For all those Europhile progressives who have held out that reform is the way to…
More economists are now criticising the British government’s fiscal rules – including those who influenced their design
There is renewed debate in Britain at present on the use and design of the new government’s fiscal rules, which many people are now saying will force expenditure cuts which will “damage the ‘foundations of the economy”, according to the Financial Times article (September 16, 2024) – UK spending cuts would damage ‘foundations of the economy’, Reeves told. Those reported ‘telling’ Reeves include British economists, who were instrumental in the design of the rules that the new Chancellor has taken on and deemed necessary to rigidly control government spending. The economists claim that if Reeves continues to operate according to the fiscal rule “inherited by the Labour government” it will cut public investment expenditure significantly and undermine prosperity. I agree that the application of the ‘Fiscal Rules’ will be damaging but I find it amusing that some of the ‘Letter Writing Economists’ were prominent in advocating such rules in the past as the way ahead for British Labour are now criticising those rules.
On March 19, 2024, the Shadow Chancellor appeared at the Bayes Business School (UCL) in London to deliver the – Rachel Reeves Mais Lecture 2024 – where she outlined how a new Labour government would reform the fiscal rules that the Tories had in place.
Her main complaint was that the rules led to “short-termism” and did not differentiate between recurrent and capital expenditure.
She said “Weak investment, with Britain alone among the G7 in having investment levels below 20 percent of GDP” was a major issue and undermined future productivity growth, which provided the capacity for non-inflationary real wages growth.
The “the new ‘British disease’ – in which short-term instability inhibits investment and drives up infrastructure costs, resulting in fewer, and smaller, new capital projects” had to be addressed.
She highlighted two issues (among others):
1. “austerity” – which had starved the economy of expenditure necessary to promote growth.
2. “failure to grasp a unique opportunity to undertake much-needed investment in our productive capacity. Investment was suffocated. Our supply-side weaknesses – in terms of both human and physical capital – were exacerbated.”
So a lack of growth in productive capacity driven by a lack of expenditure.
I have noted before that capital investment expenditure has a dual characteristic that makes it special among the aggregate expenditure categories.
On the one hand, it constitutes a flow of spending that adds to total spending in the current period and helps maintain employment.
But on the other hand, it adds to productive capacity, which then needs further expenditure growth to absorb it, if instability is not to arise.
Reeves then defined the fiscal rules that would “bind the next Labour government”:
1. “That the current budget must move into balance, so that day-to-day costs are met by revenues.”
2. “debt must be falling as a share of the economy by the fifth year of the forecast, creating the space to respond to future crises.”
In March 2016, the then Labour Opposition announced its so-called ‘fiscal credibility rule’ which Reeves has inherited.
Several of the economists who wrote to the Financial Times last week criticising Reeves were prominent in the design of the fiscal rules that the then Shadow Chancellor John McDonnell outlined in 2016 and took to the next general election.
The rule means that:
1. Recurrent expenditure must be matched at all times with tax revenue.
2. Capital expenditure would be matched with debt issuance.
3. But the overall debt to GDP ratio would fall over a five-year period.
The Tories cannot be blamed for these ‘rules’ even if they followed them themselves.
Labour itself advocated them with the help of some of the economists that are now complaining about them.
And regular readers will recall my long battles with those economists in the public sphere where I argued that the rules were untenable and would do exactly what the same economists are now claiming in their Financial Times letter.
Curious to say the least.
The overall fiscal framework invoked by Reeves is poorly conceived and not as some of those Letter-writing economists previously claimed were justified by economic theory.
They might have been justified by the mainstream macroeconomic theory but that body of work has categorically failed to stand up to the scrutiny of the real world.
Think GFC as an example.
But the Labour rules have no justification once we realise that the goal of fiscal policy is not to achieve some financial outcomes (debt to GDP ratio, primary balance, whatever).
Rather it is to underpin prosperity in a world where the private economy is inherently unstable.
In that sense, the rules work against prosperity, which is, in part, the basis of the claims made in the Financial Times letter, which I agree with.
Why investment leads to instability
While John Maynard Keynes did not consider economic growth in his essentially short-term model of output and employment, there were economists working in the so-called ‘Keynesian’ tradition that developed models of economic growth, which emphasised the importance of private saving and capital expenditure.
The famous work of – Roy Harrod (1939) and Evsey Domar (1946) produced what became known as the – Harrod–Domar model – of economic growth.
Of interest here was Harrod’s attempt to combine the short-run Keynesian expenditure multiplier with the concept of the investment accelerator (which linked the rate of growth in investment expenditure with the underlying GDP growth rate).
As background, please read the following blog posts:
1. Spending multipliers (December 28, 2009).
2. Investment and Profits (July 27, 2012).
On the one hand, investment expenditure generates current demand for goods and services, which stimulates flows of output and saving, and, along with the other expenditure categories, maintains employment.
On the other hand, Harrod considered investment expenditure to be largely driven by expectations of future movements in aggregate expenditure (GDP).
That is firms invest in capital equipment and productive capacity based upon what they think their sales at the time the capital equipment becomes productive would warrant.
In some industries, such investment involves long ‘gestation’ periods – that is a long time between making the decision to outlay the funds and the time when productive services start to flow from the augmented capacity.
This notion was the basis of the ‘investment accelerator’.
The question that interested Harrod related to the possible disjuncture between the expectations and the lived reality.
In other words, what would happen if the expectations of the firms turned out to be wrong?
Two broad errors could be made:
1. They invest too much and find they have excess capacity, which, then would lead to a significant reduction in investment in the period they realise their errors.
In that case, the cuts in investment expenditure trigger much larger declines in output (and saving) as firms lay off workers and those cuts reverberate via lost incomes throughout the economy.
This would trigger further cuts in investment expenditure (via a renewed accelerator effect) and the whole nasty show turns to a deep recession.
2. They invest too little and find they have insufficient capacity to meet the current expenditure for final goods and services – that is, final expenditure is outrunning the productive capacity (supply) side of the economy, which means the economy would be running up against the inflationary ceiling.
In that case, a sudden increase in investment expenditure (via the accelerator effect) could easily add to the inflationary pressure by stimulating further multiplier impacts before the new productive capacity had come on line.
The point of the analysis was that the dynamics of the capitalist system, which was intrinsically dependent on business firms expectations of an uncertain future, could easily become unstable – either prone to recessions or inflationary mania – as a result of expenditure mistakes being made which trigger the interaction between the demand-side (expenditure multiplier) and the supply-side (investment accelerator).
Another way of saying that is to recognise that investment expenditure adds to productive capacity which then needs to be ratified by at least that much extra expenditure for expectations to be realised.
Harrod defined a balanced growth path as being when firm expectations of aggregate demand are always correct.
Given the vagaries of the process, he considered that growth path to be an exception rather than the rule within a capitalist monetary economy.
Harrod considered the actual system to be always on a ‘knife edge’ – inherently unstable – and the possibility of veering into a deep recession with capital expenditure spiralling downwards or into an inflationary episode was high.
Later, in his 1947 paper, Evsey Domar focused on clarifying what he considered to be shortcomings in the analysis presented by John Maynard Keynes in his 1936 – General Theory.
(Reference: Domar, E.D. (1947) ‘Expansion and Employment’, American Economic Review, 37(1), March, 34-55).
Domar noted that the Classical belief in Say’s Law (supply creates its own demand and therefore unemployment is not possible for any extended period) had not only been refuted conceptually by Keynes, but subsequent historical experience had “badly shaken” the “comfortable belief”.
The ostensible reason is that:
A part of income generated by the productive process may not be returned to it; this part may be saved and hoarded.
So savings – the leakage from the flow of expenditure derived from produced income – means that demand can fall short of supply.
The “impression” that one gets from the General Theory is that in the absence of saving, full employment is guaranteed.
He thought that while that was easy to understand (“sounds perfectly straight and simple”), the derivation in the General Theory didn’t answer the questions:
… increasing productive capacity … must somehow be utilized if unemployment is to be avoided … Will a mere absence of hoarding assure such a utilization? Will not a continuous increase in expenditures (and possibly in the money supply) be necessary in order to achieve this goal?
His work tried to clarify that quandary and he introduced what he called the:
… the dual character of the investment process; that is, with the fact that investment not only generates income but also increases productive capacity.
He developed the link between the expansion of the demand-side (expenditure) and the supply-side (productive capacity) or in Harrod’s conception – the interrelationship between the expenditure multiplier and the investment accelerator.
The point was that capital expenditure (investment spending) impacted “both sides of the equation”:
… that is, it has a dual effect: on the left side it generates income via the multiplier effect; and on the right side it increases productive capacity … The explicit recognition of this dual character of investment could undoubtedly save much argument and confusion … it is difficult enough to keep investment at some reasonably high level year after year, but the requirement that it always be rising is not likely to be met for any considerable length of time … if investment and therefore income do not grow at the required rate, unused capacity develops. Capital and labor become idle. It may not be apparent why investment by increasing productive capacity creates unemployment of labor …
So demand must always be chasing the expansion in productive capacity and the link between the two – adequate growth in expenditure to absorb the growth in productive capacity can always be interrupted – leading to instability – usually a failure to achieve full employment.
For Harrod and Domar (as with Keynes) this inherent instability in the private economy was the primary justification for their advocacy of government intervention – to ensure that expenditure shortfalls would be filled with public spending to avoid damaging unemployment.
Domar recognised that inflationary periods were rare – “inflations have been so rare in our economy in peacetime, and why even in relatively prosperous periods a certain degree of underemployment has usually been present.”
These were the issues that economists debated at length in the Post World War 2 period up until the Monetarists took over the academy and defined them all away with their faux ‘free market’ concepts.
Back to the rules
While Reeves has allowed for an “escape clause” if the British Office of Budget Responsibility tells the government that the rules are untenable (for example, during a pandemic or deep recession), the problem is that by articulating the rule that overall debt must fall within five years, the Government then will craft investment expenditure plans accordingly.
And any understanding of the current reality – the debt situation and the expenditure shortfalls in public infrastructure after the devastating ‘starvation’ from the 14 years of Tory rule and the existential challenges (climate) – leads to the conclusion that even if the primary balance is zero on an ongoing basis (Rule 1), the Government would have to severely reduce public capital expenditure in real terms to go close to meeting the debt rule (Rule 2).
The only other way around it would be to:
1. Significantly cut recurrent expenditure, and/or
2. Increase tax revenue.
Which would create a primary surplus that they could offset against the capital budget (in an accounting sense) and reduce the call on debt-issuance (as an accounting not funding construct).
The arithmetic of all that doesn’t work out.
And by restricting capital investment, the Government will trigger the sorts of dynamics that Harrod and Domar well understood.
Reeves is banking on strong private sector expenditure growth driving GDP ahead of the expansion of public debt over the five years.
But by restricting public expenditure to somehow accord with her Rules, it is likely she will undermine private investment expenditure and then it is all over.
And with overall GDP growth in doubt, the ‘space’ for public investment (to meet Rule 2) will decline significantly.
It is a recipe for disaster.
There are many other problems with these rules which I have dealt with before:
1. What is recurrent and capital expenditure? Is expenditure on teachers not adding to future productive capacity?
2. The forecasts from OBR are notoriously poor – leaving the degree of precision in assessing performance against the Rules low.
3. What happens in year 5 when the debt ratio has still not fallen?
Conclusion
I thus agree with the Letter writers who note:
To follow through on these plans would be to repeat the mistakes of the past, where investment cuts made in the name of fiscal prudence have damaged the foundations of the economy and undermined the UK’s long-term fiscal sustainability.
Indeed.
That is enough for today!
(c) Copyright 2024 William Mitchell. All Rights Reserved.
“Reeves is banking on strong private sector expenditure growth driving GDP ahead of the expansion of public debt over the five years.”
The party trick is going to be to force the pension funds which are receiving ‘compulsory pension contributions’ (ie a privatised tax) to become venture capital funds with a defined percentage of their assets.
That way the ensuing waste and failure (because pension funds are not really in the business of that sort of risk management) won’t show up for a generation or so, while a lot of financial types hit the Ferrari showrooms.
It’s another way of plonking societal risk on the shoulders of younger people. Arguably they voted for it, so…
Reeves et al. are just repeating the same old sound-bites; black-hole, desperate finances, eye the prize, tighten the belts, power growth and economic responsibility.
In other words, they haven’t a clue what to do. No mention of overshoot, economic, social and ecological collapse, just more money for boosting growth and the military industrial complex.
This will not end well.
This is not really addressing the main point of the post, but the problems foreseen in the Harrod model, as described by Bill, don’t seem to exhaust all the possibilities, unless we consider a strictly closed economy. For example, we could imagine:
3. They invest too little and find they have insufficient capacity to meet the current expenditure for final goods and services – that is, final expenditure is outrunning the productive capacity (supply) side of the economy, which means the country instead imports the desired goods and services from countries that *do* have the capacity.
In that case, there would be an initial deterioration of the current account, but the final result would depend on how the exporters decided to recycle their revenue. Depending on their choices, the situation could continue for a considerable time, and the country’s productive capacity would steadily deteriorate.
With the current BoE interest rate, Sterling is over valued by about 9%. That is keeping the price of imports down and domestic imported inflation with it. (The UK is a heavy importer of food and energy at world market prices, thanks to Thatcher & Co.) Alas externally, UK exports are starting to look expensive so discounts will be required for sales into other currency areas. The Current Account deficit is around 4.5%. Back home, Chancellor Reeves budget is looking to keep the internal budget deficit below 5%.
UK non-government sector (households and businesses) savings rate is up to 11%. Seems unlikely they will be spending large on non-essential imports. So, it’s down to the government sector to go call on the magic money tree at the National Loans Fund, for some more readies to pay the foreigners.
Wanted. An MP that will put forward a private member’s Bill to (a) abolish the OBR; (b) repeal the “full funding rule” and the DMO remit; (c) transfer all outstanding government securities in issue to the NS&I, to process all future redemption of said securities at face value at term. (d) Make it illegal to ever mention the Debt to GDP ratio ever again!
@Neil Wilson re: ‘The party trick is going to be to force the pension funds which are receiving ‘compulsory pension contributions’ (ie a privatised tax) to become venture capital funds with a defined percentage of their assets.’ Pension funds are of course, not just a privatised tax, in the sense of taking pennies that might have been spent on current consumption, but very much government subsidised through tax relief, and more so for higher tax rate earners. I guess the deal for higher earners is that we’ll continue to give you a nice pension tax subsidy, even if we threaten you slightly with other tax changes, as long as your pension pots are used a bit more ‘productively’ to make up for lack of government investment. But then I always thought pension funds did invest between the private sector and the security of government bonds, so will there be a big change? Is Reeves looking for our pension funds to be more like the Canadian pension funds investing in the likes of Thames Water, who seem to have been sold a beached whale by an Australian asset management company, presumably backed by pension money?
When is the “sainted saver” trope going to get exposed for the damage this behaviour does to employment? It strikes me that this is second only to the fallacious “household budget analogy” where pernicious and persistent misunderstandings undermining the public discourse are concerned.
Would it not be the case that Labour’s fiscal rules would help drive inflation if the economy starts booming? The Treasury would have more money in the imaginary “coffers”, at least according to the orthodox economists, so the government would be able to spend past the productive limit.
Several things about investment and productive capacity (wearing my Ecological Economics hat):
1. Investment must exceed the depreciation of existing human-made capital (Kh) for the stock of Kh to increase (I > d.Kh, where d = physical depreciation rate)
2. That said, I = d.Kh can increase productive capacity if the new Kh is more efficient than the depreciated Kh at transforming natural resources to final goods and services (i.e., increases the matter-energy embodied in the transformed natural resources that ends up embodied in physical goods, thus decreasing the matter-energy embodied in immediate production waste – in other words, more goods produced from the same quantity of transformed natural resources, although such advances are limited by the first and second laws of thermodynamics)
3. An increase in Kh and/or its transformation (technical) efficiency does not increase productive capacity if labour or natural resources are the limiting factor of production (LFP) and the LFP has been exhausted (i.e., is fully employed). Because the underutilisation of labour has become acceptable, as needless as this policy is, running out of labour has not been a productive capacity issue in recent decades, although running out of specific labour skills has been a problem due to bad education/training policies (again, needless). But if a full employment policy was introduced, it could become an issue (underutilised Kh), albeit not a major problem. Why increase stocks of Kh if labour is fully employed? Yes, augment the technical efficiency of Kh, but increasing Kh stocks once labour is fully employed is pointless. One of the main Kh-increasing imperatives is needless population growth and the consequent needless increase in the labour force, which requires more Kh to fully employ. Also, three-quarters of the world’s countries have an Ecological Footprint (EF) in excess of their Biocapacity (BC), which is ecologically unsustainable. The USA, for example, has an EF twice its BC. If the USA was to reduce its rate of resource throughput so that EF = BC (ecologically sustainable), natural resources would constitute a severe LFP. All the increases in Kh would not increase its productive capacity. As Herman Daly used to say, economic logic dictates that we should invest in (increase the supply of) the LFP and maximise its productivity. If natural resources were to be extracted/harvested at a rate no greater than natural capital (Kn) can regenerate (ecologically sustainable), natural resources would be the LFP. Rather than investing in Kn, we are continuing to deplete/exhaust Kn stocks (the Earth’s source and sink capacity). Hence, we are reducing the Earth’s sustainable productive capacity (note: at the global level, EF = 1.75 x BC, and much of this is driven by population growth)
Point # 3 in my previous comment highlights the dilemma that countries like the USA face (i.e., where EF > BC). They have a population (labour force) that is too large to fully employ should they operate where EF ≤ BC – they will simply run out of natural resources before achieving the full employment of labour.
Clearly, these countries cannot move immediately to EF ≤ BC. It would trash their economies and cause mass poverty. The best way to deal with it is to first recognise that a country can operate with EF > BC if there is another country operating with EF < BC. The ecological deficit country imports natural resources from the ecological surplus country, although this is a very precarious way to operate. Because, at the global level, EF = 1.75 x BC, it is not possible for surplus countries to offset the aggregate deficit.
We have an international institution called the United Nations Framework Convention on Climate Change (UNFCCC). Virtually every country on Earth is a signatory to it. It holds conferences annually around the end of each year (Conference of the Parties or COP). Most people are familiar with COP-3 (Kyoto, 1997), which produced the Kyoto Protocol; Copenhagen (COP-15, 2009), which was to produce a new emissions protocol to supersede the Kyoto Protocol and was a complete failure; and Paris (COP-21, 2015), which produced the Paris Agreement. The process has largely failed – GHG emissions are still rising, and the actual commitments of each country put us on track for an approximate 2.7C increase (forget about the 1.5C promise in the Preamble – that target is long gone, and the Preamble no more guarantees an amenable climate than a marriage contract guarantees a successful marriage 'til death do us part'). Nonetheless, an international institutional architecture exists to deal with climate change. It has managed to get countries to make commitments, as inadequate as they are, so that offers some slight hope. Plus, its aim is to bring GHG emissions down to a safe level (net zero, where emissions ≤ global assimilative capacity).
A group of systems ecologists have come up with nine planetary boundaries that humankind needs to remain within to operate in an ecologically sustainable manner. One of them pertains to GHG emissions. We need a United Nations Framework on Planetary Boundaries (UNFPB) with nine sub-Frameworks – one for each planetary boundary. In effect, we already have one sub-Framework in the form of the UNFCCC. The aim of the UNFPB would be to operate within each planetary boundary, which if achieved, would mean EF ≤ BC at the global level. The UNFPB would generate protocols for each planetary boundary. The protocols would include flexibility mechanisms (not as easily abusable as the flexibility mechanisms in the Paris Agreement) to allow ecological deficit nations to import resources from surplus countries and utilise their share of the world's sink capacity until global EF ≤ BC and deficit countries have time to adjust towards a domestic EF ≤ BC. It would allow deficit countries to achieve and maintain the full employment of labour during the transition period.
The last sentence of my previous comment perhaps should have said that an UNFPB would provide ecological space during the transition period to enable full employment policies adopted in ecological deficit countries to smoothly achieve and maintain the full employment of labour. The UNFPB would not, itself, achieve full employment.
I’ve had the FT letter open on laptop since it appeared. I asked on British MMT Facebook group and emailed a few others about what to do, given we don’t have a sufficiently high-profile UK MMT economist whom the FT is likely to publish. As there had been no letters published in response, a few days ago I dashed off a few desperate paras but knew it was useless and didn’t send.
Dear Bill, please write a response – it’s not too late. There’s a restriction of 300 words, but if you wrote more they should offer you a column. I spoke to Stephanie at the recent MMT conference about writing for FT and she did have an op-ed some time ago. You may know that the main econ man, Martin Wolf, in reviewing the Deficit Myth, said it was good, but politicians can’t be trusted with the public purse.
It’s time!