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OPINION

The policy mix

The policy mix
June 30, 2015
The policy mix

Economists expect him to announce more spending cuts and lower planned borrowing: Sam Hill at RBC expects him to reduce forecast public sector net borrowing in 2015 from £75bn to £63bn. And Brian Hilliard at Societe Generale warns of "a fresh and aggressive phase of austerity".

This should imply a lower path for interest rates for a simple reason. More fiscal austerity implies lower aggregate demand and lower aggregate demand implies lower inflation which in turn implies lower interest rates. It is insufficiently appreciated that, for a given inflation target, a tighter fiscal policy should mean a looser monetary policy - and vice versa.

Mr Osborne's choice here has at least the merit of consistency; he has long called himself a fiscal conservative and monetary activist. And it has another virtue. A tight fiscal policy and loose monetary policy should in theory depress the exchange rate, which should boost exports and so reduce the UK’s trade deficit - as in the standard Mundell-Fleming model. You might reply that this has not worked in recent years as sterling is strong. But I suspect that it would have been even stronger had we had less austerity and higher interest rates.

However, I suspect there are three arguments against Mr Osborne's choice.

One concerns the balance of risks. When interest rates are close to zero, monetary policy cannot be relied upon to boost the economy if some adverse shock hits us: of course the Bank of England could resume quantitative easing, but the precise effects of this are uncertain. For this reason, many economists, such as Oxford University’s Simon Wren-Lewis, have long argued that fiscal austerity should be postponed until interest rates have risen.

Secondly, low interest rates stimulate the financial sector more than most others: many financial strategies are only viable at low borrowing costs. However, researchers at the IMF have shown that this isn't necessarily welcome, because a large financial sector can reduce long-term growth - perhaps by attracting talented people away from other occupations, or perhaps by increasing the risk of costly financial crises.

You might object here that low interest rates also stimulate productive investment. But herein lies a third problem. If we are in an era of secular stagnation in which there is a dearth of monetisable investment opportunities, low rates might lead to speculative malinvestments more than to productive capital spending It is one thing for monetary activism to stimulate a manufacturing renaissance, another for it to lead merely to a housing bubble.

Herein, though, lies something odd. Although the arguments about fiscal austerity invariably split along simple left-right lines, there is, I suspect, nothing inherently left-wing about the above points. There is a debate to be had about the appropriate mix of monetary and fiscal policy right now - and it shouldn't be infected by political tribalism.