Rate rise exposes dangerously outdated fiscal policy

Thursday’s rate rise came exactly one week after the Bank of England received the news it will have least wanted to hear. The latest data from the Office for National Statistics shows that families spent more on outgoings than they earned in income across the whole of 2017 – the first time this has happened since 1988.

We shouldn’t overstate the importance of a single year of data. But unfortunately 2017 is likely to be closer to the new norm than not. It is consistent with three deeper and longer-term trends of stagnant wage growth, continued high income inequality, and an economic model that is dependent on household consumer spending, rather than investment from government and firms. The only way these three trends can be reconciled is to push families into the red, and this is what has happened.

All this put the Bank of England’s monetary policy committee in an unenviable position.

The Bank knows that rates cannot remain at record lows much longer. Ultra-loose monetary policy has acted as a life support for the UK economy. But the side-effect of cheap credit is to grow household borrowing and asset bubbles. Interest rates must also rise soon if the Bank of England is going to have space to cut them again in time for the next recession. With an uncertain Brexit outcome looming, the Bank wants to make sure it has at least some room for manoeuvre.

All this put the Bank of England’s monetary policy committee in an unenviable position.

But starting the process of raising rates now could prove even more harmful in the long run. Economic activity is still dependent on credit remaining cheap and there is likely to be significant unused potential in the labour market, as shown by weak nominal pay growth and relatively low job-to-job moves. Higher rates risk locking in the UK’s low pay, low productivity trajectory, wasting economic resources and the chance for better living standards along the way.

The Bank may or may not have made the right call, but it was not a decision they should ever have been forced to make. Fiscal policy can and should be doing much more of the work.

New research at the International Monetary Fund (IMF) has set out the beginnings of a framework to measure a country’s ​‘fiscal space’ – the extent to which national governments can take on more public borrowing without harming their economy. As with most advanced economies, the UK is deemed to have at least some fiscal space on account of exceptionally low borrowing costs alone.

The IMF’s work implies a fundamental question: with interest rates stuck at their lower bound due to a weak economic performance, and households being pushed to live beyond their means, why is the Treasury not using its fiscal space to help?

The reason is that the Treasury – from civil servants to ministers and their advisers – misunderstands ​‘fiscal risk’. It defines risk in terms of threats to its own balance sheet, and sees the containment of public debt as the dominant objective of fiscal rules.

This a harmful mistake. The role of government is to pool risk, not avoid it.

As the issuer of currency and with the largest and most secure income stream in the economy, public balance sheets are the most effective absorbers of risk. Universal healthcare, unemployment benefits and pensions are all publically provided because it is much more efficient for government to take on the risk of becoming ill, old or unemployed, than to leave it to families and their private means.

The role of government is to pool risk, not avoid it.

At a time when living standards are still weak due to painfully slow growth in productivity and pay – and assuming that government has the fiscal space to do so – it makes sense for public budgets to take on more of the risk of spending and investing to help solve the problem.

As others have put it, worrying about the risk of increasing public debt when the economy is underperforming is a bit like worrying about the risk of a radiator turning on during cold weather. That’s the point of central heating.

As things stand, the government’s fiscal rules are not fit for purpose. For this reason, the New Economics Foundation is developing an alternative framework which would help the Treasury assess whether they are making best use of their available fiscal space. This wouldn’t preclude keeping space in reserve when it is truly justified, but pre-emptive action is likely to often prove more effective – especially with respect to the risks faced by society and the economy today.

The case for change is urgent. The Bank of England didn’t resolve their predicament last week, it was just a tentative first step. Until there is a step change in the Treasury’s approach, the Bank will continue to endure the same catch-22 every couple of months for many years to come.

This article was originally published on The Times Red Box

Image: Stu Smith (CC BY-NC-ND 2.0)