Flexible fiscal and monetary policy

A good post by Simon Wren Lewis on future UK macroeconomic policy – learning from the experience of the past few years. – Bold macroeconomic policy for a new government.

Essentially, it involves committing to a more flexible fiscal policy which can take into account the different requirements of liquidity trap (ZLB). Monetary policy should also be more flexible having a dual mandate of nominal GDP and inflation.

A summary of possible policy changes.

Flexible Fiscal Policy

  1. Long term goal of reducing debt to GDP to a suitable level (e.g. 40%)
  2. The long term goal should not inhibit expansionary fiscal policy if the economy needs it. If there is evidence of deep recession (i.e. zero lower bound rate – nominal rates at 0.5%) then fiscal policy should be used to stimulate economic growth.
  3. Deficit targets should be flexible to take account of cyclical downturns, i.e avoid mistakes of premature of fiscal consolidation when economy is too weak to absorb austerity.

Flexible monetary policy

A dual policy mandate should target low inflation, but also economic growth. This would give the Central Bank more flexibility to ignore cost-push inflation and also consider the wider economic environment.

Higher inflation target to give Central Bank more flexibility in achieving economic growth. The UK experience between (2008-13) has shown that inflation can be stubbornly above 2% – even if there is substantial spare capacity and unemployment. A higher inflation target makes sure we avoid deflationary pressures.

see: optimal inflation rate

Possible criticism of more flexible monetary and fiscal policy?

This approach would be an anathema to EU policy makers and proponents of austerity. They may argue greater flexibility in fiscal rules would lower the discipline to reduce debt and bond markets may not support the government in higher borrowing. A Keynesian response could be to point to countries with their own currency (US and UK) and show how bond yields have fallen during this period of ultra low interest rates. (Now with ECB intervention, EU bond yields have been able to fall too.) A greater difficulty may be deciding when fiscal rules need to be waivered. At the moment, there are clear signs, we are in a zero lower bound. But, as the economy recovers, deciding the moment to begin the long-term fiscal consolidation may be more difficult. There may be a temptation for government to argue they need greater flexibility a year before election. But, this isn’t really a criticism of more flexible fiscal policy – just an acknowledgement it needs thoughtful implementation.

The overwhelming evidence suggests that premature attempts to reduce government debt can be counter-productive in terms of lengthening recession;  in some cases  austerity has caused such a deep recession, it has slowed the reduction of debt to GDP ratios anyway.

More flexible monetary policy would also be criticised for undermining the confidence that has developed in Central Banks ability to achieve low inflation. If you increase the inflation target, the costs may lead to declining competitiveness and greater uncertainty. The argument goes once you allow a small increase in inflation, it may be impossible to stop upward spiral.

However, in the current climate how valuable is an inflation rate of 2%? What benefit is the EU gaining from an inflation rate of 1.5%. I don’t accept that in a liquidity trap with falling nominal wages, targeting a slightly higher inflation rate will cause inflation to run away.  This is an example of worrying to much about something that is only a slightly possibility – rather than dealing with the immediate problem.

Final note

To some extent, macroeconomic policy before 2008, hasn’t needed to consider these issues because it has been so long since western economies like the UK experienced a prolonged ZLB. What we don’t know is whether interest rates of 0.5% are the new normal or whether we will be able to return to the previous post war norm – with higher interest rates.

However, given the fact the past five years have been so different and damaging, it is essential that macro-policy is revisited. Relying on mere inflation targeting and old fiscal targets would be to ignore all the painful lessons of the past few years. It is one thing to make mistakes, it is another thing to fail to learn from experience.

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1 thought on “Flexible fiscal and monetary policy”

  1. Expansionary austerity is just a dream! Why won’t our politicians and bureaucrats realize and accept it! They have to take the advice of the true professionals in the economic crisis. For example they should contact the Orlando Bisegna Index, economic crisis specialists who have already improved the situation for many counties. They have helped a lot of families by dealing with business failures, unemployment and debt problems.

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