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First the fiscal rules, next monetary policy?

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Paul Mason | 12:34 UK time, Friday, 18 July 2008

One advantage of blogging versus TV reporting is that you can blog while on holiday. So I am writing this surrounded by wetsuits, binoculars, mini-Malibus, Neolithic cromlechs and the Welsh coastal mist. Subject: a) the rethink of the fiscal rules that is leading the radio news bulletins this morning and b) what that means for monetary policy. First, nobody seems to know exactly what is being envisaged - so it's worth sounding a note of caution. Many economists had presumed that a statistical rewrite of the GDP measurement, due this autumn, could raise the size of UK GDP by 2% - apparently the financial sector has been adding more to the economy than we previously understood. This statistical tweak would, I am told, allow the government to borrow another 12bn even without rewriting its fiscal rules. Second: clearly a relaxation of the rule is on the cards since, as I have pointed out both here and on Newsnight, it is going to be broken - together with the inflation target. The issue is bigger than offering Gordon Brown/Alistair Darling a get-out-of-jail card for the next Pre-Budget Report. We are facing the first big downturn of the globalised and liberalised economy and some of the rules which seemed to work during the upswing - and in fact seemed to be as immutable as a Neolithic cromlech - are proved to have just been economic tactics. They will be superseded....

...If, as is probable, the new looser fiscal framework allows the government to borrow in order to boost the economy with tax giveaways then there may have to be another, even bigger rethink about monetary policy and the inflation target.

Here's why:
a) the Bank of England has a remit to control inflation. A substantial tax giveaway has the effect of boosting demand, which all things being equal places an upward pressure on inflation. The Bank, therefore, may decide that interest rates need to go up as a result of any tax & borrowing splurge. What Alistair Darling giveth, Mervyn King may taketh away, and hath said as much in speeches and evidence to the Treasury Select Committee.
b) It is well documented that higher government borrowing pushes up long term interest rates on government bonds, whatever happens to the short term end of the curve. So there is an objective aspect, as well as a policy aspect, to the impact of any fiscal stimulus on interest rates.

For both reasons those advocating an economic strategy to postpone or weaken the downturn by means of stimulating demand have argued that it is pointless using tax giveaways without at the same time cutting interest rates or loosening monetary policy. In fact the uber-Keynesians want the monetary stimulus first, then the fiscal package.
The difficulty in the UK is that the central bank has been independent for only just over a decade and has a lot to "prove" about its actual independence. All the noises coming from the Bank say: "tinker freely with your fiscal policy - it's your egg and your face Mr Darling - but don't mess with monetary policy".

Yet monetary policy, and the 2% interest rate target is not as immutable as a Neolithic cromlech: it was invented by Gordon Brown and has been changed once already in the past decade (from 2.5% RPIX to 2% CPI). It could be changed again. There is a whole generation of politicians and journalists who believe the 2% target and the CPI targeting regime is in some way unchangeable - yet it can be changed and I predict probably will be.

The policy is updated annually in a remit letter, which repeatedly states the Bank has to pursue price stability and "subject to that" the government's economic policy objective of "high and stable levels of growth and employment".

If the government resorts to tax giveaways to boost growth, it makes no sense for the 2% CPI targeting regime to dictate action that cancels the stimulus out. I hope if any of my colleagues manage to get Labour ministers in front of a microphone today they will get them to address this issue.

How could monetary policy be relaxed? The "old" way of doing this would be quiet pressure from the Treasury on the Bank. Interestingly, during the Northern Rock debacle Mervyn King publicly expressed nostalgia for the "old" way of doing things; he would have preferred a secret weekend bailout of the Rock but EU law forbade it. I don't think, however, we will get any secret weekend change of heart by the entire MPC over interest rates: that would make a nonsense of Bank independence.

However just as there is scope for a technical rethink on the fiscal rules, there is ample scope to let the civil servants loose on the inflation target - in particular because the European Union, with whose HICP inflation measure the CPI is harmonised, is itself looking at whether there could be a more sophisticated measure. Plus,iIt could easily be relaxed by changing it to a target "band" rather than a target "line".

Taking it out of the civil servants' hands completely, the government (any government) could simply decide that monetary priorities should not proceed from "low inflation first, growth second" but, as in the USA, consider high growth and employment on a par with price stability, allowing pro-active interest rate cuts, Bernanke style.

All this, of course, is a matter for political debate: there is a perfectly rational case for the government to stick to the fiscal and monetary targets, as hard times is what they were designed for. However if you are going to relax one, you have to relax the other - and if you are going to pursue Keynesian demand stimuli it is worth doing them in the order that the man himself prescribed: monetary first, fiscal when all else fails.

Anyway, the wind has changed, the mist over the cromlechs has cleared, there are middle aged guys in wetsuits mentally re-living scenes from Big Wednesday amid sub 1 metre waves. I must join them. If a monetary rethink does happen, a whole generation of politicians will greet the move as one ex-Labour minister did when Britain abandoned the gold standard in 1931: "We didn't know you could do that!" But you can.


  • Comment number 1.


    When a limited company can't cover its debts, the trick is to re value all the knackered office chairs and storage racking to a point where solvency is notionally restored. (Don't ask how I know.) Perhaps, in view of Britain's up-valued GDP, Gordon is more in touch with the real world than we thought! I just hope the extra sales are not of Scotch Mist to bogus companies, invented by an insurance minion and existing only in Cyberspace.

  • Comment number 2.

    its cheaper to have a few million on unemployment benefits scratching away on £50 a week . that's what the tories did and it 'worked'.

    no inflation risk there thus no interest rate problem [high unemployment also keeps down wage demands]

    we could [like the romans] engineer our way out of energy inflation by

    1. building 90-120 day energy storage to store gas etc during low summer prices and so stabilise the price over a year [wholesale gas prices are crashing at the moment]

    2. rolling out a two way grid [employs 1/4 million people generates 23 billion euros in germany] that will incentivise mico generation.

    3. have a land tax on ignored land.

    but according to the govt who sound psychologically defeated 'nothing' can be done so nothing will be done.

  • Comment number 3.


    I would like to add to bookhimdano's truly inspired projects, micro-generator treadmills for all able-bodies prisoners, linked, additionaly, to food supply (reward system) and built in-house by inmates. There should be a break-even target for prisons to aspire to, with an annual award for getting into profit.

  • Comment number 4.

    You are holidaying in Wales ? I always knew you were a man of taste and sophistication !

    Just don't tell everyone else how wonderful it is, or it will soon look like the other 'West Country'.

    Your post is cogent and intelligent - see it does you good to get away from the smoke for a while. I'm not a great economist, but when I was educated in it, I was always surprised at how inter-connected the whole thing was - like a massive game of Ker-Plunk! where messing around with one thing would invariably cause a problem elsewhere.

    The trouble is that Gordon Brown hasn't quite realised this and treats more as a game of 'Buck-a-Roo!' and has been loading more and more tax burden, not thinking that the poor horse will buck the trend at the next election.

    All this talk about 'Oooh, we can just change the symmetrical [symmetrical !! not a line !!] target for inflation to be a 'band', and that borrowing can be tweaked 'just until payday for the economy', is frankly a little worrying.

    I can understand that stormy seas are approaching and that different [desperate?] measures are required - but one has to acknowledge that once the inflation genie is out of the bottle it ain't going to be going back in, unless it is to a bigger can of worms - or something like that...

    The problem is that these guys are hoist by their own petard - by 'sexing up' the significance of these measures in the first place, and raising our expectations that they could meet them, it is a much bigger loss of face, and they've got further to fall than if they'd kept their pride hidden under a bushel..

    But enough of this frivolity - you have more serious business to attend to - like enjoying yourself !! If one thing gives me comfort in this 'credit crunch' it is knowing that the thoughts of Chairman Tom Hodgkinson may soon gain widespread acceptance, and his ideas won't be dismissed as eccentric..

  • Comment number 5.

    Gordon's Rules:
    1. Make a rule that you think you can meet.
    2. When you can't meet rule 1, change it.
    3. Don't think too much about rules and how they might work in the future.
    4. Blame the EU for the rules.
    5. Blame everyone else for not playing by the rules.

  • Comment number 6.

    Blogpolice (5) right on the button!

    What we need above all right now imho is to put in place some degree of protection against foreclosure for the 'innocent' homeowners (I write as a committed tenant and not a homeowner myself).

    As for deflation it's obviously going to be painful and with no savings to speak of a whole lot more painful for both individuals and UK plc itself.

    I doubt that treating ourselves to another spending spree based on a statistical rehash of our GDP figure will be politically sound, especially since the upgraded figure will apparently factor in a hitherto unrecognised contribution from the financial sector, already responsible in recent times for half our GDP growth but I fancy not for much longer.

    The disease was a credit bubble and the appropiate medicine is thus presumably a tighter control on credit for the time being. We should grin and bear it it seems to me. Actually cutting interest rates strikes me as something of a homeopathic sort remedy 1. we can only possibly do it in tiny amounts because it is certainly poison after all 2. it doesn't actually work anyway except in the minds of the converted.

    I'm partial to the odd cromlech myself BTW Paul. I do much like to sit on them and ponder that some things are indeed pretty immutable. When they did Stonehenge do you imagine the tribal elders of the time (not Druids after all so the history books boringly correct us) had Millennium Dome type debates amongst themselves? It is certainly possible for a nation to ruin itself on some expansive project or other - 12th century (or so) Cambodia and Angkor Wat comes to mind and then there's London 2012 to come ...

  • Comment number 7.

    Newspaper Journalists Rules:

    1.Find a political story which you think will get you noticed.
    2.When you can't find one, make up one.
    3. Don't think too much about the truth, simply about how it may help your own future.
    4. Use all gossip a fact.
    5.Blame everyone when your story is not as big as the Watergate Scandal.
    6.Find obscure MPs to help create your story.


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