The British economy is suffering, once again, from a shortage of options in the face of shocks. The injections of monetary and fiscal demand during the Covid lockdowns were still swilling around the system when supply chains started to fail and energy and food costs rose, first in line with a world economic recovery and then from the consequences of Russia’s invasion of Ukraine. Rising food and energy costs have affected the poorest households the most and are acting to drag down demand, as well as exacerbate income inequalities. It is also quite clear that fiscal policy could be used to smooth the income shock across all income brackets. And if it did so, aggregate demand would rise enough to allow the Bank of England to raise interest rates more decisively. But our policymakers lack the collective courage to do the right thing. They still want to hide behind arbitrary fiscal rules. In our fiscal space, the narrative says “There Is No Alternative”—but there certainly is.
When will this game end? Time and again we have been told that there is little room for manoeuvre when the weather turns unpleasant and, as a result, we find that the UK economy underperforms its peers. Since the financial crisis of 2008, the fiscal policy choices have asked too much of the Bank of England.
The Bank has been asked to fix the mix by having to stoke up sufficient levels of demand to meet the inflation target. Fiscal policy has been set on too constricted a course, in a world of tighter financial regulations and considerable scarring in the real economy, 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 macro-economic priority, it would be a significantly easier task if the Treasury provided an appropriate cushion for the poorest households, who have also suffered most during Covid. Equity alone demands that we pay attention. But efficiency makes the siren call.
Let me focus on the supply side. The well-documented poor performance in UK productivity is just another way of saying that we are not generating sufficient prosperity across the country and that real wages have tended to stagnate. Our track record makes the current adjustment in real wages—which have to fall because the costs of our raw materials, foods and energy have gone up relative to the value of our domestic production—even harder to bear as the impact falls disproportionately on households with lower incomes. Actually, we estimate that the impact on those households could easily be reduced with no deterioration in the medium-term sustainability of our fiscal position.
Politics and economics ought to be closely aligned. Perhaps an even better example of why a fiscal rule can also lead to amplifying rather than dampening the economic cycle. The right response to a temporary negative income shock is to smooth it with more debt borrowed from our better-off futures. Indeed, the inflation shock has, on balance, improved our overall fiscal position as nominal tax revenues have increased relative to fixed cash expenditures. There is money to steady the ship.
It is critical, though, that inflation does not persist and is not expected to persist, as that would raise public borrowing costs and pose much more of a problem for fiscal sustainability. And here we turn to the question of the Bank of England. Rightly we should celebrate the 25th anniversary of the central bank’s independence, as the Monetary Policy Committee has hit its objective over its lifetime, with inflation at around 2 per cent. But it is now 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, without sinking an economy that is facing the ragged edge of Brexit, a compression in trade and a lack of direction.
The Bank can only achieve this if it continues to be charged with the sole mandate of reaching the safe port of price stability. It does not need a broader remit or to be given further objectives, though more dialogue and discussion on complex trade-offs would help us understand better the choices that are faced at every meeting. Indeed, fiscal policy could learn very well from the Bank of England framework by adopting a measure of wellbeing of the British people as its own objective (and remembering that deficits are an instrument, not a target of policy). NIESR warned in 1998 that co-ordination problems between monetary and fiscal policy may become rife without a mechanism to ensure the right mix of the two and, increasingly, that seems to be the case. We will need to work together and not drift apart if we are to avoid being smashed on the rocks.
