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20 November 2019updated 07 Jun 2021 5:31pm

Labour’s fiscal credibility rule isn’t neoliberal — whatever MMTers say

By Simon Wren-Lewis

Is Labour’s fiscal policy rule neoliberal? That is the charge some on the left, particularly followers of the Modern Monetary Theory (MMT) movement, have laid against Labour’s fiscal credibility rule (FCR). MMT stands for nothing very informative, but it is a non-mainstream macroeconomic school of thought aligned to the left. Bill Mitchell, one of the leading lights of MMT, has run a relentless campaign against the FCR through his blog. As my own work with Jonathan Portes helped provide the intellectual foundation for the FCR, I will try and explain why I find the charge of neoliberalism nonsensical.

Although MMT has had its biggest impact in the US, it is increasingly discussed by those on Labour’s left (e.g. for and against). Here I will give a lay person’s guide to the aspects of MMT that lead to its followers’ dislike of Labour’s rule. MMT’s key idea is that fiscal policy (changing taxes and government spending) is better suited to stabilising the macroeconomy than a central bank setting interest rates.

Almost without exception, advanced economies use interest rates set by an independent central bank to control output and inflation. In the UK the Bank of England’s mandate (the inflation target and how quickly it has to be reached) is determined by the chancellor. If the chancellor wants to raise the inflation target, or scrap it altogether, they can do so. But the month-to-month task of actually choosing what interest rate is most likely to meet the chancellor’s mandate is left to the Monetary Policy Committee (MPC), who are either Bank insiders or outsiders appointed by the Treasury.

Why is the choice of setting interest rates delegated to the MPC? Getting this choice right is a highly technical task, requiring detailed discussions of different forecasts and macroeconomic models. If the MPC is working well, they bring strong expertise to the table to help make a decision.

These experts could just give their advice in secret to the chancellor, leaving the chancellor to accept or reject their advice. The danger in doing so is that the chancellor will allow party political motives to influence what they do, to the detriment of the economy. As one Treasury insider once told me in the years before the Bank of England (BoE) became independent, the chancellor recognised that rates had to rise but there is no way it was happening before the party conference.

A fundamental problem with today’s way of doing things occurred during the 2008 financial crisis. Interest rates fell to a level that became their lower bound. Central banks thought that cutting rates any further was ineffective and risky. When that happens, something else needs to provide economic stimulus. The BoE tried various measures (such as quantitative easing), but they were all rather hit and miss because they had not been used much before.

Under the Labour government in 2009, fiscal policy was used to provide the stimulus that monetary policy could no longer reliably offer. But in 2010, the Conservative-Liberal Democrat coalition government was formed and resolved that fiscal stimulus had to become austerity, with disastrous results in the UK and the other countries that adopted it. Most macroeconomists rejected austerity in 2010, and their number increased steadily as the impact of austerity became clear.

It is now received wisdom among academic economists that when interest rates hit their lower bound, fiscal policy needs to provide a large stimulus to the economy. Labour’s FCR is the first in the world to formalise this. If interest rates hit their lower bound, the normal rule is suspended and a fiscal stimulus occurs that is sufficient to end the recession. Labour’s rule is therefore designed to prevent austerity happening again.

MMT wants to go one step further. It wants to use fiscal policy to stabilise the economy at all times, and not just when monetary policy is out of action. This is not a ridiculous proposal. The question is whether it would work as well as the current regime. Most macroeconomists prefer using interest rates when possible because rates can be moved quickly. This also enables the decision to be easily delegated to experts, which avoids party political influence interfering with macrostabilisation. However, an obvious drawback of the current regime is that it cannot work when rates hit their lower bound, so in a bad recession you have to switch to fiscal policy. Labour’s fiscal rule hardwired that switch into policy.

If you are still reading you have probably decided by now that the debate between MMT and mainstream macro about whether to use fiscal policy all the time, or just when interest rates hit their lower bound, is pretty technical and best left to macroeconomists. I think that conclusion is correct. But why do many MMTers, as they are known, call Labour’s rule neoliberal? To understand this, you have to understand that MMT is far from just another school of macroeconomics.

MMT is also a political movement of the left. Mitchell himself supports Lexit. This movement is therefore indignant that a Corbyn-led Labour Party has adopted a rule that is derived from mainstream economics, rather than MMT. Their aim is to win a political as well as an economic battle. Pretty much anything is fair game in this political battle, including describing those like myself who defend Labour’s fiscal rule as neoliberal. (To see how ludicrous this charge is, see here.)

These attacks do however raise a legitimate issue. Why the need for a fiscal rule at all? Why not let the chancellor choose the budget deficit level depending on economic circumstances? The answer is provided by something called deficit bias, which preoccupied economic policy before the global financial crisis. In the 30 years before this crisis, the ratio of OECD government debt-to-GDP almost doubled for no justifiable reason.

Deficit bias happens because politicians like cutting taxes or raising spending through borrowing, because it puts off any obvious economic pain. But if deficit bias does substantially raise the debt-to-GDP ratio, as it did before the financial crisis, then more debt requires paying more interest which in turn requires higher taxes or lower spending. Deficit bias does not avoid the downside of cutting taxes or increasing spending, it just puts it off until a later date. Deficit bias has not gone away. Donald Trump cut taxes for the rich, but he avoided a lot of political flack by doing this through borrowing.

Contrary to many alarmists in the City, the world does not come to an end if you have deficit bias. Deficit bias just makes life harder for future governments. So it is good practice, and a sign of fiscal responsibility, for governments to follow a fiscal rule. Nothing about this good practice need be neoliberal.

You can certainly make a fiscal rule neoliberal through asymmetry (deficits matter, but budget surpluses do not) and saying that only public spending should be cut, rather than taxes raised, to reduce an excessive deficit. Labour’s fiscal credibility rule does neither of these things. It targets the current deficit (which excludes infrastructure spending), leaving public investment free to meet public needs and benefit from low borrowing costs. The target only needs to be over a rolling, five-year period. As a result, the rule is compatible with the chancellor enacting a modest stimulus during a mild recession. In a severe recession, fiscal stimulus is mandatory, making austerity impossible.

MMTers like to suggest that government spending could be higher under MMT than under the FCR. This is simply false if the MPC is doing its job. Indeed, if higher interest rates reduce demand, as most empirical evidence suggests, for given taxes, government spending will be higher under the FCR than under an MMT policy.

MMTers might argue that leaving interest rates decisions to a central bank is neoliberal. That charge has less force in the UK, where the chancellor has complete control of the Bank’s mandate, than in the Eurozone, for example. Delegation of decisions to experts is hardly neoliberal. Is NICE, the UK organisation that decides whether drugs are cost-effective, a neoliberal organisation? There is a legitimate issue of what happens when experts fail to do their job, but that is an issue for UK monetary policy that has nothing to do with Labour’s fiscal rule.

MMTers’ hyperbolic criticisms of Labour’s fiscal rule do, however, raise some serious questions about MMT. MMT has been important in the US in helping to counteract excessive concern among many Democrats about budget deficits, and in fighting the nonsense that says we cannot afford to tackle climate change. However, both points can be made using entirely conventional macroeconomics, as my article on the Green New Deal showed. Yet MMT also wants to be a revolutionary movement that overthrows mainstream macroeconomics.

There have been two revolutions in macroeconomics in the last 100 years and both have brought major and radical new ideas to the table. As yet, MMT only offers ideas that can easily be expressed as part of the mainstream. For example, using fiscal rather than monetary policy was a big debate when I was studying as an undergraduate more than 40 years ago. That does not make MMT’s ideas wrong, but they are certainly not revolutionary and they will certainly not replace the mainstream, even if MMTers call all their opponents neoliberal. 

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