Home > Fiscal Policy, Monetary Policy > UK Macro Policy, A Short Story

UK Macro Policy, A Short Story

A short story for Jonathan Portes and Prateek Buch.  Is the use of deficit-funded capital spending a sensible way to fine-tune UK demand policy?  Opinions welcome.  (What would Krugman say?)

George Osborne writes to the Bank of England:

Dear Bank of England, please target 2% inflation!  Thanks!

The Bank of England meets and prepares its reply:

Dear George.  Here’s the path we’ve set out for the nominal economy.  You’re going to get above-target inflation and poor real GDP growth over the next two years, with the CPI rate hitting 2% after that.  Is that OK?

George replies:

Dear Bankers, thanks!  That’s really great.  I actually want a bit more inflation and faster nominal GDP growth.  But instead of telling you to provide a bit more inflation and/or NGDP, I am going to do a £30bn capital spending package over two years.  I have told my voters this will raise NGDP!  So take it as a subtle hint.

Bank of England to George Osborne:

Erm, really?  Do you want us to target 2% inflation or not?  We could just target higher NGDP growth, but we’ll probably get even higher inflation too.  Shall we do that?

George Osborne to Bank of England:

WOAH.  STOP RIGHT THERE.  What are you thinking?  Please target 2% inflation.  Gosh darnit guys, aren’t I making this clear?  Can you imagine what Ed Balls would say if I asked for more inflation?  I’d be crucified!   2%, 2%, 2%.  Got it?

One month passes.  Stuff happens… let’s say for the sake of argument that one of our major trading partners tips into recession.   The Bank meets to set monetary policy again.

Bank of England to George Osborne:

Well George, we’re going to target 2% inflation like you said.  Here’s the path we’ve set out for the nominal economy.   Exports are looking a lot worse than last month, but government spending is up!  So you’re getting an above-target CPI rate and poor real GDP growth over the next two years.  We’ll hit the 2% after two years – is that OK?

p.s. By the way George, the national debt is looking pretty ugly.  You might want to think about getting the deficit down.

  1. May 16, 2013 at 12:51

    The argument in the story only makes sense in so far as deficit financed capital spending is a perfect substitute for monetary stimulus of a given type and in given conditions. They are not and building a motorway is not the same as cutting the top rate of income tax or cutting the basic rate of income tax or raising tax credits or a rate cut or bond buying and there is only a limited extent to which thinking about the issues in such reified terms is helpful. I’m not sure anyone doesn’t realise that monetary policy might in some circumstances offset fiscal stimulus so talking in these terms just muddies the waters.

    I’m not sure that I have an answer and would unhelpfully wish to start by rephrasing the question to read instead:
    ” Is the use of deficit-funded capital spending a sensible way to fine-tune UK demand?”
    I would then want to make the question a bit more concrete so let’s suppose that the question is
    “Should the government fund the construction of a new stretch of motorway?”

    I think the specifics of the motorway in question matter and that this is not irrelevant to the actual question but it is however a distraction from the also interesting question is at hand so let’s assume that the project is, or rather was, marginal according to standard criteria. I would assume that if the idea of slack capacity that provides one argument for fiscal stimulus held, there should be some price signal shifting in favour of the project. However that still is a diversion from the question so lets suppose it is still marginal after this signal. Eventually we come to the question of whether the gains from the road project offset the losses from any induced monetary tightening. This is a genuinely tricky question and won’t be answered with much precision because of the near imponderable uncertainties on either side. I would argue that if the foregone monetary easing is more QE rather than a foregone rate cut the answer should more likely be favourable to the project given the very uncertain impact of QE on the UK economy. Also if there is significant unemployment or dormant capacity in the sector receiving the investment the effects are more likely to be positive. The real problems are likely to be that the projects might be chosen in a pork barrel or quixotic way,

    In the end if I accept the point of view of the story it shouldn’t make much difference either way.

  2. May 16, 2013 at 15:45

    v interesting, thanks for the link love and response. I like a good story.

    A thoughts occurs. This Sumner-esque reaction to fiscal expansion occurs because the target remains 2% inflation. Does the story have an alternative ending if the target is changed to, say, 5% NGDP growth per year, or indeed a set level (not rate, but level), of NGDP X years hence? Would Bank then relent and give fiscal loosening time to do its job? genuine question. also, what would be the effect of target set by Chancellor being “give us full employment/wage rises of certain level, however you choose to do it?”

    shows importance of coordination between fiscal and monetary moves, as I believe Adam Posen tweeted at you earlier. I am not saying that fiscal loosening is without consequences, nor that no monetary tightening at all would follow.

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