s possible to sympathise with the view that public investment decisions should be made on a long-term basis, and that such investment should not rise and fall frequently with the tide of the cycle.  However, on occasion, the demands of macroeconomic crises will trump that desire.  And it may be reasonable now to expect real finance costs to be low for a very long time [look at long-term real rates now for instance], and that deficit finance to take account of this bounty, on projects that generate genuine future returns [meaning future tax revenues] would be justified for a long time to come.

All this is not to say I am against legislative constraints on the macroeconomic aspects of fiscal policy.  On the contrary, I am in favour.  But I think they should, [as they did until now] follow the model of the Bank of England.  Delegate, as far as democratic niceties allow, to an expert, independent body, a set of objectives, and give them the discretion to pursue them, rather than tie them to inappropriate and, therefore, ultimately non-credible rules.

In this case that could mean expanding the role of the OBR to comment on the appropriateness of the fiscal stance.  Not just in so far as it bears on long-term sustainability, its current mandate.  But whether, given a government defined objective, it weighs appropriately those competing demands, the demand to stabilise vigorously today, vs the demand to preserve the capacity to do so in the future.  In support of that it would form a view about the appropriate debt/GDP ratio, the output gap, the evidence on the likely size and frequency of recessions and crises [and what strain on finances fiscal stabilisers such crises would put].  Perhaps even and independent view of the efficacy of monetary policy tools that are the alternative.  Such legislation could even go so far as to stipulate that in the extreme event that interest rates are constrained at zero, the fiscal stance could be decided, or at least discussed openly with the Bank of England’s Monetary Policy Committee.

As some have pointed out, this Charter should not be considered a left-right issue.  Even fiscal hawks should be concerned not to legislate in this fashion, just as monetary policy hawks, frightened about inflation stability, should not try to tie a central bank to a monetary policy rule that is not foolproof.

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