Warning note added on 13th August. There's a serious mistake below (unlike me of course...:-)). I assumed that if a long lasting and deep recession lasts more than five years, then the fiscal rule would prevent adequate stimulus being implemented. That possibility is actually catered for by Simon Wren-Lewis's so called "knockout" clause, which is that if interest rates are at or near zero, and more deficit is need in such a long lasting recession, then the five year rule is ignored. Put another way, the rule is that if interest rates are well above zero, then a deficit plus interest rate cuts are used to combat the recession, but if interest rate cuts cannot be used because they are at zero, then there's no limit to the deficit. However, I'll leave the paragraphs below unaltered, i.e. I'll leave the mistake there.
The rule is that the budget should balance over the medium term (five years to be exact), while borrowing should only be permitted to fund investment.
Well the first bit of nonsense there is that education is one huge investment, but for some strange reason the advocates of “borrow to invest” never claim the entire education budget should be funded via borrowing. For some more flaws in the idea that public investments should be via borrowing, see sections 4 to 4.6 here.
Next, Labour’s fiscal rule contravenes Keynes’s dictum: “Look after unemployment, and the budget will look after itself”. I.e. given a recession, as Keynes said, the state needs to print or borrow money without limit and spend it (and/or cut taxes) until the recession is cured. If that involves running a deficit for MORE THAN five years, then Keynes’s response would doubtless be “then so be it”, and quite right.
Next, if the budget balances over the very long term, the real value of the monetary base will eventually shrink to nothing because of inflation! I.e. inflation gradually erodes the real value of base money, thus if the stock of base money (and the national debt) relative to real GDP is to be maintained, then a more or less constant deficit is needed. Plus real economic growth increases GDP, which further increases the need for a deficit if the “base money to GDP” ratio is to be maintained.
Note that the actual size of the deficit needed to keep the stock of base money and debt constant relative to GDP is quite large, as I’ve explained a dozen times on this blog. To illustrate with some not unrealistic figures, if inflation is at the 2% target and the stock of base money and debt are 50% of GDP, and real growth is 2%, then the deficit needed to achieve the latter “constant” relationship is (2+2)x50%=2% of GDP.
Simon Wren-Lewis (emeritus Oxford economics prof and co-author of the rule) claims a fiscal rule is needed so as to deal with what he calls “deficit bias”, i.e. the temptation that politicians always fall for (first pointed out by David Hume over two hundred years ago), namely to borrow too much. (Incidentally I have plenty of respect for Wren-Lewis an read most of his articles, but I think he's gone off the rails here.)
Well clearly the temptation to borrow too much needs to be countered, but there’s a simple solution to the problem, namely to have some sort of committee of economists (e.g. the Bank of England Monetary Policy Committee) decide all matters relating to the deficit, stimulus, etc, while politicians stick to strictly POLITICAL matters, like what proportion of GDP is allocated to public spending and how the latter is split between education, health, defence, etc. And what do you know? That’s the system advocated by Positive Money!
Plus it is hard to see why any government should not be happy with that system because where the central bank (CB) is relatively independent, the government has ALREADY handed the final say over the amount of stimulus to the CB: that is, if government implements what the CB thinks is too large a deficit, the CB can, under existing arrangements, nullify that with an interest rate rise.
Moreover, Wren-Lewis himself claimed recently that CBs ought to have the right to tell governments what to do when it comes to strictly economic rather than political matters.