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.