Plan B: Set up a recovery fund

Dear Chancellor,

Britain's growth continues to disappoint, and the risks from the world economy (especially the eurozone) continue to mount. You have recently reiterated your commitment to your deficit-reduction plan in this parliament and to adopting "no plan B". Few doubt the seriousness of your intent and the importance of "credibility" in what is an uncertain world.

Yet there are two aspects to credibility. One, emphasised in the economics literature, is commitment to the medium-term objective. The other is a credible strategy for getting from point A to point B. The credibility that matters is a combination of both.

It is usually taken for granted that austerity is the correct way to reduce budget deficits and lower national debt. But is it? Sometimes, steering straight towards an objective does not get you there at all. A well-known example is steering a boat (from the rear). To move the boat on to a parallel course to the left, the first move is to swing the rudder the "wrong" way so that the back of the boat goes further away from the objective. After this, the rudder has to swing the other way before finally straightening up on the new course. It is quite tricky and timing is important. Control engineers call such systems "non-minimum phase". Normal feedback control does not work.

Fiscal policy is similar to this. Ordinarily, this does not matter, because there is another instrument - monetary policy, which also affects the exchange rate - that can be used to steer the economy and maintain growth. Monetary policy is like steering from the front or, to continue the nautical analogy, like using a tugboat to help manoeuvre.

In normal times, fiscal austerity to meet de­ficit and debt objectives can be offset by appropriate monetary easing. Institutions such as the Monetary Policy Committee (MPC) are mandated to behave in this way. The control problem re-emerges if monetary and exchange-rate policy cannot be used (as in a country in the eurozone), or if interest rates are in effect already at their minimum (as in the US and the UK).

At this stage in the recovery, policymakers and politicians face a difficult task. If they use fiscal policy to speed up growth, they risk the wrath of the bond markets, it appears. If they do not, they risk slow growth or even a double dip - which will also swell deficits. They seem to be damned either way. There is only one way to steer. This is to go for growth first and credibly commit to fiscal adjustment as the private sector recovers. Anything else will not work.

How, then, could growth be stimulated? Most suggestions about ways out of the impasse focus on how to revive private-sector spending, especially investment. You are obviously thinking along these lines, given your proposal for credit easing at the Conservative party conference early this month.

Suggestions abound - from further quanti­tative easing (already announced by the MPC) to scrapping planning regulations on selected housing or infrastructure projects. All these proposals may help but many will take time. It is hard to believe that consumer and investor confidence will revive in advance of an increase in anticipated growth. And there may be further downward shocks to expectations and confidence from abroad.

The only lever left is fiscal policy, which has to be used to get growth in the short term while maintaining the commitment to rebalancing in the medium term. My preference would be public investment for infrastructure, which is sorely needed and could be financed, currently, at negative real interest rates. How about a recovery fund, financed by index-linked gilts? The point here is that fiscal policy must go in what would appear to be the "wrong way", initially. A commitment to growth through fiscal stimulus would be Plan B, with a vengeance.

The argument against this is, in a word, "credibility". Would credibility be threatened? I doubt it. No one appears to doubt your commitment to medium-term fiscal adjustment. However, I am worried that your credibility in a wider sense is under threat.

Many of us, including traders in the financial markets, generally doubt that you will reach your objective by ploughing on regardless. (Sensibly, you have said that you will let the automatic stabilisers operate, which means that you will miss your deficit targets anyway if there are severe shocks or a serious slowdown.)

A strategy to use expansionary fiscal policy to maintain growth and then adjust policy to control deficits and government debt as the private sector revives would have greater credibility than your current course of action.

Timing is everything. What we need is a chancellor whose commitment to fiscal sustainability in the medium term is without doubt - but whom we also trust is a competent steersman.

Christopher Allsopp is a fellow of New College, Oxford, and director of the Oxford Institute for Energy Studies. He served on the MPC between 2000 and 2003

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