The policy mix

Should the next Labour government embrace fiscal conservativism as Hopi Sen suggests? I'm genuinely not sure.

Let's start from the premise that, for a given inflation target (or indeed a target for anything else), a tighter fiscal policy must imply a looser monetary policy. Fiscal conservativism thus implies monetary activism. Our question then becomes one of the right policy mix. What are the merits of a tight fiscal/loose monetary policy mix relative to those of looser fiscal and tighter monetary policy?

There are (at least) six considerations here:

1. What's the impact on the exchange rate? The textbook Mundell-Fleming model says a tight fiscal/loose money policy should depress sterling, which those hoping for reindustrialization might welcome. Personally, though, I don't think this is a big issue. Exchange rates rarely move as predictably as models assume, and the link between sterling and exports isn't obviously strong.

2.How close will we be to the zero bound? It's probably fair to say that the impact of monetary policies such as QE is more uncertain than that of ordinary interest rate moves. It is therefore imprudent to be a monetary rather than fiscal activist near the zero bound. I'd be happier with Hopi's policy mix in a world of, say, 5% interest rates than one of say 1% rates.

3.What sort of gilt yields will the next government inherit? Higher borrowing costs mean that a tighter fiscal policy is needed to ensure a stable debt-GDP level. The more the "bond bubble" deflates, therefore, the more reasonable will be Hopi's proposal.

4.What will be the impact on asset prices? Other things equal, a loose money/tight fiscal policy mix is more conducive to asset price bubbles (and therefore bursts) than the alternative. They might, therefore, sow the seeds of the next financial crisis*.

5.What determines capital spending? We all want this to rise. But how to achieve this? If capex is interest-rate senstive, then a tight fiscal/loose money is the way to go. But the very fact that investment has been so weak recently suggests this is not the case. A better way to boost capex might be simply looser policy generally - via a higher inflation target or a level-NGDP target or whatever. This would get the accelerator effect going.

6. What would be the impact on employment? I suspect that properly-targeted looser fiscal policy, such as genuine jobs guarantees, might do more to cut unemployment than loose monetary policy alone.  

On balance, this leaves me with an open mind about Hopi's call. I am, though, clear on two things.

First, fiscal conservatism must be coordinated with monetary policy; Hopi's fiscal council will have to work very closely with the MPC. One criticism of George Osborne is that, in keeping the inflation target unchanged for two years, he didn't create enough roomfor monetary activism.

Secondly, Labour's fiscal policy should not be influenced by misplaced calls to apologize for its conduct in office. Economic policy should not be influenced by the post-truth media. But it probably will be. 

* It's for this reason that I'm not sure about Simon's claim that, with hindsight, the last government should have run a tighter fiscal policy. Doing so would have reduced interest rates and so created an even greater house price bubble and even more profligate behaviour by banks.

Comments

[Metatone]

Accounting isn't everything, but I do fear that people aren't taking seriously the relationship between public and private debt. There are some very suggestive graphs of an apparent correlation.

Now, that's not proof, but I'd be a lot more comfortable if the people proposing fiscal conservatism could explain the mechanism by which said correlation will be broken.

[Ralph Musgrave]

Monetary policy, i.e. interest rate adjustments or QE are nonsense because they alter the mix of investment and consumption spending, and there is no reason to suppose the optimum mix of those who changes as between when an economy is in recession as compared to other times (not to mention the bubble inflating effects of low interest rates).

The only possible excuse for monetary policy is that the lags might be shorter than in the case of fiscal, but there is no strong evidence for that.

Ergo we might as well abandon monetary policy and just create and spend new money into the economy to the extent that stimulus is needed. That policy was advocated by Milton Friedman in 1948 and is currently advocated by followers of Modern Monetary Theory, Positive Money, the New Economics Foundation, etc etc.

Unfortunately the latter ultra-simple policy would put large numbers of academics out of work, so the policy might not get enthusiastic support in academia.

[Keith]

Having targets for the public sector but not for the private sector is a fools game as the financial crisis illustrates. The Labour regime did follow fiscal conservatism but if the private sector screws up that is of little use.