A note to John McDonnell’s economic adviser on fiscal rules, and their desirability

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I was in debate with James Meadway, the former NEF economist who is now John McDonnell's senior economics adviser, on Twitter on Sunday. The subject of discussion was the need for a fiscal rule that says that current government spending should be covered by taxation with borrowing only permitted for government investment purposes. John McDonnell has signed Labour up to such a rule and I argue that to do so does not make economic sense and commits anyone doing so to austerity even when it may not be needed, which is the antithesis of what I think left of centre economic policy should be right now.

I will work in a theoretical explanation of my objections (the maths is incomplete as yet but give me a day or two, with luck) but in more narrative detail my objections are, in essence, fourfold.

First, I object because this rule clearly has a political commitment to austerity in current government spending inherent within it in an economic downturn. I know, of course, that the rule is meant to be achieved  over a cycle, but given that no one has any clue how long such cycles last and what might happen next within one once such a rule is adopted the pressure to balance the books at any point in time is very strong and austerity inducing and that makes no sense in an economic downturn. As such a rule of this sort is always going to be bad news for a government that believes it has a Keynesian role: the two are just not compatible one with another in practical political terms.

Second, if the rule does exist over a cycle then it follows that there is a commitment to running a current government surplus on occasion: this has to be the case.  What this means is that any government with such a rule will, to make it work, guarantee that it will sometimes dampen the economy and at least partially withdraw cash from it simply for the reason of making its current books balance irrespective of whether or not the economy requires that dampening down or not and irrespective of the need for that spending (which is the much bigger issue) And since we know that as matter of fact an economy can be in equilibrium far from the point where there is full employment what this means is that the goal of balancing the books has been made a higher priority by anyone adopting such a rule than the goal of achieving full employment at a decent wage for those in the economy in question, let alone any goal of meeting social need. I think that's wrong: I have to say that as far as I am concerned that aiming for full employment and meeting social need is much more important than book-keeping exercises and unless by some lucky and currently unknown coincidence the rule happens to be adopted at a point in time when the economy is working at full capacity with fair wages and full employment this fiscal rule will pretty much guarantee this position cannot be reached again because one of the vital instruments for achieving that goal is ruled out of use by setting a balanced current spending rule.

Third, this goal quite explicitly embraces the idea that the government is a household that has to be balance its books. This is one reason why James Meadways's support for this is so bizarre: coming from NEF he should know this is absolutely not a true description of the government's role in the economy but he has apparently forgotten all he did there.

To reiterate on this issue then for those who are not familiar with it, government's don't have to balance their books because they can create money:  that is their prerogative that makes them distinct and separate from all other players in the economy and which gives them their unique economic role.

That unique economic role is to be the borrower of last resort: as the creator of money this is what they have to be. When everyone else insists on saving (which is pretty much what is happening now in our economy) then the government has to provide them with the means to do so by borrowing.

This has two consequences in this context. In  the first instance any limitation on borrowing might mean that there could be a credit crisis in the economy and the government will be unable to deal with it because it would have announced in advance that it could not : that would be ridiculous.  But more important, what being borrower of last resort means is that the government actually has no choice but to meet the demand for cash in the economy:  that is its role, as I have explained in this paper and elsewhere.  What this means is that  government borrowing takes a residual position: in other words the government has to lend what borrowers demand because it is the creator of cash but what that also means is that to say that it will limit its borrowing is to state a tautological impossibility: it denies the reality of the governments position in the economy as it is pretending it will not create money when in truth that is exactly what it has to do, come what may.

Fourthly, for now,  such a policy makes no sense when we also now know that government is under no obligation to repay its debts. There are two reasons for saying this:  one is the theoretical position that the government can always print money, instead of borrow: the Bank of England admitted this in 2014. Second is the practical manifestation of this: QE has for all practical purposes already monetised £375bn of UK government debt. No fiscal rule is needed for borrowing then: such a rule ignores the role of QE which we know exists, and that's absurd. But in that case if such a rule is adopted it can only be because those doing so think that the government is akin to a household and must repay its debts even though there are very good reasons why on occasion it should create money through QE instead to clear them.

A fiscal rule does not then recognise the new understanding of money in macroeconomics.

But worse than that it guarantees an inclination towards austerity that will always be hard to resist in the short term and a likely failure to achieve full employment over the longer term.

And ff that's a left wing policy I'm French (which as far as I know is completely untrue).

But in that case let me deal with James Meadway's rather odd retort in this exchange when he asked whether I was in favour of spending forever if I do not accept this rule. Ignoring the implication of this comment which is that unless I artificially shackle myself with rules that have no relationship to the reality of life  then I will immediately act in a reckless fashion because I am otherwise entirely devoid of sound judgement, let me explain that there may be another more sensible rule that could be followed.

Assuming that we want rising wages, improved infrastructure and a sustainable economy and that at present we are under-using economic capacity (and most especially labour, which is both unproductive and underpaid), have almost zero interest rates, and have a seemingly unlimited glut of savings seeking government bonds as a place of security with no sign that this pattern will change in the foreseeable future then the obvious rule to put in place is that the government will borrow until such time as there is sign that lending capacity is becoming limited, wage inflation is a risk and all capacity is being used. Judgement will obviously be required in this process, but that's what politicians are expected to use based on economic advice.

My suggestion is that this rule of mine would deliver the economy this country wants.

What the rule that James supports, which John McDonnell has signed up to, guarantees instead is no change in the fundamental structure of economic policy in this country, a continuation of austerity and worse, as my theoretical arguments will suggest, an increase in inequality. That's why I have rejected such rules. It's why I walked away from John McDonnell's ideas last year. It's why I have suggested John McDonnell is way to the right of me economically, and somewhere in the area Ed Balls once was. And it's why a Corbyn leadership has nothing to offer those who think that he is the answer to this country's economic problems. If this is the way he's going that's the last thing he is: he will instead compound them.

We have to do better than that and I have suggested how.