Policy Research in Macroeconomics

Corbyn’s Investment Bank – a step towards a rational fiscal policy


Adding Up Fallacy

If you follow the Guardian then you know that among his other transgressions (like being on the verge of winning), Jeremy Corbyn is “a high-risk choice” to lead the Labour Party, because “he could crash and burn very quickly”.  We are told that this fiery end would be the consequence of economic policies that do not “add up”.

The idea that economic policies should “add up” frequently reflects a fundamental confusion derivative from neoliberal ideology, that candidates (and governments) must be sure that “they get their sums right”. This, in turn, leads to allegations that the lack of sound arithmetic will lead to that great evil, inflation

The fallacy lies in an underlying belief that borrowing is a bad thing, and public sector borrowing is very nasty, indeed.  Corbyn does pose a risk but not to members of the Labour Party or the broader public (contrary to FT View).  The prevailing approach to economic policy and to the public sector are at risk as a direct result of Corbyn proposing effective policies that do not “add up” in the neoliberal sense.

Sense and Nonsense on Deficits & Money

Almost all discussion of fiscal policy in general and for Britain accepts the neoliberal dogma that the public sector budget should be balanced (or run a surplus for the ultra-neoliberals).  Sometimes explicit and always implicit is the quasi-religious belief that (expenditure = revenue) should over-ride all other fiscal priorities.

More pragmatic neoliberals accept that during periods of economic downturn no government can avoid fiscal deficits, often described pejoratively as “revenue shortfalls” or for the true believers, fiscal “black holes”.  Those neoliberals tolerant of recession deficits stress both their temporary nature and the necessity to compensate for them by surpluses when the economy recovers.

This fiscal canon that “deficits are a problem” suffers for many analytical and even logical inconsistencies.  First, it presumes an automatic process that ensures market economies will by their nature tend to full capacity, as if there exists a great free market magnet at maximum capacity, irresistibly pulling the system out of recession and into recovery.  By this ideology fiscal policy should be neutral and deficits represent a problem, signalling non-neutrality.

Integral to this fiscal neutrality ideology is the conviction that deficits invariably generate inflationary pressure.  This bit of fiscal nonsense achieves its justification through misunderstanding (or mis-representing) the nature of money.  The neoliberals tell us that deficits involve “printing money”, a malign practice specific to governments and central banks.

Those who believe that only governments “print money” need a crash course in basic economics.  What governments print is a tiny traction of the “money supply”, which consists overwhelmingly of bank credit.  Though governments and central banks can and do generate credit, private financial institutions generate far more in Britain and other market economies. 

To put it simply, “banks create money”.  The balanced budget ideologues would agree, but believe they have the killer response – banks create money on the basis of a “monetary base” that governments control.  This represents more nonsense on the same neoliberal theme.  Over thirty years ago most economists rejected the effectiveness of inflation management by “targeting” the monetary base.  In the late 1980s almost all central banks, including those in the UK and the US, abandoned the policy in favour of manipulating the central bank lending rate (“interest rate”).

This relates directly to the attacks on Corbyn’s economic policies.  Fiscal deficits in themselves are not a problem (stressing the invariant need to eliminate them is ideology).  Specifying some general rule on when they should be in balance, such as “over the cycle” or “at full employment” has no theoretical justification (the same ideology in superficially more sophisticated form, see my Pieria article 17 August).  And, governments do not have monopoly on money creation or the generation of inflationary pressures.

Active Fiscal Policy

I presume that all four candidates for the Labour leadership are committed to maintaining the UK economy near full employment.  If so, for consistency each should commit to an active fiscal policy.  And active fiscal policy has two components, the use of current expenditure to reduce the short term instability of the economy and the capital budget to increase the capacity for growth.

The use of current expenditure to stabilize the UK economy near full capacity has an obvious justification.  Almost all items in the capital budget involve projects with implementation over several budget years.  Assume that the government starts construction of a new rail line that has an expenditure period of four years.  Then, two years later the economy moves so close to full capacity that inflationary pressures result. 

No rational government would stop the rail project half-finished.  Therefore, the appropriate fiscal instrument to temper the inflationary pressure would be reductions in current expenditure or an increase in taxation.  In effect the current budget becomes the countercyclical mechanism and the capital budget an instrument to increase medium and long term economic capacity. 

To state the rule simply, use the current budget to keep us at maximum capacity by management of aggregate demand and the capital budget to increase that capacity.  The latter can indirectly to manage demand by the mode of its financing, through bond sales to the Bank of England or to private buyers.  The former increases the monetary base and the latter does not.

National Investment Bank

The national investment bank proposed by Jeremy Corbyn should be placed in the context of this budgetary division of function.  In a recent Guardian article Robert Skidelsky explained the need for such an institution, which he has long advocated.

I would link the functional division of the budget to the points made by Lord Skidelsky.  When faced with fiscal deficits governments in many countries choose public investment as the first candidate for cuts, motivated by the belief that these could be less politically dangerous than cuts in health or education services.  Chancellor George Osborne has applied this approach with zeal (Office of National Statistics, Quarterly Survey of Capital Expenditure).

A national investment bank would serve as an effective way to avoid politically motivated cuts in public investment.  Parliament would formally separate the current and capital budgets.  The former would be proposed and approved an annual basis much like present practice. 

The government would design a capital budget for a longer period (for example, three years), with annual adjustments as earlier projects cess end and new ones begin.  Implementation of this budget would be the responsibility of the national investment bank.  This arrangement might be seen as similar in practice to the “independence” of the Bank of England.  The selection and design of projects would be a political decision, with their implementation through a designed non-political institution.

Redefining the Budget

This reform of the budgetary process would have several advantages: 1) it would formally separate current and capital budgets and assign each its appropriate role; 2) it would reduce (though never eliminate) the diversion of long term investments into short term political opportunism; and 3) potentially make for a more rational selection, design and implementation of public investment.

Such a reform goes beyond what is proposed by Jeremy Corbyn, but would correct a longstanding flaw in the budgeting system, the Treasury practice of making little if no distinction between borrowing for current expenditure and borrowing for investment.  If nothing else, a formalization of this distinction would make a great contribution to rational discussion of fiscal policy and especially deficits by over-riding the fiscal ideology of “getting the sums right”.

This article is cross posted from Pieria, 27th August 2015.

3 Responses

  1. guardian has ran anti austerity articles for ever and were pushing milliband to go that way, why are you writing this as if they have been there all along chuckling with osborne. everything it so confrontational these days, no one can write an article without blaming someone for something in the first paragraph.

  2. Re: National Investment Bank. This seems such a good idea, for so many reasons … why is this not happening? What could be the objection to separating current (short term) and capital (longer term) needs?

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