Before the end of the year, Britain is set to have an election, a Budget and a new fiscal framework. I have argued that the nation can afford to relax the current rules pledging to lower the burden of public debt in normal times so long as extra investment is subject to expert scrutiny. But we also need to think about rewriting the UK’s rules for times of economic pain.
As the Resolution Foundation has recently reasoned, with interest rates close to zero, monetary tools to stimulate the economy no longer have much power and relying on these alone “risks a deeper, more prolonged and more painful recession than is necessary”. Fiscal policy should play a new and explicit role when the next recession comes.
The problem is in designing a sensible new framework using fiscal tools that preserves the UK’s coherent separation of economic powers. This gives the Bank of England operational independence to damp booms and busts, leaves tax and expenditure decisions with elected representatives and tasks the Office for Budget Responsibility with reporting on the sustainability of the public finances and ensuring forecasts stay honest.
Currently, the government’s Charter for Budget Responsibility says the Treasury can review its fiscal rules “in the event of a significant negative shock to the UK economy”. The Labour party proposed a fiscal credibility rule in 2017 that can be suspended on the say so of the Bank of England’s Monetary Policy Committee. Both fall short. The government’s trigger for action is ill-defined, while Labour’s relies on MPC members voting themselves out of a job. Both say nothing about what happens next.
Drawing on the work of Adair Turner, former head of the Financial Services Authority, and academics Jonathan Portes and Simon Wren-Lewis, it is possible to sketch out a blueprint for a new framework that includes an explicit role for discretionary fiscal stimulus.
The solution is to devolve to the MPC both the decision to use fiscal policy in a downturn and to let the committee determine the required amount of fiscal stimulus. That way the operationally independent BoE would retain its role as the body that smooths the economic cycle and keeps inflation on track.
But the MPC should not implement the fiscal stimulus, leaving that task to the chancellor, who would effectively be given a temporary budget to spend in a timely manner. Since it would be madness to link public sector pay or vital infrastructure spending to the vagaries of the economic cycle, the tools at the chancellor’s disposal should be temporary tax cuts.
As far as possible, the tax measures should encourage domestic spending, so the best fiscal levers to pull are value added tax on services and rebates of council tax. The former would be highly concentrated on domestic demand, while the latter would use the inherently regressive nature of council tax to channel additional spending power disproportionately to poorer households.
The OBR’s role would be unchanged. It would produce independent forecasts that guarded against over-optimism either from the Treasury or the BoE. It would also continue to report on the sustainability of the public finances in a world where fiscal levers are used for stabilisation. With deficits likely to be larger in downturns, these reports should prompt the government to plan larger surpluses in normal times so it can maintain a balanced current budget over the whole cycle.
Implementing a new fiscal and monetary framework along these lines would benefit from cross-party support. There is nothing in these proposals that would prevent political parties having very different attitudes towards prudence in the public finances, and the levels of taxation and public spending. So, with sufficient will, it could be done. Even better, progress along these lines would show that despite Brexit woes, there are areas in which Britain can still lead the world.
