Functional finance and fiscal rules – a synthesis (Part II)

Introduction

A curious argument has broken out over the Labour’s proposed fiscal rule. Some advocates of functional finance, in particular, have been vociferous in their criticisms. There is scope for a considered and respectful debate, despite an inauspicious start. As I suggested in Part I, I think there is some sensible common ground between the two perspectives, and also some nuance which has been omitted so far. This second part is an attempt at synthesis and clarification.

Labour has announced what looks like a very sensible and flexible fiscal rule – and this should not surprise us. The rule has been devised in consultation with two of the country’s leading macroeconomists – Simon Wren-Lewis and Jonathan Portes – who have done decades of serious research on the subject. Much of the criticism they have received seems to reflect ignorance of their track record and the depth of their research. Google ‘Simon Wren-Lewis and fiscal rules’ and you’ll see how much reading is needed to get up to speed. At a minimum, read this.

Wren-Lewis and Portes are among the country’s pre-eminent public voices of reason from academia on fiscal policy, monetary policy, Brexit, and a great deal more. For example, no one to my knowledge has more incisively criticised unintended bias in the media and austerity. Wren-Lewis’s reputation rests on reasonableness, relentless appeal to empirical evidence, decency in exchange, a sense of public duty, deep rigour, and a lifetime’s work dedicated to macroeconomics. Shouting him down lessens our democratic process.

Both Wren-Lewis and Portes have been relentlessly consistent and rational, in their criticism of Britain’s post-crisis fiscal policy, and in their analysis of Brexit. And although they have advised the Labour Party, there is nothing I read in their work that needs to be seen as partisan. They are both resolutely empirical.

So what is this (in)famous fiscal rule and what is the nature of the criticism it has received? Deriving a relatively clear and simple rule for fiscal policy does not imply simplistic analysis. For full context on the depth of understanding on the complexity and difficulties this paper by Wren-Lewis and Portes is a good starting point.

Based on their extensive work, Wren-Lewis and Portes, together with the shadow treasury team, conclude that the government should balance current expenditure over rolling five year periods, with a knock-out operating at the lower bound on interest rates. The government should also aim to target a reduction in the ratio of public sector debt to trend GDP over the life of parliament.

This looks very reasonable – and clear. It is totally at odds with austerity in the face of a deflationary recession, because it advocates suspending the rule at the zero interest rate bound, and it permits borrowing for capital expenditure, because the rolling balance is only for current expenditure. It also imposes a constraint on public capex, because there is a long-term target for the ratio of net debt to trend GDP.

As the authors would be first to admit, none of these principles are cast in stone. An ‘optimal’ fiscal policy could diverge for a host of reasons. But the bar is not set at ‘optimal’ – we need something reasonable, flexible, explainable to the public, and something that can be used to hold the government to account.

Some caveats

Before returning to the specifics of the rule – there are some caveats. Institutional reforms, which I would advocate, may well render aspects of the rule redundant. There are two important ways in which our current macro-policy institutional framework needs reform. First, we clearly need to reduce central banks reliance on interest rates to manage demand. Simon Wren-Lewis, Mark Blyth, and I, argue in The Guardian, that the Bank of England should be given the power to make equal transfers to all households if needed to meet their inflation target. In addition, I would set up an independent capital expenditure commission to plan major 10-year public sector capital expenditure, and an independent sovereign wealth fund to create broader equity ownership (as outlined here with Mark Blyth, and here with Tristan Hanson). I would make borrowing to fund asset purchases and capital expenditure independent of the fiscal rule. Public sector capex should be determined by the available return on capital and its cost. The only difference between the calculus of the public and private sector in this regard is that the ‘return’ on public capex should incorporate externalities (as the private sector does in ‘impact’ and ‘social’ investing). If the return on investment exceeds the cost of capital it *always* makes sense, because it also improves debt sustainability. The main challenge is one of political economy, so the assessment of value created must be independent of the political business cycle and the vote-buying incentives of the political class. The balance sheet implications for the state of the sovereign wealth fund are described in detail here.

A cash-transfering central bank, a sovereign wealth fund to increase equity ownership, and an independent public capital expenditure commission, are long-overdue institutional innovations which tackle our major macro problems. This is the making of a credible radical agenda – far more interesting than a naive return to 1970s, or a ‘run deficits until there’s an inflation problem’ approach to fiscal policy..

None of these caveats is inherently inconsistent with the core of Labour’s fiscal rule, of course. Balancing rolling five-year current balances would remain very relevant. The knock-out should stay in place if the Bank of England needs help, although I suspect that a cash transfer-empowered BoE would not. This is another reason to empower it. If an effective BoE succeeds in reducing the frequency and severity of recessions, it will be transparently clear if the government is meeting its rolling five-year target of balance.

The ratio of public sector debt to trend GDP becomes less significant in this context because it will be determined by positive or negative trend growth shocks and the perceived return on public sector capex, and the cost of finance. Importantly for those who rightly reflect on the fact that fiscal targets imply private sector targets of the opposite sign, the reverse is also true – if the private sector sees huge investment opportunity at full employment and this drives up real interest rates, public sector investment will be lower than is otherwise the case due to a higher cost of capital. It is conceivable that a capital expenditure commission would recommend periodic shifts in the debt to trend GDP ratio, if deemed beneficial.

Ok, so I have outlined some institutional reforms which I think need to be on the table, which render some aspects of the Labour’s fiscal rule less likely to be relevant. The only substantive change would be to allow for variance in the debt/GDP ratio subject to the decisions of the capital expenditure commission. And serious innovations in the BoE’s tool box might render the ‘knock-out’ redundant.

Controversy

So what are the more heated objections to Labour’s proposed fiscal rule? I think they come in two forms. One proposes an alternative rule – without calling it such – which is that fiscal policy should target inflation. Let’s call this ‘hard’ MMT in heterodox land, or The Fiscal Theory of the Price Level in hyper-orthodox land. One of the deep ironies in this debate is that the reasoning of some members of MMT is virtually identical to that of extreme orthodoxy – such as Chris Sims and John Cochrane. Both argue that inflation is always and everywhere a fiscal phenomenon (incorrectly, as it happens – yes, Friedman was fundamentally right, and monetary policy is distinct from fiscal policy). The other objection holds that targeting a public sector deficit is impossible – because a change in public sector behaviour has opposite consequences for the private sector. This follows from simple national income identities – if the public sector targets a surplus, the private sector, or balance of payments must go in to deficit. If the public sector mends the roof when the sun in shining, the rest of the economy burns it down! Let’s call this ‘soft’ MMT in heterodox land, in hyper-orthodox land, the closest analogue is Ricardian equivalence. Both are really attempts to understand fiscal policy targets in ‘general equilibrium’, or perhaps more accurately, at an holistic system level. This is entirely reasonable – even if the conclusions of Barro have the wrong sign (fiscal stimulus in a recession is likely to reduce the probability of higher future taxes), and ‘identity-defeatism’ appears empirically false – governments can hit fiscal targets and can have good reasons to.

Should fiscal policy target inflation?

Let’s consider ‘hard’ MMT – should fiscal policy target stable inflation or full employment, which some advocates appears to argue. Or to put it less forcefully, should the government run a deficit as large as it can until inflation starts rising, at which point it should tighten fiscal policy, which seems very close to what Stephanie is advocating?

We need to step back to unpick this. For a government which has the power to print money the fundamental constraint on fiscal policy is inflation. Stephanie Kelton, Simon Wren-Lewis and I agree on this. So when the threat is deflation, worrying about budget deficits makes little sense (let’s caveat the Eurozone, to which I will return). This may seem obvious – and it should do: if the government can finance itself by printing money, the only risk with state money-printing is inflation. So if there is deflation, a money-printing state has an unconstrained check book.

As Simon has pointed out, this is obvious, although he also acknowledges it has been periodically obscured in the debate, perhaps for political ends. Despite the self-evidence of this line of reasoning, many governments decided or were advised to tighten fiscal policy after the financial crisis despite the fact that deflation was a real and present danger. Nonsense about ‘household budgets’ and balancing the books was trotted out – arguably destroying the Liberal Democrats in the process. Households don’t have printing presses, and individual household’s budget decisions do not affect aggregate demand, employment and output. The government is simply not a household.

This set of observances seems very robust. But there are some very important nuances and less clear implications. Firstly, these statements are institutionally contingent. For example, in the Eurozone, national governments – as a matter of law – cannot print money. So this reasoning does not apply. In fact, we can not determine ex ante what a Eurozone government should do faced with deflation – although it is crystal clear what the ECB is mandated to do by law.

Also, although the Eurozone is institutionally unique, and renders many of MMT’s policy prescriptions redundant to this jurisdiction, as astute economists including Stephanie have shown, it is only at the extreme of a spectrum. The reality of political economy is that the population across the developed world does not trust its elected politicians with the printing press. Denial of this fact seems to run through a lot of MMT commentary and analysis I read. Central Banks are not independent across the developed world as a result of a quixotic hijacking of power by a spock-like subset of the technocracy. They are independent due to a democratic revolt against the abuse of the printing press by the political class. History suggests that democratic process is reinforced by an independent judiciary, an independent public service, and independent central banks. All, of course, are subject to law approved by legitimate legislatures. My objection to the Troika – one of the worst cases of institutional failure in the developed world in the last twenty years – is not ‘technocracy’, but illegality and dishonesty with catastrophic consequences.

Also, observing that inflation is a constraint on fiscal policy, does not give guidance on the right policy – it only tells you that people are talking nonsense when they say that policy *needs* to be tightened during deflation. If independent central banks are signalling a deflationary risk and hoovering up government bonds, a contraction in fiscal policy is a form of self-harm. But this in no way suggests that fiscal policy should either target full employment or stable inflation as seems to be suggested here, nor should it simply be eased until there is inflation, as suggested here. In fact, as I make clear below, reformed monetary institutions are likely to be far more effective at meeting these objectives.

Ok, so accepting that the obvious theoretical constraint on fiscal policy is inflation, is of limited use. Yes, it tells us that a combination austerity with QE is snake oil, but this neither amounts to a workable set of principles for fiscal policy, nor an answer to the policy dilemma of how to square a need to protect the printing press from politicians and make monetary policy fit for purpose.

The two major macro-policy issues which need to be addressed are: 1) how do we manage aggregate demand through the cycle, and 2) what do we do when faced with a major negative shock? The right policy when faced with a deflationary threat is in fact very complex and needs a lot more rigorous debate, which is oddly not really occurring. Changing targets for central banks is a complete distraction, as is handing these targets over to the fiscal authorities. The serious proposals on the table are Bernanke’s off-budget helicopter drop, cash transfers to households – or direct support for consumption as the Czech central bank has described it – or the Wren-Lewis/Portes proposal for a knock-out, where the fiscal authorities are called in by the central bank (in their suggestion, at the zero bound, but it could be earlier, in principle). These are serious institutional reforms which tackle monetary policy failure without compromising the democratic principles of central bank independence.

Who is responsible for inflation and managing aggregate spending?

In order to navigate these two questions, the first consideration is to understand the relative merits of monetary and fiscal policy – something I have discussed at length here and Simon Wren-Lewis has discussed here. The democratic legitimacy of decisions-makers, which I will return to, should be considered independently of the efficacy of policy.

The options available for counter-cyclical demand-management (or full employment or inflation-targeting, if you prefer) are: 1) fiscal policy only, 2) monetary policy only, 3) a combination of both, 4) reformed monetary and/or fiscal policy.

In my opinion (4) is clearly the best option, and it has received insufficient attention in public debate, despite the collective trauma of one of the most severe recessions in the post-War era. Counter-cycle fiscal policy needs reform of process, monetary policy needs reform of powers. What do I mean by this? Start by considering the pros and cons of monetary and fiscal policy, as counter-cyclical tools:

Fiscal policy. Pros: directly affects income and spending. Cons: gets hijacked by party politics, doesn’t take effect quickly or occur in a timely manner. Put bluntly: if one party is pro-deficits and the other anti- the severity of the recession will depend arbitrarily on which is in power. Consensus around inflation-targeting, given this alternative, is a godsend – whatever about its considerable limitations.

Monetary policy: Pros: Very timely, avoids party-political bickering and logjams in execution. Cons: only works – if it works at all – indirectly, by altering asset prices and/or leverage. Can be financially destabilising.

This quick inventory of the relative merits of fiscal and monetary policy points immediately to the areas in need of reform. If fiscal policy is to be helpful cyclically it needs to be set up so as to be implemented rapidly. In a sense, this is why the greatest counter-cyclical fiscal effects are the so-called ‘automatic stabilisers’. Perhaps there should be no changes in fiscal policy designed to balance over rolling five year periods, and the budget deficit/surplus would simply be caused by cyclical changes in revenue.

As regards monetary policy, the key area in need of reform is clearly the tools available to the central bank. Monetary policy would be optimal if it could change incomes directly. Intriguingly, Lars Svensson says as much (slide 10). And the Czech central bank has now outlined how to do this. So monetary reform is obvious – mandate central banks the power to target household income and spending directly. Arguably, the ECB already has this power – the European public should make clear that it expects it to be used.

The second question concerns the legitimacy of macro-economic policy-making. This area has become terribly confused. Just because a decision is made by public servant, and not an “elected” politician, does not render it illegitimate. Relatively well-functioning democracies have recognised: 1) There should be checks and balances on political power, we don’t want politicians, the executive, independent state agencies, the legislature, the judiciary, the army, the police, and the media – the essential institutions of democracy – to have too much power. All are subject to scrutiny and checks and balances; 2) We distribute power using diverse processes – we use majoritarian voting processes for the main legislative body, and a variety of non-electoral and electoral methods for other institutions and certain constitutional legal structures.

It follows that one cannot simply dismiss the actions of central banks as ‘undemocratic’ because they are ‘unelected’. Our laws are almost entirely implemented by unelected public servants. What matters are the legitimacy of the rules, mandates, and effective public scrutiny. Democratic process requires permanent vigilance.

For example, the ECB has been given a legal mandate to deliver price stability. This was granted by democratically-elected representatives of member states, which voluntarily joined the Euro. In order to fulfil this mandate, it has clearly defined monetary power – which includes, by the way, a monetary bazooka. It should be scrutinised. If it acts in breach of this mandate, it should be reprimanded through the courts.

Similarly, it would be entirely legitimate for the Bank of England to be granted the power by parliament to make cash transfers to households. Parliament should specify the rule.

In summary, democratic process can result in varying mixes of monetary and fiscal counter-cyclical policies, even if we all agree on how economies work. Different institutional arrangements are also likely to prevail in different jurisdictions. And ‘legitimacy’ is complex. Dismissing public servants as ‘unelected technocrats’ is trite.

My preference is to give more effective tools to central banks outside the Eurozone, as outlined above, and within the Eurozone to enforce and debate the law. The law is far more radical than realised. I do not think it is realistic to expect fiscal policy to ‘work’ for the well-rehearsed reasons outlined above. To a significant extent, central banks were given independence because finance ministries or treasuries were no longer trusted by the public to act in their interests. If reliance on fiscal policy is to increase, the emphasis should probably be on some form of automatic stabilisers that have cross-party support – otherwise our vulnerability to recession will vary once again with the political cycle.

Fiscal rules and accounting identities – inconsistency or choice?

Having a fiscal rule is also not inconsistent with the logic of sectoral accounting identities,- although thinking about these interrelationships reveals the inevitable complexity and why it is important to incorporate flexibility in the rule. The essential point here is that any sector of the economy’s spending is another sector’s income, so if any sector runs a surplus – spending less than it receives – another must run a deficit. In an open economy, if the private sector and public sector both run surpluses, as in Italy, the rest of the world runs a deficit. By this logic, I have argued that George Osborne’s catch-phrase that one should ‘fix the roof when the sun is shining’ implies that the private sector should simultaneously burn its roof down. Indeed after a financial crisis when the private sector is both mentally-scarred and attempting to repair its balance sheet – which neuters monetary policy – there is absolutely a case for running more persistent deficits.

Does this logic present an insurmountable problem for a fiscal rule? There are two points here. I have seen it argued that it is simply not possible for the government to hit its target because of changes in other balances. If a target is flexible, this hardline seems implausible, although in very unusual cases such as Japan, persistent and extreme savings behaviour by the private sector could make it very hard to meet even a very flexible rule – although the Japanese ‘debt problem’ now looks like an accounting error. Also, the knock-out option of the Wren-Lewis/Portes rule is really a permanent opt-out in Japan’s case.

The more fundamental point, I think, is that suggesting that Labour’s rule is somehow setting a fiscal objective independently of what the private sector is doing is disingenuous. In essence Labour’s rule is likely to be doing a version of responding to private sector behaviour. It is likely to be running surpluses, or smaller deficits, when the private sector is cyclically ‘optimistic’. Any ‘through the cycle’ rule, implicitly assumes behaviourally-driven cyclical attitudes by the private sector towards risk. Offsetting this optimism with public sector ‘saving’ seems wise.

The real question is whether running a surplus or reducing a deficit when the economy is growing above trend is destabilising in any way? If we believe that real interest rate structures are dangerous low -either for reasons of monetary policy efficacy, or financial stability – there is obviously a case for running looser fiscal policy to raise prevailing real interest rates, even during a phase of above trend growth. That is the intelligent defence of Trump’s deficit, which Stephanie side-steps, and Krugman and Summers ignore due to partisanship. Advocates of secular stagnation (I’m not), haven’t a leg to stand on objecting to Trump’s deficit – they can obviously dispute its composition, but that’s a totally separate argument). Stephanie Kelton is at least consistent on this point. She wants everyone to run a deficit.

Put more bluntly, could a fiscal rule reinforce the pro-cyclicality of private sector balance sheet dynamics? This is possible, but I suspect second order. Also, the emerging consensus that prudential regulations are the best means to target financial sector leverage – the most pernicious form of cyclical risk – seems right.

All of these considerations amount to viewing fiscal policy in ‘general’ rather than ‘partial’ equilibrium, which opens a large set of complexities. Indeed, the reality is extremely complex and the inter-relationships will change. We can add further complexity if we break the assumption of standard fiscal sustainability equations, that r (real interest rates) and g (real growth) are variables independent of policy – which they are not. What if fiscal stimulus affects trend g, and how should one respond to independent changes in r?

We must also distinguish between stocks of assets and liabilities and deficits and surpluses, something Wren-Lewis and Portes discuss but others typically ignore. We tend to simply assume that liabilities are the sum of deficits. But they aren’t. I have a major problem with the treatment of base money as a liability and conclude that stock of net debt in the UK is far lower than measured. In addition, the properties of government bonds are not static and private sector demand for them can shift dramatically for reasons completely independent of fiscal policy – such as regulatory shifts in demand for bonds by the financial sector and changes in correlations with other assets. John McDonnell’s point about the dollar as a ‘reserve currency’ is pertinent – I would not focus on its ‘reserve currency’ status, but I would acknowledge that Treasuries have very specific correlation properties, which make them act as safety assets. The huge change in the cyclical risk properties of government bonds, as a result of the elimination of inflation risk, could be exploited to great effect by an enlightened radical reforming government.

It is extremely important to remember that the risk properties of government bonds, actually hangs on assumed price stability, which is almost certainly a result of deregulated product and labour markets, and independent central banks. One of the ironies of some MMT arguments is that re-regulating labour and product markets would entirely neuter the role of counter-cyclical fiscal policy. The entire discussion about what markets will do is actually premised on whether or not markets perceive there to be inflation risk. Markets currently believe in price stability, largely because the evidence suggests – in the developed world – that whatever central banks do, inflation barely moves. This has provided the state with huge counter-cyclical policy powers. In heavily-regulated, ‘1970s’, economies there is no role for counter-cyclical fiscal policy – this is the risk-based definition of an emerging market.

All of these points merely suggest that reality is more complex than fiscal sustainability equations tend to assume, and that no fiscal rule will be perfect, or cover all eventualities. But that is not a reason to have no rule. It is a reason for flexibility and wisdom in the rule one adopts – criteria which labour’s rule meets. The alternative being proposed – that the fiscal authorities target full employment or inflation stability (and monetary policy does what?) seems to ignore all the evidence on institutional bias and failure, not to mention the democratic mandate for varying degrees of central bank independence. Give the monetary authorities the right tools, and legislate clearly on their mandate, and it becomes very clear that recessions can be either avoided or brief. Effective full employment – such as prevails now across much of the devloped world- combined with price stability, is demonstrably possible, but it likely depends upon competitive product and labour markets, and a legacy of sustained low inflation. Threatening any of these pillars would be ill-advised.

A synthesis and conclusion: rules help

It is worth reminding ourselves why we need a fiscal rule. Politicians are not trusted to always act in the interests of the public. At least one reason for the current global electoral revolt against mainstream politicians reflects the opposite belief – that our elected representatives are too often in it for themselves, or those connected to them. There is a long history of governments abusing the power of fiat money-printing, the result of which has been decades of institutional reform, including a global trend towards independent central banks. It should go without saying that ‘independence’ does not mean ‘illegitimate’. An independent judiciary underwrites democracy. To conflate independence with illegitimacy is to abandon thought. The laws governing independent central banks should be set by democratically legitimate legislatures, and their work requires constant scrutiny, and periodically evolving mandates.

Recognising that there is no constraint on fiscal policy when there is a threat of deflation – for example during a financial crisis and its aftermath – is in no way inconsistent with Labour’s fiscal rule. Beyond this, the truism that inflation is the ultimate constraint on the spending of a money-printing state, does not really help us much with designing a fiscal framework.

Wren-Lewis and Portes, perceptively quote Coen Teulings – director of the Dutch fiscal council – who observes that the absence of the equivalent of a Taylor rule left governments at sea when it came to fiscal policy after the financial crisis. This is very important. Pre-agreed rules give the public a relatively clear way of assessing what the government can do, and a highly flexible pre-agreed rule such as that proposed by Labour would also give them the confidence to be brave faced with another cyclical calamity.

So is Labour’s rule fit for purpose? As I have hopefully shown, an ‘optimal’ fiscal rule is extremely difficult to design. So the criterion cannot be perfection. Yes, there are lots of problems with any rule, and sets of circumstances where they will not be ideal. The real test is not perfection, but an assessment relative to the alternatives. On this basis, Labour’s rule definitively looks the best on offer.