Fixing the Mix
As it enters a new Caroleon age, Britain is faced neither with post-war reconstruction, industrial decline, nor the need to deregulate or hitch its colours to the rise of the City. Its problem is how to bring the country and devolved nations together, working for economic and social progress for all. That implies both a stronger regional focus and establishing the UK as a small open economy able to deal with a global economic blueprint we must accept is no longer made in our image.No new IMF nor World Bank would, for example, offer the UK a seat at the top table, which was certainly the natural order in the first half of the twentieth century.
The UK’s relative decline has accelerated since the financial crisis. Income per head has hardly grown and those in lower income brackets have suffered from more insecure employment alongside limited improvements in wellbeing. These problems have been exacerbated in the face of recent shocks including COVID-19 and Russia’s invasion of Ukraine.
Rising food and energy costs have affected the poorest households most, dragging down demand and exacerbating income inequalities. Clearly, fiscal policy should be used to smooth the income shock across lower-income brackets. While we should not hide behind arbitrary fiscal rules, equally the institutions underpinning economic competence, HM Treasury, the Bank of England, the OBR and the DMO should be respected. Their expertise will respond best when challenged by clear vision accompanied by rigorous analysis of the UK’s underlying problems. That is the gambit that political leadership must adopt.
Since the OBR was established in 2010, if not for longer, the prevailing narrative has been “There Is No Alternative”. But there certainly is. The post-financial crisis self-imposed constraint on fiscal policy has led to a continual slide in the net worth of the public sector and in our net international investment position. We need a long-term commitment to public investment in physical and digital infrastructure and in human capital and the health service. This would not only boost current demand but also ensure the correct conditions were in place for the private supply of goods and services to thrive. The private sector would likely respond elastically to freer international movement of labour, providing a more stable environment for foreign and domestic investment.
Since 2008, fiscal policy has asked too much of the Bank of England, which has been expected to fix the mix by stoking up sufficient levels of demand to meet the inflation target, with insufficient attention paid to supporting the supply side. The result is that excess demand in the shadow of COVID has produced the largest spike in inflation for 30 years. While bringing inflation back to levels consistent with price stability is the immediate macroeconomic priority, it would be a significantly easier task if HM Treasury provided an appropriate cushion for the poorest households, who have also suffered most during the pandemic and subsequently.
The well-documented poor performance in UK productivity signals that we are not generating sufficient prosperity across the country and this had been reflected in stagnating real wages. When the costs of our raw materials, food and energy go up relative to the value of domestic production real wages must fall, but this is so hard to bear when the impact falls disproportionately on lower income households. But, the impact on those households could be reduced with no deterioration in the medium-term sustainability of our fiscal position, if, instead of a price cap on the average household, a sliding price cap raising marginal costs for households using more energy shifts the onus onto better off households. Politics and economics ought to be closely aligned. They have not been and so we have seen how a fiscal rule can lead to amplifying rather than dampening the economic cycle. The right response to a temporary negative income shock is to smooth it with debt borrowed from our better-off futures and a slower movement to higher tax if there is a structural deficit. And there is a structural deficit.
It is critical, though, that inflation does not persist, and is not expected to persist, as that would raise public borrowing costs and pose more of a problem for fiscal sustainability. Here we turn to the question of the Bank of England, which is set to face its most difficult task, even with the insulation of reputation: to drain excess demand from the economy, including the liquidity generated by huge asset purchases under Quantitative Easing, whilst facing the ragged edge of Brexit with a compression in trade and a lack of direction – which we can infer from stalling levels of investment. It can only achieve this if the Bank continues to be charged with the sole mandate of reaching the safety of price stability. It does not need a broader remit, though more dialogue and discussion on complex trade-offs would help us understand better the choices being faced at every meeting.
Indeed, fiscal policy could follow the Bank of England framework and adopt a target for a significant increase in well-being for all working families across the nation. This would imply assessing fiscal policies through the lens of what they mean for all families across income brackets over the medium term and then prioritising policies that support medium- term growth. For that to happen HM Treasury, along with the OBR, will have to re-think how they assess the returns to large scale public investment, the employment it creates and the impact on general government net worth. Concurrently, politicians will have to develop better ideas on how to use public money and be prepared to commit to long run plans, which may mean handing over public investment schemes to some amalgam of the National Infrastructure Commission, the UK Investment Bank and an Industrial Strategy Council, with an assessment of its implications for the supply side provided by the OBR. Let the politicians define the objectives and then be sufficiently confident to allow the experts to play the game.
My three suggested reforms are:
- The creation of a Department of Economic and Social Progress charged with monitoring and delivering plans consistent with long term economic objectives for higher levels of sustainable growth across the regions and devolved nations.
- The introduction of two set piece economic events per year, the reporting of the economic impact of alternate tax and spending strategies, and the publication of an Annual State of the Economy Report outlining progress against objectives at the national, household, and regional level. Both the latter should be done with the support of a fiscal council of experts.
- The establishment of a Development Bank to channel long finance into infrastructure and industry and build relationships with local authorities and devolved nations to bring meaningful levels of funding with long run commitments across the UK to support industrial strategy and regional regeneration.
About the author
Professor Jagjit S. Chadha is Director of the National Institute of Economic and Social Research. He is the author of “Money Minders: the Parables, Trade-offs and Lags of Central Banking”, published by Cambridge University Press.
Photo credit: Alicja Ziajowska, Unsplash