Patrick Minford is Professor of Applied Economics at Cardiff University
Rachel Reeves has doubled down on the restrictive pressures of the fiscal rules she has inherited from the Tory government, promising to increase yet further the powers of its non-government budget monitor, the Office of Budget Responsibility.
The dominant rule is that the ratio of public debt to GDP must be falling five years ahead. This rule fails to ensure long run solvency and yet kills off all short run fiscal flexibility that could ensure appropriate fiscal policy, whether in keeping damaging taxes down through lean times or providing counter-cyclical support to the economy.
The Treasury cynically favours this rule because it ensures that it is dominant across all Whitehall, needed to sign off everything. Yet in propagating it, it undermines the proper management of the economy, for which it is ultimately responsible.
Meanwhile, by giving the OBR the analytical task of reviewing the effects of all economic policies, the Treasury has surrendered its key analytical functions to a nongovernmental agency without the necessary expertise; the OBR has no models for assessing productivity growth, the central issue for Labour’s growth agenda.
The sad but predictable result of all this is that Labour will blunder into the same mistakes as their predecessor Conservatives, and there will be no resulting growth. Given its promises and its supporters’ desire to raise public spending, whatever Rachel Reeves may now be saying, a Labour government will be under huge pressure to raise taxes.
Sir Keir Starmer has ruled out raising income tax, National Insurance or VAT rates; so what is left will be taxes on the ‘wealthy’, ie. the very entrepreneurial classes that are needed to create the innovation that generates productivity growth.
However these taxes are levied, whether on capital gains and ‘carried interest’, the withdrawal of the inheritance tax exemption on small businesses, or in some other way such as a pure wealth tax, the damage will be intense and strike at the heart of Labour’s growth strategy.
There is extensive research showing that productivity growth depends on the business incentives to innovate, as economic theory says it does. This is true of the US, China, and the UK, to name just a few of the places I and others have studied.
For the British ourselves the direct experience from the decades of the Thatcher reforms is highly persuasive. Our per capita growth accelerated after they were enacted, and we overtook both Germany and France in our average living standard, measured in common world prices, in the process. Coming from well behind in 1980, the UK overtook France and Germany by 2010 and stayed ahead by 2020, in spite of policy backsliding – see Figure 1.
Figure 1. PPP GDP per capita – Penn tables – US 1980 = 100*
*UK, Germany, France GDP per capita relative to US at PPP exchange rates; linked to US GDP per capita at 2005 world prices, PPP. PPP values from Penn Tables, Univ. of Pennsylvania. 2020 estimates: updated by change in real GDP per capita as per national sources, corrected for estimated effect of COVID.
Source: Fed of St Louis.
The irony of all this in terms of Labour’s own debate is that the standard rates of income tax or VAT are quite well suited as a general revenue source because they are spread widely across the population and are roughly related to ability to pay.
Hence they both have limited impact on entrepreneurial incentives, and so on growth. But more to the point, it is not urgent to raise taxes at all in the short term; it is the fiscal rule that needs changing to permit short term borrowing and yet to ensure solvency in an effective way over the long term.
The algebra of solvency is in fact straightforward: there must be a commitment to creating a primary surplus (ie. one excluding debt interest) sufficient to pay the debt interest in the long run. Whatever debt is issued is then backed by this commitment. It is not in fact that hard to appeal to the existence of this commitment for the UK, with three hundred years of solvency behind it and a panoply of broad effective taxes to use if necessary.
We are left with the prospect that her self-imposed short term fiscal rule will still frustrate Labour’s growth strategy by causing the imposition of higher taxes on entrepreneurs
Much nonsense is spewed out over Liz Truss’s government along the lines of ‘lost market confidence’; yet the Credit Default Swap rate of 40 basis points then indicated a mere 0.7% chance of default, about the same as Canada today – confidence remained quite intact. The truth is that Liz Truss’s enemies across Whitehall, her own backbenches and leftwing economic thinktanks made common cause to destroy her government with this nonsense.
All it needed for the government’s survival was for the Treasury to issue a proper long-term projection for the public finances and for the Bank to keep the gilt-edged market calm, as it had done when the pension funds’ liquidity crisis it had failed as a regulator to foresee had erupted earlier. But of course, this government’s survival did not suit these agencies’ own agenda.
Now that we have a leftwing government in place, much to the tastes of these enemies of the Truss government, you would think they would not want to derail it too by insisting on the current fiscal rule. Yet all the signs are that this rule will not be abandoned in favour of the long run commitment strategy that makes proper sense. Sympathetic commentators are nevertheless searching for ways of creating ‘headroom’ within this rule.
One such suggestion is that the Bank’s profits and losses not be transferred to the Treasury accounts as currently is agreed by the Treasury. The Bank is of course currently making losses, as it pays out interest on bank reserves at a high short-term rate while receiving interest on its gilt holdings at older and lower long run rates. When it sells these gilts under ‘Quantitative tightening’, QT, it makes a capital loss also.
However, this suggestion fails to notice that the Bank is a wholly owned subsidiary of the government; so, being inside the public sector, its net profits are already consolidated with the government’s net surplus.
Furthermore, its capital loss on the sale of gilts is not a loss to the public sector because these gilts were a government liability on which it had made a capital gain; so the capital loss and gain cancel for the public sector. This would be seen clearly if the government’s debt on its own balance sheet were regularly marked to market.
All that is happening under QT is that long gilts are issued to private buyers in exchange for cash, which when deposited in the banks reduces bank reserves, which count as short term debt because short term interest is paid on them. So this suggestion would make no difference to the fiscal situation of the public sector.
Another suggestion, backed by the newly successful Reform party, has been not to pay short term interest on bank reserves. With these currently standing at around £900 billion, the public sector would gain around £45 billion from doing this. The Bank opposes it as weakening its control of interest rates; in this, it is supported by other central banks doing the same, notably the Fed and the ECB.
However, before the financial crisis, central banks deployed a broader toolkit in controlling interest rates and the supply of money. In particular, they frequently used the options of setting compulsory ratios for bank-held assets, such as liquid assets and bank reserves.
There could be a tranche of assets that the banks had to hold as ‘required’ reserves with no interest payable; only reserves above this, ‘excess reserves’, might carry market interest under this set-up, so that the banks could not undermine the Bank’s rates set in the open market by selling their holdings of non-interest-bearing reserves for Treasury Bills or other short-term assets.
Alternatively, banks could be encouraged to use these excess reserves to extend credit and prevented from buying market bills instead. By increasing excess reserves, central banks could boost credit supply. As bank reserves are simply cash on which no interest is earned, it is legally correct to treat them like cash; indeed when the Bank buys bonds in the market for cash, that cash is then deposited in the banks, and the Bank helpfully swaps the cash for deposits in the Bank, so creating bank reserves; it could legally insist the banks held it as cash instead.
Setting compulsory cash/reserve ratios is a tool whereby the Bank can control banks’ ability to create credit and money, as in pre-crisis times. What paying interest on reserves does is to pay a windfall subsidy to the banks as interest rates rise.
This is a direct cost to the taxpayer; yet, as pre-crisis practice shows, it is not necessary for the control of interest rates, credit and money. It is true – and may be welcome to central banks – that it cushions the effect of monetary tightening on the banks, reducing the chance of bank failures; but potential bank failure is best controlled by bank capital adequacy, not by taxpayer handouts.
What has happened in the Bank’s monetary policy implementation is a switch in practical procedures that has turned out to be extremely costly to the UK taxpayer. Yet this switch has come about with no pushback from the Treasury or indeed much public debate either – apart from a few lone voices like mine.
The Bank has pushed ahead, arguing for what central banks find convenient; yet, unlike the Fed and the ECB that are not technically owned by respectively the federal US government or the federal EU, the Bank is wholly owned by the UK taxpayer and legally a current part of the UK public sector.
Ultimately, this is also true of the Fed and the ECB, but only if they are wound up as going concerns, in which case the US Federal Government and the EU national governments jointly would be on the hook respectively to settle their net debts.
Rachel Reeves is rumoured to be thinking of excluding the Bank’s balance sheet from the government’s accounts; in effect this would redefine the fiscal rules. By excluding the Bank’s current losses from the accounts, it would improve matters, increasing her net revenue by nearly $20 billion.
It would be better to deal with the reserves as above, saving more than double this. Yet she has so far foolishly backed the Bank in this reserves debate, much against her best interests. We are left with the prospect that her self-imposed short term fiscal rule will still frustrate Labour’s growth strategy by causing the imposition of higher taxes on entrepreneurs.
Some will argue that this failure is a good thing since it will help to put paid to Labour’s prospects of continuing power. Unfortunately, it will also prolong the country’s economic suffering, already far too lengthy under a misguided Tory government. It would be better if Labour could improve the country’s economic fortunes after such a long failure – somehow, if we can, we must help them do so. Then the Tories too may learn how to do things better if and when they get another chance.