Britain's budget surpluses and economic policy gaps

Posted by ap507 at Mar 20, 2015 12:20 PM |
Professor Stephen Hall gives his views on how a lack of coordination in UK macroeconomic policy causes problems

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The lack of coordination of the different parts of UK macroeconomic policy – ­fiscal, monetary and financial­ – has caused problems for some time now. Political, not economic, factors have continued to have undue influence. They are much in evidence currently in the chancellor’s proposal to run budget surpluses in the future, in spite of his earlier quite elaborate extensions to both financial and prudential regulation. If these new arrangements work, there is no need to build up surpluses to offset the effects of a future crisis and this calls into question his motives for doing it.

There are important lessons to learn from the years before the financial crisis, when financial liberalisation in the UK and elsewhere led to huge increases in private sector debt based on highly speculative collateral requirements. This fuelled a rapid increase in the consumption-to-income ratio, the major engine of growth in the economy then. After two years of fiscal consolidation, Labour also slackened the fiscal stance in the early 2000s. If the Bank of England had been operating independently as planned, it would have tightened monetary policy, which would also have curbed the asset bubble and limited the excessive risk­taking in the financial sector, as well as acting simultaneously to offset the fiscal relaxation. This, however, did not happen, either due to a complete failure of the Bank to understand these developments or because it was not actually operating independently.

The Bank could claim that the financial changes were difficult to judge, but this is not really tenable given the very obvious evidence at the time that the economy was on an unsustainable path, with bubbles in housing and financial markets, large increases in household debt stocks and a financial sector that had largely abandoned traditional prudential practices. It is hard not to conclude that the Bank was swayed by the government in its judgments.

The experience since the coalition took office in 2010 has been a continuation of similar (un)co-ordination problems, now accentuated by the additional complications due to the establishment of the financial policy committee (FPC), with macro­financial responsibilities, and a Prudential Regulation Authority (PRA), with a more micro focus. Each is in the BoE and chaired by the governor.

There are now four separate agencies if we include the Financial Conduct Authority (FCA), which is external to the BoE, each with an interest in monetary, financial and prudential aspects of macroeconomic policy, although each has a different set of specialisms and concerns. Although the organisational structure allows for the ready interchange of information and judgments between them, this is no guarantee of effective coordination, as the experience of having a Treasury representative at the MPC meetings showed.

What’s more, the recovery when it eventually appeared was initiated largely by the Treasury’s “help-to-buy” scheme and clearly raises the spectre of another episode of debt–fuelled consumption as the main engine of growth.

The most recent exchange of letters between the governor and the chancellor discounts another boom­-bust financial cycle at present. The chancellor no doubt sees this as evidence that the apparatus he put in place for financial stability, prudent bank behaviour and monetary policy is working well. He is only partly correct. On the larger question of the actual source of the recovery the MPC is not saying, and the OBR is not permitted to say, that there is no basis yet for the sort of recovery he promised in 2010.

George Osborne’s proposal to run budget surpluses in the future aims to build up a “buffer” against further large-scale financial shocks like the 2009 one. The key issue again is whether the responses from the MPC, the FPC and the PRA will integrate with the fiscal plan for surpluses. The new agencies identify, monitor and put in place corrective actions to alleviate growing systemic financial stress in the economy and build up the resilience of individual financial firms to withstand more idiosyncratic shocks.

Their existence implies that even if they are only partly successful in doing what they were set up to do, this will change the optimal amount of saving the Treasury will need to do, as the presence and the actions of these agencies change the economy’s response to any shock.

In turn, the successful implementation of these financial stability and prudential policy requirements might even be sufficient to eliminate the need to build up the budget reserve the chancellor is advocating. So why should he do it? Is it actually because the chancellor wants to reduce the state more than he is prepared to admit before the election?

This article originally appeared on the Guardian's website on March 19 and was written by Professor Stephen Hall (University of Leicester) and Brian Henry (Oxford).

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