What a UK macro-financial framework should look like as Brexit is negotiated

Peter Doyle, a former IMF staffer, advises the UK government not to delay rewriting the fiscal and macro-financial rules for the Brexit era…

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Former UK Chancellor George Osborne’s fiscal framework has been scrapped, not before time. By default, the rest of the macro-financial framework remains, for now. Given that, the school holidays, and preoccupations with prospects for Article 50, free movement, and UK access to the single market, it is tempting to leave Mr Osborne’s successor, Philip Hammond, as he might prefer, to devise a new macro-financial framework for the autumn undisturbed by public advice.

But pressing macro concerns counsel against a simple framework “holding action”. Good framework design matters; and, left to its own devices, HMT has a dire record—producing over a dozen UK macro-financial frameworks since 1979, all said to be TINA, all-IMF-backed, and all, in part or whole, scrapped, bringing us to the current impasse. And off-the-shelf framework proposals cannot now, like old tyres, simply be retread, leaving substantive public debate to after-the-Autumn-Statement- fact, unless you think that the referendum didn’t change much.

But it did, in seven ways which are central to good framework design now:

  • the two-to-three year macro outlook has deteriorated sharply, again raising issues of the lower bound and exhaustion of QE, and need to support demand;
  • prospects for trend growth have also deteriorated due to prospective interruptions in trading links and controls on migrant labor, weakening fiscal sustainability;
  • revenue prospects are particularly aggravated if some finance activities emigrate;
  • that threat adds pressure on supervisors to resume “light touch” regulation, re-aggravating moral hazard in UK finance and the associated contingent risks to the fiscal;
  • though, free of EU constraints, UK policy discretion might be used well in future, Leave political behaviour suggests that counterproductive discretionary policy is now more likely across the board;
  • gilt yields fell immediately post-referendum, anticipating the near-term hit to demand, but all the factors just noted will compromise UK resilience in the face of further global shocks;
  • and all UK macro decision-making is now situated in the context of interactive negotiations with the EU over the timing and form of Brexit.

In that light, consider two proposals (without attribution or detail) already aired…

Reset the framework to accommodate big permanent corporate tax rate cuts

No. If the motive is to offset immediate temporary trade and labour uncertainties, any such cuts should be announced as temporary—to pull activity forward. If permanent, they would have less short-term demand impact and further compromise fiscal sustainability and thereby resilience to global shocks, unless offset by other tax rises and spending cuts. Either way, by accelerating the “race to the bottom” on international corporate taxation, they would be seen as hostile by the EU, infecting the Brexit negotiations. This step would be a manifestation of the general loss of quality in discretionary policy-making that the Leave vote threatened.

Revert to an across the cycle golden rule

No. This notion may have had some intuitive appeal in happier global times—when UK and global public debt and financial sector risk were thought low and trend growth was thought high. But even then, it did little for public investment, which is a much broader entity than such rules accommodate and is anyway more constrained by poor pipeline preparation and planning processes than it is by budget limits.

But public debt is now high and trend growth low. Concern with the former would likely call for a “current surplus” across-the-cycle rather than “golden balance”, while the latter—to the extent it reflects insufficient global demand—might call for a globally co-ordinated demand-boosting “current deficit” across-the-cycle rule.

Post-referendum, however, concerns with UK trend growth, resilience, and need to reinforce Britain’s fall-back macro position in negotiations with EU on Brexit all tilt the scales towards a current surplus across-the-cycle target for the UK, as does the damage done by the Leave decision itself to any prospect of European cooperation with a UK-led globally co-ordinated current deficit initiative.

But whether a UK fiscal rule were to target current surpluses or deficits across the cycle, alone or in tandem with others, implementation of any across-the-cycle rules would be totally dominated by their “get-out” clauses.

This is because so many big shocks may come (think Italy, other latent Euro threats, China, Saudi, Japan, Trump, etc) and because there are now so many UK-specific uncertainties, including the outlook for trend productivity growth, the adequacy of financial regulatory reforms post-crisis and now post-referendum, and the form and timing of Brexit itself, including its potential fallout on the Union with Scotland and Northern Ireland.

Indeed, prospect of the dominance of get-out clauses suggests that framework redesign would better focus centrally on those uncertainties, rather than relegating them to get-out clauses in any of the conceivable across-the-cycle frameworks.

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So what would a macro-financial framework directly designed around those uncertainties look like right now?

It should have six key elements.

First, it would abjure any grandiloquent “fiscal charter” form, the hectoring certainties of which inherently overlook how unstable the macro environment is, and which earned Mrs. May’s evaluation that Mr Osborne “over-promised and under-delivered”.

Any medium-term or over-the cycle parameters in the fiscal framework should have the official status only of indicative numbers or projections at best, not pedestaled targets or formal anchors.

Second, the mandate of the OBR should accordingly be substantially recast for lack of pedastaled targets to monitor and because it was misspecified in the first place. Osborne’s given motivation for creating the OBR—”political interference” in HMT revenue projections—was largely fabricated; annual current revenue was seldom overprojected (see page 68) by more than one and never more than two per cent in the 2000s. And while he was highlighting those revenue over-projections in the 2000s, he overlooked—indeed supported—financial sector policies which constituted exponentially bigger threats to the fiscal.

That mis-focus is reflected in the OBR mandate that he set. His mis-stated critique justified restriction of its role to assessments of projections of government policies and expressly prevented it from evaluating alternatives to those policies. In this way, it is prevented from fully informing public debate on big threats to the fiscal and what might be done about them—which is why the referendum debate proceeded with no OBR input, despite the very considerable implications for the fiscal.

The point now, more than ever, is not whether small biases in aggregate annual revenue projections occur or whether, absent major macro shocks, long-term fiscal sustainability is likely. Instead, the point is whether policy in any sphere generates further big threats to the fiscal. That now includes threats which might come from government policies on the particular forms and timing of Brexit.

Thus, the OBR’s mandate has to be turned on its head. Responsibility for short-term macro and revenue projections should be returned to HMT. Instead, and akin to the US Congressional Budget Office, the OBR should be mandated to provide clear independent technical assessments of big aggregate threats to the fiscal from wherever they may originate and it should provide public technical analysis of policy options on those big risks. It should be restaffed and re-resourced to add real, financial, and international capabilities to its mainly fiscal skill set to do so.

Third, public investment must be strengthened, not just in support of short-term demand but also to offset the many hits to productivity and trend growth post-referendum. The primary means of doing so is to address the shortfalls in planning and pipeline preparation directly, rather than to fascinate over the precise specification of any fiscal rule.

Fourth, in setting overall fiscal policy for this parliament, the mantra “hope for the best and plan for the worst” should be applied in full to the numbers in which fiscal projections are nested, notably concerning assumptions on the form, timing, and consequences of Brexit.

So, for reasons outlined earlier—including preparing the UK macro for the possibility that negotiations with the EU might ultimately produce a non-cooperative outcome—policy should be guided towards securing cyclically-adjusted current surpluses of some 1 per cent of GDP, not as a formal target but as a guiding rule of thumb. This would rule out any suggestion of sizable corporate tax rate cuts.

Fifth, in the wake of Osborne’s copious signalling of an easing of official attitudes towards the financial sector — including the outster of FCA chief Martin Wheatley — confirmation is needed that regulatory defenses against financial sector risks will not be further eased in the face of post-referendum pressure on parts of finance to emigrate. From this perspective, the decision by the Bank of England post-referendum to lower the countercyclical capital buffer for banks but not (yet) to adjust policy rates or QE constitutes, at best, an ambiguous signal about the Bank’s priorities on this which needs to be corrected.

Correction cannot be by means of blustery assurances of regulatory intent or even formal rebuttal of Mr Osborne’s “New Settlement with Finance.” Instead, in the context of monetary action described below and given inadequate global bank capital standards, the Bank of England should immediately commit to raise the systemic risk capital buffers applied to UK banks in line with the recent recommendations of John Vickers, chair of the Independent Commission on Banking. And Vickers should be invited to reconsider the adequacy of his call in light of Leave, which he had not anticipated.

Last, and probably most critical of all, with fiscal support for demand reliant only on automatic stabilizers with little immediate support actually available from public investment (given past poor preparation of the pipeline), and with the current account deficit running at some 7 per cent of GDP, monetary policy must now take the lead in the stabilization of both domestic and external imbalances.

This is not a case of “overburdening” monetary policy. While the depreciation of sterling following Leave and prospective interest rate cuts and QE will help on the domestic and external fronts, options within the current monetary framework are running low. So this is the time to respond to concerns which date back to the early 1990s (Summers and De Long) that central bank inflation targets are too low.

A target of 5 percent for UK inflation should be set for the Bank of England immediately. This would further depreciate sterling, stimulating short-term domestic activity and assisting on the external side.

Thus, rather than follow the current mantra to “look through” the inflation boost from depreciation, the MPC should be mandated immediately to “lock that inflation in”.

In addition to further supporting domestic and external rebalancing, critically, this would help to restore the potency of the interest rate instrument itself. And the urgency of that is underlined by the multiplicity of global and UK-specific threats that lie ahead, all of which underscore the importance of assuring the potency of that instrument within the macro-financial framework.

Post-referendum, in an appropriately humble tone, in the context of a re-mandated OBR, strengthened public investment procedures, fiscal policy broadly oriented to a cyclically-adjusted current surplus of 1 per cent of GDP, and reinforced credibility on financial regulation, a 5 per cent inflation target set immediately is the appropriate form of “forward guidance.”

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