Select Committee on Economic Affairs Second Report

Fiscal Policy

26.  The Chancellor of the Exchequer sets fiscal policy, but does not in general use it as a short-term policy instrument, although the fiscal instrument might be used in crisis conditions. The fiscal rules involve a broad balance of current expenditure over the economic cycle. Public debt can be increased if its purpose is to finance public-sector investment. The ceiling is a ratio of less than 40 per cent of public debt to GDP. The rules are specified by the Chancellor. They do not have a statutory basis and are less formal than those of the Stability and Growth Pact. Moreover, an assessment of whether they have been met depends on how investment is defined and how the cycle is measured. In practice, however, it is hard to believe that a significant and persistent move away from the Chancellor's fiscal stance would not be recognised and commented on. The British economy meets the Stability and Growth Pact criteria, and, using the same indices — the harmonised index of consumer prices — our inflation performance is comparable to that of the European Monetary System.

27.  In evidence in December, the Governor of the Bank of England said in relation to the current fiscal position that "the bulk of what we are seeing is cyclical" (Q122-126). Mr King, in evidence to us in February 2002, also said: "It is difficult to make cyclical adjustments. Nevertheless, it is a very reasonable judgement that most of that deterioration in the outlook is cyclical" (Q13). We take all that to mean that automatic stabilisers are at work. The Governor also said that monetary policy had not been changed as a result of the fiscal position. He and the Deputy Governor, Mr King, emphasised the existence of risk and uncertainty in these matters. In connection with the recent International Monetary Fund assessment, the Governor pointed out how difficult it is to distinguish the cyclical from the structural element, and noted the relationship between the revenue shortfall and the fall in the financial market. It is interesting to compare that evidence with the Governor's evidence of February 2002, when he said: "we actually welcome the fact that public spending increased at a very happy time. You can argue as much as you like whether that was fortunate or by design. Whatever it was, I think we welcomed it" (Q12). He added: "We base ourselves on PBR[11] and on that basis we would take a relatively relaxed view" (Q15). We were also interested to hear Mr King's remark that an upturn in output might not be accompanied by a similar upturn in financial markets or company profits (Q126).

28.  Interestingly, Mr Dicks also said that fiscal policy was helpful at this stage of the cycle (Q165). Mr Kaletsky and Ms Coyle expressed similar opinions (Q168). According to Mr Kaletsky: "If fiscal policy had been tighter, perhaps one would have had a slightly looser monetary policy, but it is not clear to me that that would be a better or healthier mix for the UK economy right now." Ms Coyle thought that in the longer term fiscal policy had helped keep interest rates down.

29.  Mr Kaletsky added that in principle it would be best if monetary and fiscal policy were in the same hands. Mr Weale took the opposite view, arguing that monetary and fiscal policy could be conducted independently of each other. He also thought that a tighter fiscal policy was required given the imbalances in services and manufacturing. We note that if, as is commonly thought, the imbalances are due to monetary policy, fiscal policy would in fact be reacting to monetary policy, which seems to compromise the notion that they could be independent.

30.  There was less agreement about the Chancellor's fiscal rules when compared with the Stability and Growth Pact. Mr Weale seemed to favour something more formal than we have at present (Q172). Mr Kaletsky said: "Our system is more or less uniformly better than the Stability and Growth Pact arrangement", but Mr Dicks argued that the Stability and Growth Pact "is right in principle, but there are flaws in its design and they can be improved" (Q172).

31.  Mr Taylor recognised the role of automatic stabilisers, but he considered that the Stability and Growth Pact placed too much emphasis on fiscal deficits and not enough on an active fiscal policy over the cycle. The problem, he said, was in not having surpluses in good times to offset deficits in bad times, resulting in a build-up of long-term debt (Q235). He believed that current fiscal policy might be looser than it seems, and that public sector borrowing might need to increase. Mr Howard expressed similar fears (Q276). He also considered that, although fiscal rules had a role to play, the ones currently in place could be improved: "one should not pretend that these rules are a permanent guarantee of prudence and stability and everything that is good in the world." Mr Taylor supported the Stability and Growth Pact, and was less inclined to favour major changes (Q237).

32.  We are impressed by the unanimity with which witnesses supported the view that much of the deterioration of fiscal position is cyclical, and that fiscal intervention is therefore not necessary at present. We note that it is extremely difficult to know what is and is not cyclical, and we express our hope that the optimism of our witnesses is justified. We will return to this topic in a later Report.


33.  Imbalances in the economy include, notably, differences between the service and production sectors in regard to output and the inflation rate. Comparing the two sectors, it might be argued that the remit is misplaced in that there is no single inflation rate in any meaningful sense, but two relevant inflation rates (see, for example, Chart 4.13 in the Bank of England's Inflation Report of February 2003). Why should the target relate to the overall average, with no account taken of its two main component parts?[12]

34.  As Mr King said, "the central view is that growth will be close to trend and inflation close to target. It cannot get nearer to that as an overall outlook and yet all of us feel there are risks and uncertainties and certain fragilities in the economy and that is because of the imbalances. We have spent a lot of time on the [Monetary Policy] Committee trying to analyse how that imbalance will unwind and whether it is likely to happen smoothly and steadily or whether there will be a sharper adjustment at some point and, if so, what that means for our strategy on interest rates"(Q146).

35.  It is interesting that although the MPC considers sectoral differences and imbalances, its members insist that the overall inflation rate is what matters, and that that is all they can target. As fiscal policy is set for at least the medium term, that cannot directly rectify the imbalance either. The Governor said that the imbalance "has its origin in the international environment" (Q146). We find that strange, as the imbalance continues to exist in a variety of different parts of the world economy. It seems, therefore, that we have a serious problem, but that no one is or can be charged with solving it. The answer may be Panglossian: all is well or will come well of its own accord.

36.  Mr Taylor said that imbalances are a matter for the Government (Q208, Q227). He referred to the Chancellor's "vast range of economic tools" (Q212). He also emphasised the importance of the exchange rate (Q227 and following). He did not tell us what economic tools he had in mind or how he thought the Chancellor should use them. Obviously, one aspect of his approach is based on the UK's joining the ERM, a topic on which, for the time being, we as a Committee do not pronounce. A more obvious point arising from Mr Taylor's evidence is that it is generally assumed that the exchange rate is a monetary phenomenon, and, therefore, a matter for the MPC (which rejects it as a target), not the Chancellor. Moreover, if monetary policy is directed at inflation, and fiscal policy is intended to meet medium-term prudential public financial aims, the exchange rate will otherwise be determined largely by external market forces. In that sense the Governor is surely correct.

37.  Mr Howard referred to a different set of imbalances, including the housing market, low saving and high borrowing (Q254). We do not doubt the importance of expressing concern about such developments, assuming that the emphasis is on household behaviour. However, it is difficult to see how they are caused by government action. We are particularly interested in Mr Howard's proposition that the Government policies are, at least in part, responsible for the decline in the stock market, and have "systematically discouraged saving" (Q255). We have not heard such a proposition from the MPC.

38.  Interestingly, members of The Times shadow MPC exonerated the MPC of blame for the consequences of aiming at and getting close to the inflation target. Ms Coyle reminded us that "manufacturing industry has had problems for decades in this country" (Q176). She might have said the same about productivity. Other members of The Times shadow MPC also offered some policy suggestions. Mr Weale suggested that a tax on mortgage interest rates might help the housing market (Q175). Mr Kaletsky mentioned a capital gains tax on housing and manufacturing subsidies (Q176). Having done so, he did not go on to advocate the policy as practical. He was sanguine about the exchange rate, and did not consider it to be the cause of manufacturing industry's problems. More generally, while recognising the existence of the imbalances, members of The Times shadow MPC seemed relaxed about them, although they said that debt will start to become a burden in the long term (Q186).

39.  Some interesting background to the imbalance question is offered by Professor Wynne Godley of the Financial Times, who is pessimistic about the imbalances, the current account deficit and the extent to which consumer spending is financed by net household borrowing.[13] He says that "the strategic policy issues raised by the imbalances are complex and cannot be resolved by the manipulation of short term interest rates by the Bank of England's monetary policy committee." Above all, he warns that monetary easing coupled with sterling depreciation might be ineffective both with respect to the external position and the mitigation of a domestic recession. We believe that that warning should be taken seriously, but we are inclined to emphasise the word "might".

40.  Some, but not all, the imbalances in the economy may result from inflation targeting by the MPC. Some might be reduced by Government intervention, but precisely how that should be accomplished was not clearly specified by our witnesses. A few problems may go away of their own accord. No witness suggested that the UK economy was heading for a critical state or that immediate or short term action was called for. Certainly, none of the evidence we did receive led us to predict that the MPC would cut interest rates as it did in February 2003. We examine this further in paragraphs 47-51 below. Although it was not part of our remit for this inquiry, we do not doubt that longer-term policy adjustments aimed at improving productivity and the way in which markets work are desirable. We merely add that that has been the stock in trade of all governments for half a century.

41.  It is clear from the evidence that we have taken that there are substantial imbalances in the economy at present. Of them, the three which are most concerning are

·  the imbalance between consumer spending and investment;

·  rising house prices, and the attendant rise in mortgage equity withdrawal; and

·  the trade balance and current account deficit.

We conclude that some of these imbalances may (like the fiscal position described in paragraphs 26-32 above) be cyclical. In relation to these imbalances in the economy we consider that some intervention in the future may be necessary.

Development of Monetary Policy

42.  The Governor of the Bank of England told us that no significant changes had been made in the conduct of monetary policy, and he saw no reason why they should (Q90). We find that rather difficult to understand. Apart from anything else, it means that from the start the MPC knew exactly what it had to do, and has learned nothing of major significance since. We stand second to none in our admiration for the MPC, but that the very first group of members obtained perfection of procedure immediately, and that none of their successors made any further progress, is difficult to accept. An obvious change is that the external members of the MPC now have their own research assistance—in order, presumably, to improve the way they undertook their task. Are we to infer that no improvement has occurred? We also understand that the role of regional agents has been enhanced.

43.  We would expect that, like any other decision-making body, the MPC would review everything it does from time to time. The decision-making process gives rise to such questions as whether the frequency of interest rates changes is right and whether moves +/- 0.25% are optimal. They are, of course, interrelated. Changes have also taken place in what the Governor calls the "environment"; inflation expectations; attitudes to debt; and the housing market. Although we agree with Mr King (Q90) that "the target is given to us by the government [and it] would not be right for us to try and fiddle around with the definition", the vast research effort of the Bank must from time to time throw light on whether RPIX is an adequate measure of inflation. Adopting an uncritical attitude to the way inflation is measured is surely not a necessary part of the remit of the MPC.

44.   This takes us back to the question of MPC appointments. If the MPC has perfected the conduct of monetary policy, does it matter much who the members are? As Mr Dicks said, members of the MPC "are there to exercise their judgement": they are not automatons. He remarked that "we could replace the MPC and its shadow with a computer if we just respond to the inflation forecasts" (Q189). If nothing fundamental has changed in relation either to the inflation process or to the MPC's approach to monetary policy, the question arises whether the MPC could feed its judgement on the environment into an automaton (that is, a computer programme) in order to determine the policy.

45.  We consider that the time is ripe for some serious research into the operation of monetary policy in the past five years, and above all whether, and in what ways, the Bank of England Act 1998 has made a difference. We would be interested to know whether the MPC shares our concern.

46.  It is possible that the Bank itself is conducting such research. We do not have the resources to undertake the task, but it would be an interesting research project for one of our leading academic economics departments. One question on which such research might focus is that asked by Professor Godley: "Is it possible that people expect more from the MPC than it could possibly achieve?"[14]

11   Pre-Budget Report Back

12   For the path of output, see charts 3.2 and A in the Bank of England's Inflation Report of February 2003. Back

13   Financial Times, 28 January 2003. Back

14   Financial Times, 28 January 2003. Back

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