MNI INTERVIEW: UK Fiscal Framework Stifles Growth - Benigno

The UK's fiscal rules impose unnecessary fiscal tightening which tends to suppress growth and eventually push the national debt burden up rather than down, a prominent economics professor who has just submitted evidence to a House of Lords Economic Affairs Committee's inquiry told MNI.

The framework is based on outdated thinking and is self-defeating, Gianluca Benigno, University of Lausanne professor and former head of international research at the New York Fed, said in an interview.

The "fiscal rules are meant to reduce the deficit. They are meant to reduce the debt-to-GDP ratio, but they are failing systemically ... Why are they not succeeding? Because the rules suppress growth and rely on growth to succeed," he said, pointing in particular to “a monetary-fiscal feedback loop that is amplified by institutional features.”

ACCOUNTING FOR BOE LOSSES

Under the framework, any losses made by the Bank of England in its bond purchasing operations are indemnified by the Treasury, which then has to cover them with borrowing. As these losses occur when interest rates rise, which pushes up payments to investors who have sold the bonds in return for central bank reserves remunerated at Bank Rate, that means that "the macroeconomic outcome is a situation in which you have relatively tight monetary policy, and also a fiscal policy that is tight," Benigno added.

The government’s need to ensure that it has headroom over its rule for day-to-day costs to be met by revenues by 2029/30 means that it has a permanent temptation to pencil in tax hikes or spending cuts which are deferred towards the end of that period, Benigno said.

"Even if fiscal policy is mildly supportive next year, the rolling targets ensure it will tighten in the medium-term. That is the core problem  … and monetary policy amplfiies these pressures," Benigno said. (See MNI INTERVIEW: Put Fiscal Coordination In BOE Remit  - NIESR)

One option would be to adopt a similar framework to that in the U.S., where central bank losses are deferred and "you don't impute them directly now, but you defer them in such a way that when you have those profits later on they compensate," he said.

Another way of easing the government’s fiscal burden, according to Benigno, would be to end full reserve remuneration, paying a lower rate on some part of the Bank's reserves, though this would be beyond the scope of any reform of the fiscal rules and is something which BOE Governor Andrew Bailey has publicly opposed. (See MNI INTERVIEW: Secular Stagnation Author Says Debt Raising R*)

While lawmakers are holding an inquiry into the fiscal framework, Chancellor of the Exchequer Rachel Reeves has not so far supported any fundamental reform, though she has made some changes, shifting the debt target measure to public sector net financial liabilities, and has introduced some flexibility around the balanced budget rule. (See MNI INTERVIEW: UK Needs To Slash Spending Share Of GDP- Chadha)

MONETARY POLICY

In addition to unnecessary fiscal tightness, BOE monetary policy is also too tight, Benigno said, stressing the importance of acknowledging that monetary policy works though multiple routes and that, for example, rate cuts lower rental inflation while higher rates add to fiscal pressures.

"The transmission mechanisms of monetary policy are richer and more complex ... than just raising rates to tame aggregate demand and eventually lower, through some mechanism, nominal wage growth and service inflation," he said.

"The Bank remains heavily focussed on nominal wage growth, which I think is the only thing that is saving the economy by supporting consumption for now," he said.

"My prediction is that as we enter 2026 things are going to be actually worsening in terms of economic activity and unemployment might be higher than what the Bank is currently forecasting," as previous policy changes feed through and it is "not going to face that much inflationary pressure."