What John McDonnell should say

John McDonnell, Shadow Chancellor, has launched a national seminar series, ostensibly a conversation about a "New Economics." This effort will not have had any time to bear fruit before George Osborne delivers his 2016 budget next week, and McDonnell has to respond. Fortunately, there is no need for a "new economics" since the old economics suffices perfectly well to frame a discussion of the nation’s economic challenges.

The case against the Government’s fiscal surplus rule must be made, and a more effective alternative proposed. The rule commits the government to producing a budget surplus by 2019/20, and to keeping the budget in surplus unless growth falls below one per cent. There are some echoes of sound economics in the rule. These need to be recognized in order to understand what a much better, credible fiscal framework would look like.

The first echo is that it is a rule. Properly designed, such commitments can be the thing that allows the government to use fiscal policy vigorously, when needed, without scaring the bond markets. Second, the rule makes the point that fiscal policy needs to be more relaxed when the economy is weaker. Most of us agree on that. Third, the rule confronts the task of weighing the competing priorities on fiscal policy: the need to repair finances so that when a future crisis hits the taps can be turned on again, versus the need not to derail the recovery now.

However, the rule clearly strikes the wrong balance for the circumstances the economy finds itself in today, and no doubt will do so again in the future. The routs in global financial markets have highlighted the risks that the UK is running with its current mix of monetary and fiscal policy. With interest rates close to their floor of zero, and further quantitative easing of dubious worth, a moderate fiscal stimulus would allow for higher interest rates, and leave the Bank of England more room to loosen policy through tried and tested means in the future, should it need to.

Note that this case against the fiscal surplus plan is not—as the Labour leadership team stresses repeatedly—primarily about "fighting austerity." If we take the Bank of England’s forecasts at face value, there is just about enough stimulus in the economy to bring inflation back to target. Instead what is needed is a change in the mix of demand in the economy between public and private, leaning less on over-extended monetary policy.

A better fiscal framework than the one piloted by George Osborne would inch the government towards delegating the responsibility for the macroeconomic demand management side of fiscal policy to a third party, such as an enhanced Office for Budget Responsibility.

This idea, so far, has been an anathema to all of the major political parties. But, as in the case of the Bank of England, any delegation would be done in the context of the government defining and retaining control of the goals of fiscal demand management, loosening control only of the instruments and implementation.

Those goals would emerge from a proper study of the costs of recessions and booms to different groups in society, the benefits of using policy to smooth them, the limits to the debt to GDP ratio that such smoothing has to live within, and the likely frequency of crises of the magnitude of the 2008 crash which put so much pressure on public finances, and which put a premium on balance sheet repair.

A small step in this direction that our democracy might swallow would be to codify the use of vigorous, discretionary fiscal boosts when monetary policy runs out of room to cut further. The Bank of England would be mandated to call a meeting of a Fiscal Council, comprising itself, the Treasury and the OBR. The Bank would set out its analysis of and a recommendation for the missing stimulus it seeks, in terms of equivalent interest rate cuts it cannot make. The Treasury would decide whether it accepts the BOE’s argument, and if it does, how it proposes to implement the stimulus and rebuild finances subsequently. The OBR would comment on whether the whole plan met the goals of demand management and long term fiscal sustainability.

The BoE recommendation and the OBR comments would have no statutory force over the Treasury. But—a bit like the "Ken and Eddie show" (The meetings of Kenneth Clarke, then Chancellor, and Eddie George, then Governor of the BoE, in the mid 1990s) that operated the inflation target before the Bank was made independent, the minutes and documents exchanged would be made public, so that if the Treasury decided to do its own thing anyway, it would need to explain why.

But John McDonnell went into the 2015 leadership campaign having gone on public record stating that the Bank of England should be taken back under “democratic control,” so it would be quite some journey for him to travel to sign up to these ideas.

Another reform to push for that also springs from unfashionable, old economics would be to declare an intention to raise the inflation target, at such a time as the Bank of England manages to achieve the current one of two per cent. On the face of it, this might seem a heretical thought, but in fact the logic is quite conventional, and comes out of a reworking of the thought processes Ed Balls and Gordon Brown went through drawing up the two per cent target in 1997 when the Bank was first made independent.

In the longer term, interest rates settle at a rate that compensates people for lending their money, plus compensation for the inflation that erodes its value while they have parted with it. So raising the inflation target would raise interest rates, eventually, higher above their zero floor. And that would make more room still for a cut when the next crisis hits (and putting less strain on fiscal policy).

I recommend this hesitantly, because moving the inflation goalposts has its risks. People may wonder whether the government has lost the heart to control inflation. But the two per cent number settled on by Brown and Balls was chosen when we had no idea that financial crashes were still possible. And sticking with a target that leaves monetary policy tools without adequate room for maneuver to hit it may also undermine faith in the authorities’s competence and motives.

A final note I would sound at the dispatch box is of disapproval at the ritualistic tinkering with the detail of taxes and duties that is the typical budget—whether given by Labour, the Coalition or the Conservatives. This tinkering, which has cursed all budgets I can remember, springs from the desire to be seen to be doing something. It represents a clear failure to weigh the costs of volatility and uncertainty in the tax regime on the economy against the benefits of reform. Businesses and private folk need less tinkering in order to plan future investment spending, or plan their futures.

The perfect time to start disapproving of this is when you are in opposition, like McDonnell and his Labour Party, and you don’t have to resist the political temptation to find sweeteners to distract from other difficult decisions. A cry for "tax stability" would be an easier thing to execute than scurrying, at impossibly short notice, to respond to Osborne’s budget speech in a way that suggests which measures Labour approves of, and which it doesn’t.

It would be much easier for the Shadow Chancellor to pour scorn upon his opposite number than to do the right thing should Labour find itself in office. How could we put an end to the "one pence here, two pence there" phenomenon in future budgets? Some device is needed which makes it politically costly for Chancellors to change tax details every year. It is beyond my expertise to offer a solution, but I live in hope that someone else will find a way.