Saturday, 6 August 2016

Labour’s flawed fiscal rule.

The UK Labour Party’s recently announced fiscal rule is just a variation on the old so called “golden rule” which says that the government budget should balance over the cycle, with borrowing only undertaken to fund investment. That rule was first proposed by the Labour finance minister, Gordon Brown, in the 1990s.

The above mentioned variation is that government can ignore the golden rule it if the Bank of England has no way to effecting stimulus, i.e. if interest rates are at or near zero. (That assumes negative interest rates are a bit of a nonsense, which is fair enough assumption far as I’m concerned)

Well the golden rule and Labour’s recent variation on it sound amazingly responsible, and possibly that’s the main object of the exercise: to persuade the electorate that the party adopting the golden rule is responsible. At any rate the first flaw in that rule is that it assumes the amount of stimulus needed is equal to or at least closely related to the amount of public investment needed. That is obvious nonsense.

But first, there is a subsidiary matter to be settled, which is the question as to whether “borrow and invest” (or more generally “borrow and spend”) is stimulatory. And there are two possible scenarios there: first, the state borrows with the result that interest rates rise, but the central bank (CB) lets that interest rate rise stay in place. Second, the central bank agrees with the fiscal authorities that stimulus is needed, and hence that an interest rate rise would be inappropriate, thus the CB prints money and buys back sufficient government issued bonds to keep interest rates stable.

Consensus, far as I can see, is that both scenarios are stimulatory, though obviously the “keep interest rates stable” scenario is MORE STIMULATORY. In short, “borrow and spend” is stimulatory. Thus I’ll make the not unreasonable assumption (with a view to keeping things simple) that “borrow and spend” is stimulatory regardless of what the CB subsequently does with interest rates.

The first flaw.

So the first flaw in the golden rule (to repeat) is that it assumes that the amount of stimulus needed is equal to or closely related to the amount of public investment that needs to be undertaken. There is of course absolutely no reason for that assumption.

To illustrate, suppose government reviews public investment, and concludes it needs to be increased. Indeed, many people have claimed both in the US, UK and elsewhere in recent years that infrastructure investment should be increased.

But if the economy is currently at capacity, the additional demand stemming from that extra investment spending is not allowable: if it goes ahead without raising taxes, it will cause excess inflation! So the extra investment has to be funded via tax rather than borrowing. It’s all nonsense.

The second flaw.

A second flaw in the golden rule is a simple point which I’ve made many times, but which the economics profession seems to be too dim to understand. It’s thus.

Given the 2% inflation target, the REAL VALUE of the monetary base and national debt will shrink. And assuming those two are to remain constant in real terms (a not unreasonable assumption) that means they’ll have to be topped up regularly. But there’s only one way of topping them up: a deficit!

Moreover, given growth (in real terms) and assuming the base and debt are to remain constant relative to real GDP, then even more “topping up” will be needed!

Thus a significant amount of deficit is needed every year which has ABSOLUTELY NOTHING TO DO with investment. If you ever wondered why politicians and economists spend much of their time scratching their heads about why never ending deficits seem to be needed, you now have part of the answer!

Conclusion: the golden rule is nonsense.

The “golden golden rule”.

So what’s the absolutely ideal golden rule? Well there’s not much wrong with Keynes’s dictum, “Look after unemployment and the budget will look after itself”. In other words, if unemployment is excessive, then simply have government print or borrow money and spend it (and/or cut taxes).

As Keynes put it in a letter to Roosevelt in 1933, the “public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money.”

What’s the point of government borrowing?

As to which of those two options to adopt (print or borrow), it’s frankly a bit difficult to see the point of borrowing (which has a deflationary effect) when the object of the exercise is the opposite, namely “reflation” (to use a term which has gone out of use). “Reflation” means or used to mean the same as “stimulus”. In short, “borrow and spend” is a bit like throwing dirt over your car before washing it.

Indeed, the latter idea, namely that stimulus should be effected simply by printing was advocated by Milton Friedman and is currently advocated by Positive Money.

A second reason for questioning the logic behind borrowing so as to invest, is that borrowing clearly makes sense if the entity doing the investing has absolutely no other source of cash, as is the case with many households buying a home. But government has a near inexhaustible source of cash: the long suffering taxpayer. Plus it’s appropriate for government to PRINT a certain amount of new money most years.

Third, the Swiss academic, Kersten Kellerman had a close look at the “borrow versus tax/print” argument, and concluded that public borrowing does not make sense. That’s in a paper entitled “Debt financing of public investment: on a popular misinterpretation of the Golden Rule.” published by Science Direct and the European Journal of Political Economy.

Thus the claim by the Guardian that “Almost all macro economists support governments borrowing to make productive investments..” is wide of the mark.

For some more arguments against government borrowing, see my paper “Government borrowing is near pointless”.

And finally, given that the whole idea of borrowing so as to fund public investment is doubtful, it’s legitimate to ask why Keynes implicitly endorsed the idea in the above quote. (I say “implicitly” because he actually endorsed “borrow and spend” with a view to escaping recessions in the above quote, rather than specifically “borrow to invest”.)

Well my guess is that given that Keynes was an extremely intelligent man, he probably understood the dubious nature of “borrow to invest”. However, he realized he was dealing with idiots, or at least with people who were idiots relative to himself. Thus he couldn’t come out too blatantly in favour of “print and spend” because every time the words print and money appear in the same sentence, hoards of economic illiterates come out of the woodwork chanting “inflation”.

Thus assuming Keynes ACTUALLY DID favour “print and spend”, he probably wouldn’t have said as much too openly. There are certainly exchanges he had with Abba Lerner in which Keynes cautioned against saying things that might upset the above economic illiterates.

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