Many parents have tried it and so have governments and central banks – and for good reason. Persistently sticking to explicit “rules”, even ones that are inherently arbitrary, can play an important role in changing behaviour and perceptions.
Visible adherence to rules by governments and central banks can also help restore credibility, regain influence and increase the probability of their preferred outcomes. Yet, there are also situations in which the configuration of some rules can get in the way of good decision-making. This is increasingly evident on both sides of the Atlantic, risking economic and social wellbeing.
Economists have been attracted to rules in policymaking as a way to overcome the legacy of past mistakes and structures that undermine economic growth and financial stability. The most popular of these were the adoption of explicit and well-publicised inflation targets for central banks, caps on fiscal deficits and limits to increases in public debt.
Rules applied to companies, especially to banks, proliferated in the aftermath of the 2008 financial crisis and in an era of greater emphasis on consumer protection.
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Such rules have been effective. They have contributed to more stable and anchored inflationary expectations, better fiscal policy, greater focus on debt and a less vulnerable banking system. And they were supported by a domestic consensus favouring deregulation, liberalisation and fiscal prudence, and the international one of ever-deeper globalisation.
But what worked well in the past may now be getting in the way of economic wellbeing in three specific cases: namely, in the specification of the UK’s fiscal rules, the US inflation target and Europe’s permutations of budget constraints.
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Last week, Rachel Reeves, UK chancellor, reiterated the new Labour government’s comprehensive adherence to fiscal rules when she stressed: “If we cannot afford it, we cannot do it.”
This followed the presentation of a £22 billion (€25.6 billion) budget “black hole” that prompted a series of spending cuts, including cancelling some road and rail projects and limiting winter fuel credits to fewer pensioners.
It took place in the context of a government that not just fully embraced its predecessor’s fiscal rules, including a lower debt burden by the end of a five-year period, but also reinforced them – including a new self-imposed requirement to share with the Office for Budget Responsibility a detailed three-year spending plan every two years on how public finances are being spent.
As important as this is for communication and maintaining market credibility, there is a risk the current specification of the fiscal rules will get in the way of the government’s critical “growth mission”. This specification does not differentiate enough in both the sources and, more importantly, the uses of funds. It is also arbitrary in its time horizon.
The UK would be well-served by a reassessment of the fiscal rules by a group of credible experts tasked with integrating them in a more sophisticated manner with the government’s growth mission.
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To reduce the risk of market disruption – something the British government seems particularly worried about after the experience with former prime minister Liz Truss – this would be accompanied by institutional measures to enhance communication with market participants, similar to what the US government does with its Treasury Borrowing Advisory Committee.
The US and Europe also find themselves stuck with rules that, while well-meaning, need some reform.
This includes the Federal Reserve’s 2 per cent inflation target which was well-suited for yesterday’s world of insufficient aggregate demand but is too tight for today and tomorrow’s world of global fragmentation, the rewiring of supply chains and pockets of supply constraints.
The latest weak economic data amplify what has evolved into an excessive approach to forward policy guidance, including too detailed quarterly “dot plots” of economic projections.
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In Europe, domestic and regional fiscal constraints undermine the investments needed to boost productivity and growth.
Douglas MacArthur, the late US general, is purported to have said “rules are mostly made to be broken and are too often for the lazy to hide behind”. This is not what I am advancing here. Instead, I am suggesting that the specification of certain rules needs to be updated to ensure that they serve their initial purpose and reflect the world of today and tomorrow. Absent that, they could well end up hindering economic and social wellbeing. – Copyright The Financial Times Limited 2024
Mohamed el-Erian is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy
