Labour’s leaked manifesto and fiscal rules

If the document being described as a leak of a draft of the Labour manifesto really is that, the section on fiscal policy, tweeted by Robert Peston, is interesting.

It contains the encouraging suggestion that HMT rules would be suspended at the point where interest rates hit their effective lower bound.  It is unfortunately silent about what happens next.

My preference is that the Bank of England’s Monetary Policy Committee be asked to quantify the missing stimulus in terms of the trajectory for its constrained instrument.  The Treasury or Office for Budget Responsibility [OBR] would then devise a set of paths for spending and tax instruments that reproduced this stimulus – which would be a thing that varies over time – and which included a plan for unwinding.

Regardless of who devised the plan, the OBR would report on its consistency with long-term fiscal sustainability.

This procedure would have to be regularly updated as news about the economy unfolded, and the missing stimulus grew or shrank.  To be practical, the updating could coincide with the Inflation Report forecast updates.

Without specifying what happens at the zero bound, the suspension of all fiscal plans at this point leaves policy entirely unconstrained and prey to the politics of the moment.

This is of particular importance right now, since it could be that rates are not ready for lift off for two years or more, perhaps even longer if one or more of the many downside risks [China credit, Eurozone banks, no Brexit deal] were to crystallize.  So there would be a non-negligible chance that the rules as written amount to ‘do whatever we feel like for the foreseeable future’.

If the MPC are not asked to quantify the stimulus, it begs the question why they are trusted to quantify and implement the stimulus when their instruments allow them to.  Put differently, why would the finance ministry be trusted with the job of macro stabilisation at the zero bound, but not trusted away from it?

The leaked Labour plan – if that is what it is – includes a provision committing to reductions in the ratio of government debt to trend GDP.  Such a plan is a little odd.  In the long-term, I don’t see the motivation for continually reducing this ratio.  In the shorter term, with monetary policy constrained at the zero bound now, and the cost of public finance so low, it is not a sensible thing to emphasise.

Regardless, using the ‘trend’ in the ratio creates difficulties.  At the least, what ‘trend’ GDP was at any point in time would have to be decided independently by the OBR.  Right now, establishing what trend GDP is, with the path of productivity so extraordinarily low after the financial crisis, and the peculiar developments in the labour market reducing the apparent natural rate of unemployment, trend GDP is hazardous.  And this is without getting into the analytical controversies about the many, many models of trend that could plausibly be taken to the data.

It is tricky to draw general lessons from the academic literature on government debt.  But if forced to, I’d say that one should try to estimate a maximum desirable debt/GDP that could be sustained without risking a run on our UK government bonds;  and estimate a likely frequency/magnitude of recessions, and their implications for the trajectory of deficits and debt as governments deal with them.  Out of this would emerge a rough idea of the average level of debt/GDP that would be desirable.

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4 Responses to Labour’s leaked manifesto and fiscal rules

  1. Tony Holmes says:

    Why focus on the debt / GDP ratio, rather than debt service costs ? By (probably inappropriate) analogy with a mortgage, what matters is whether you can make your monthly repayments, not whether your mortgage is £100K or £200K. Also, as life in Japan goes on with a debt / GDP ratio of 220% , what does that imply for the UK estimate of maximum desirable debt / GDP ?

    • Tony Yates says:

      Partly beause Labour chose to – or seem to have, if the leak is genuine. But also because the GDP denominator measures the income flow that can be taxed to service the debt. As I mention in the post, in the short term, with service costs so low, there is not a reason to prioritise reducing debt/GDP or debt/trend GDP.

  2. Nick Edmonds says:

    When you talk about a run on UK government bonds, what do you have in mind that people would be wanting to switch into when they try to sell their gilts? Is that into sterling bank deposits or into foreign government bonds or something else?

    • Tony Yates says:

      Anything that doesn’t look like being wholly or partially defaulted on, or inflated away, or both. Sterling bank deposits unlikely, as the banks themselves would be threatened by a loss of confidence in the ability of the UK govt to roll over / pay back its debt.

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