New Labour sets out to win `Wall Street cred'
Monday 22 May 1995
Policy credibility has a precise definition. It means that the public believes that the Government will carry out its stated plans. It is valuable because, if it exists, the private sector will adjust its expectations and behaviour to the objectives of the Government. Two examples connected to the inflation target will show how important this can be.
First, the labour market. If management and unions believe that the Government fully intends to change policy so that the inflation target will be hit, they will reduce their wage bargains in line with this target. Simply because they have done this, the target will be much easier to hit. In the opposite case, in which wage deals are not reduced in line with the inflation target, the Government will instead need to create a recession in order to force lower deals on an unbelieving labour market.
Second, the financial markets. If the inflation target is credible, this will immediately be reflected in the interest rates demanded by bond owners. If it is not credible, a high inflation risk premium will continue to be priced into bond yields. Even if the Government can then succeed in achieving the low inflation rate it is promising, it will have imposed a long period of very high real interest rates on the economy.
Obviously, then, credibility is of immense long-term value. But how best can it be attained? Simply stating that the Government intends to deliver low inflation - no matter how vehemently - may have little impact on rational economic agents, since they know that when times get tough the Government will have an incentive to renege on previous commitments. They will not believe such empty promises in the first place.
The answer to this problem, according to economic theory, is for the Government to pre-commit itself to a system whereby it will be punished if it reneges on earlier pledges. For example, if the Prime Minister promised to resign and call a general election were the inflation target to be breached, this would persuade the private sector of his resolve.
Or would it? The point about pre-committing to a specific punishment in case of failure is that the private sector must believe that the punishment itself is credible. It must be the sort of thing that the Government might actually do when the time comes, rather than seek to wriggle out of it. Political suicide would not qualify under this test.
Economic theorists could design a "law of optimal punishment", if they have not done so already. The more severe the punishment, the less likely the public would be to believe that the Government would actually carry it out. But the less severe the punishment, the more likely the Government would be to swallow the medicine and ditch its original policy objective anyway. Something in the middle - such as the loss of reputation that would follow from the failure to hit an inflation target - may work best.
In a democracy, policy credibility must also seek to survive a possible change of administration. Otherwise, the private sector will have to judge whether the objective could be ditched under an alternative political arrangement. Hence, the Government's objective needs to be achievable without imposing such short-term strains on the economy that the electorate chooses an alternative economic team.
The exchange rate mechanism was an example of a policy commitment that failed not because the punishment imposed on the Government was too small - it was massive, and long-lasting - but because the objective itself turned out to be too ambitious. Although there was never any public hint that the Government was willing to adjust sterling's central parity against the German mark in 1992, the extent of the domestic recession, and the damage it was doing to the housing market and the financial sector, was so great that that it was literally incredible to the markets that the policy could continue.
If Messrs Major and Lamont had sought to maintain the measures necessary to keep sterling in the ERM in September 1992 - 15 per cent base rates in the depths of recession - there would quite soon have been a different set of characters in Downing Street to reverse the policy, though it is far from clear who they would have been.
So a credible economic strategy must have the following elements. The targets must in themselves must be broadly plausible, in the sense that they could be achieved without imposing too much damage on the level of output and employment in the short term. Otherwise the private sector will simply assume that the targets will be abandoned at the crucial moment.
Furthermore, the Government must set up an arrangement whereby it will face some form of credible punishment if it subsequently reneges on its original commitments. That is the best available method of persuading the private sector that, in practice, the inflation bias inherent in macro- economic policy will be removed.
Gordon Brown's economic team clearly understands these requirements. Although the Shadow Chancellor has been on the receiving end of some knock- about for mentioning "endogenous growth theory" in one of his early speeches - the knockers conveniently forget that he did it as a self-deprecatory joke - anyone with any sense will be pleased that he is showing awareness of recent developments in macroeconomic theory. Partly because of this, his important speech last Wednesday laid out a macro framework that was tougher and more coherent than anything we have heard before from a British opposition party - including the Thatcher opposition in the late 1970s.
Mr Brown's framework does not differ too dramatically from the present government's, but where it does, it moves the present structure in the direction of greater transparency and rigour. On the fiscal side, he has promised to stabilise the government's debt ratio over the course of a cycle at a "sensible and prudent" level, which his team has suggested will be inside the Maastricht limit of 60 per cent of gross domestic product. (The debt ratio in 1997 will be about 50 per cent.)
In addition, Mr Brown has promised to meet the "golden rule" of public finance, under which government borrowing must be no greater than its investment, or more accurately the amount the Exchequer contributes to national asset creation each year. As the graph shows, this will limit the public sector borrowing requirement over the course of the cycle to under 2 per cent of GDP - almost exactly what the present government has achieved over the past decade.
The government's progress on these objectives will assessed each year by a beefed-up independent panel of Treasury advisers. Finally, on the monetary side, Mr Brown says he will retain the inflation target, and will increase the transparency of the monetary mechanism in preparation for greater independence for the Bank of England.
Of course, the real test of new Labour's resolve will only come in government, but the Shadow Chancellor's battle for Wall Street cred has started well.
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