when what you try to stabilise is inflation? Exchange rates – but why tie
yourself to the problems of your anchor currency, and at a rate that may
do you serious or persistent damage? To succeed, inflation targeting
depends on trust. Workers and firms bargaining over wages need to base
their calculations on a shared belief that the rate of inflation over the contract period would be close to target. And in their product price-setting
role, firms need to share that belief as well. If everyone’s inflation expectations are anchored at or near the target, actual inflation will average out
at or near the target, too.
Inflation-targeting is something of a self-justifying hypothesis. To
work, the public’s trust must be earned. Any tendency for inflation to
stray, on the upside (or down), has to be countered by a rise (or a fall) in
the policy rate. This will tend to squeeze (strengthen) aggregate demand,
and thereby limit (or strengthen) rises in pay – which should translate
into lower (higher) inflation. But the medicine takes time to work: its
maximum impact is felt between eighteen and twenty-four months later.
And when everyone learns to expect that shocks to inflation will be countered this way, the medicine’s dosage can come down. The details of the
inflation-targeting framework vary from country to country. And there
are many that now employ it, from Brazil, Canada, Chile, Colombia,
19 The goal would be changed at most once a year. In practice it was altered just once, at the
end of 2003.
Mexico and Peru in the Americas, to South Africa. In Asia it has spread
from New Zealand to Australia, the Philippines, South Korea, Thailand
and Turkey; Japan may join them. Iceland, Norway, Poland and Sweden
are Europe’s main inflation-targeters, along with Britain, and it forms an
increasingly important element in the European Central Bank’s monetary policy framework. It has thus far been accompanied, wherever it has
been applied, by steadier and lower inflation. But this begs several questions. Among them, might inflation have fallen and steadied anyway?
And what is the optimum rate of inflation?
Until 2004–5, at least, when oil prices jumped sharply, inflation has
tended to fall and steady almost everywhere, and not just in inflation-targeting countries. Furthermore countries that adopted inflation targeting
did so, typically, because some previous regime broke down, sometimes
quite chaotically. And though we have fifteen years of experience for
Britain, and three more than that for New Zealand, most inflationtargeting regimes are much younger. Scrutiny of long data spans, and of a
wide spectrum of countries’ experiences, is needed before we can hope to
get a full picture.
So it is still too early to hope to ascertain exactly what the added value
from inflation-targeting actually is. Furthermore, if a country operates
an unsustainable fiscal policy regime, with rising ratios of debt to
national income, say, no monetary framework can defend it against the
grave turbulence that must eventually ensue. Another worrying point is
the ‘Iron Law of Contempt’ in macro-economics: every generation is
united, if in nothing else, in despising some aspect of the conventional
wisdom of thirty or so years before. This makes one ask what it is about
our current macro-economic and central banking convictions that posterity will deride us for. And experts are still debating how much of the
more benign economic environment of the past fifteen years or so, not
just in Britain but in so much of the world, is due to improved policy
frameworks, or improved policy decisions, or better luck in the form of
fewer and less sinister shocks.20 Almost certainly, it was due to a combination of all three.
Where should the inflation target be set? The Chicago tradition, pioneered by Milton Friedman (1969), had it that inflation was best not at
zero, nor at a positive value, but negative –minus the real rate of interest.
That way ‘real’ money (currency in purchasing power terms) could
20 The Treasury Select Committee held a ‘Ten Years On’ inquiry; its submissions are available
on www.publications.parliament.uk/pa/cm200607/cmselect/cmtreasy/299/299we01.htm.
become a free good, priced at its marginal cost, assumed to be zero. In
other words, nominal interest should ideally be abolished. Friedman’s
original argument has recently been reinforced.21 Arguments for aiming
above this, possibly for zero or even positive inflation, are essentially
second-best. They are numerous. Perhaps the strongest22 stems from two
facts – first, that nominal interest rates cannot be negative, and second,
that altering policy rates is the standard (and arguably indispensable)
mechanism for cooling or reviving economic activity at times of macroeconomic stress. Aiming way above Friedman’s optimum preserves the
option to reflate if needed; aiming at his optimum closes it. A low positive
inflation target, just a little above zero, may be best on balance. If so,
Brown’s choice of numbers is commendable.
Partly to guard against any possible conflict of interest that might confront the newly independent Bank of England, it lost two functions it had
long enjoyed: managing the government’s debt and supervising commercial banks. The first passed to a newly created Debt Management Office.
The second transferred to another new body, the FSA (Financial Services
Authority). The FSA swept up the oversight responsibilities of a dozen
previously separate institutions. Brown, or his adviser Ed Balls, will have
feared that the Bank might be thought to be torn, at some point, between
the macro-economic benefits of changing policy interest rates in one
direction, when keeping a big retail bank afloat might push them in the
other. And the boundaries between different kinds of financial institution
were becoming progressively more blurred. Separate regulators were now
an inappropriate, even dangerous anachronism.23
One final monetary decision of Brown’s was much more contentious –
and ultimately (when details became public eight years later) quite
embarrassing. This was his sale of a large slice of the country’s gold
reserves in 1999. There were actually some quite good arguments for
selling some gold then. Russia and South Africa, the two main producers,
21 By R. Lagos and R. Wright, ‘A Unified Framework for Monetary Theory and Policy
Analysis’, Journal of Political Economy, 113, 2005: 463–84; and G. Rocheteau and R.
Wright (2005), ‘Money in Competitive Equilibrium, in Search Equilibrium, and in
Competitive Search Equilibrium’, Econometrica, 73, 2005: 175–202.
22 See P. Sinclair, ‘The Optimum Rate of Inflation: An Academic Perspective’, Bank of
England Quarterly Bulletin, 43, 2003: 343–51, for more on this – and for four other
second-best counter-arguments to Friedman.
23 Goodhart’s contribution in R. Brealey, C. Goodhart, J. Healey, G. Hoggarth, C. Shu and P.
Sinclair, Financial Stability and Central Banks (London: Routledge, 2001) speaks eloquently to this, but argues against applying a central bank–supe
rvision split in developing
countries.
were facing serious challenges, and might respond by selling more gold.
Looking back, gold had usually proved a poorly performing asset. Falls in
inflation rates around the world, and some trend to freer floating, would
reduce official and private demand for gold. And industrial and dental
use did not seem buoyant. Furthermore, if agents were rational and
neutral to risk, expected risk-adjusted yields on gold holdings could not
systematically exceed those on other, arguably more useful assets. In retrospect, however, we can now see that gold actually did very well in the
ensuing eight years. It was pushed up mainly by the indirect effect of
falling real interest rates (reflecting greater longevity and lighter capital
taxation, inter alia), and rapid Indian growth. Yet this was not easily foreseen. The key flaw in Brown’s decision was not so much the principle of
selling some gold, but rather the way the gold was to be sold – not secretly,
but in large pre-announced auctions. Dealers would then bid down
prices in anticipation, ensuring that the nation would get bad prices. For a
government that wore transparency on its sleeve but often concealed, as
with peerage loans, what it was really doing, this was an amazing lapse.
Advice was ignored. In matters like that, only a fool plays poker with all
his cards face up.
The gold sale was an embarrassment, at least in the way it was handled
– too deaf to advice, yet also too transparent. And in retrospect it is clear
that luck was against the policy of sale in 1999. But if ill luck and refusal to
listen to good advice lost the British taxpayers £2 billion or so in that case,
they were amply rewarded by another astonishing success: this was the
auction of the third generation of telephony licences, in 1999. This raised
£22.5 billion, and drew unbridled praise from the National Audit Office,
which has always been (both under Blair and earlier) much more often a
source of castigation of government error than of congratulation.24 The
good fortune here was to achieve the sales just before the dot.com bubble
crashed in 2000–1. But the skill was the decision to listen, and follow,
advice from some of Britain’s leading economic experts on the relevant
technical aspects of auction theory and games in her universities. The
success helped to restore Whitehall’s respect for academic economists,
which had been impaired by the 365 signatories to the 1981 ‘letter’ to The
Times, to something more like what it had been in the 1960s.
24 National Audit Office, ‘The Auction of Radio Spectrum for the Third Generation of
Mobile Telephones’, report for the House of Commons, 15 October 2001.
Taxation and public finance
Economic policy goes far beyond growth, inflation, and currency,
exchange rate, banking and auction issues. One of the central functions
of the Treasury is to manage the government’s finances, and in particular
the structure and levels of taxation, and public expenditure. In the
Blair–Brown diarchy, these were domains firmly reserved to Brown. But
the Prime Minister’s official title is ‘First Lord of the Treasury’; all Brown’s
key decisions were agreed in discussions with Blair, even if briefly and
often at short notice; and prime responsibility for all government policy,
wherever formulated and applied, rests with 10 Downing Street. Nonetheless, Blair’s role in the management of the British economy from 1997
to 2007 is more pomp and theatre than reality: in Bagehot’s term, the
Prime Minister had become a ‘dignified’ rather than ‘efficient’ part of the
Constitution in this sphere. Maybe that was wise. Blair must have ruminated on how economic disputes, many of them centred on European
exchange rate matters, had worsened Thatcher’s relationships with two
Chancellors, Lawson and Major, and, in turn, Major’s with Lamont.
There were earlier examples of friction between 10 and 11 Downing
Street too, such as Macmillan’s difficulties with Thorneycroft and Selwyn
Lloyd. Heath had worked well with – and dominated – Barber, as, to a
lesser extent, Wilson had with Callaghan. But Blair would hardly play
Heath when confronted with Gordon Brown.
Tax policy in the Blair years was not just remarkably conservative; it
was strictly Conservative in key respects. There were ‘stealth’ increases in
taxation – higher National Insurance contributions, increases in real taxation on motor fuel until stopped in the wake of protests in 2000, sharp
real increases in council tax bills as central government tightened its
funding support for many local authorities, for example – but the main
feature was the absence of changes in the cynosure tax rates. The standard
rate of value-added tax had been changed twice under the Thatcher–Major governments – up to 15% in 1979, and up again, to compensate for
the revenue lost when council tax replaced poll tax in 1991, to 17.5%.
Throughout Blair’s decade, 17.5% is where it stayed. The standard rate of
income tax was lowered slightly (23% to 22%, with a pre-announced cut
to 20% to take effect in 2008), something that, in the twentieth century,
only Conservative or Conservative-dominated administrations had
achieved. The top rate of income tax, which had been cut from 83% on
earned and 98% on unearned to 60% and later 40% under Thatcher,
raising spirited Labour opposition at the time, was firmly held at 40%.
The main argument against a steeply increasing structure of marginal
income taxes is twofold.25 First, if everyone’s utility is to count in social
welfare, the top marginal rate should be zero right at the top. And second,
you can think of a high marginal rate on higher incomes, with lower rates
below, as providing a hefty implicit lump sum transfer to people with
large earnings. Such transfers are utterly unjustified on the grounds of
justice (it is the poor that need them far more) or efficiency (recipients of
transfers normally react by working less). In 1999, Brown experimented
with a low starting rate of income tax, 10%, but announced its forthcoming abolition in his March 2007 Budget. This was a very rare case of a
Brown bouleversement.
Previous Conservative governments had modified the main tax on
company profits, Corporation Tax (CT): allowances had been reduced to
accompany a reduction in rates; and the relatively generous tax treatment
of dividends, as opposed to retained earnings, became somewhat less
generous. Brown’s 1997 Budget continued these trends, reducing the
standard rate of CT, while trimming allowances and abolishing the dividend income tax credit for pension funds (which Norman Lamont, six
years earlier, had already reduced from 25% to 20%; Brown likewise completed his predecessors’ task of doing away with the last chunk of mortgage interest relief against income tax). Like the gold sales, this was
something that could in principle be defended ex ante, but, as matters
&nb
sp; turned out, proved unfortunate ex post. But unlike the gold sales, the politics of the issue was handled with too little explanation, not too much.
The case for lowering the tax rate and broadening the base was that the
tax system would be less distorted. Put another way, an ‘average’ person
could be presumed to benefit, sooner or later, at no loss to the Exchequer.
Any move to greater neutrality in taxation would generally tend to
achieve this, at least under suitable conditions. Lower rates and broader
bases were a Treasury aim discernible in Brown’s five Conservative predecessors as Chancellor, in the way they revised VAT, CT or income tax. Add
to this the old (Labour) view that discouraging dividend distribution
may spur companies into more investment, and one can see that Brown’s
‘pension credit raid’ appeared to make some sense from several standpoints.
25 The pioneering and immensely influential paper by J. A. Mirrlees, ‘An Exploration in the
Theory of Optimum Income Taxation’, Review of Economic Studies, 38, 1971: 175–208,
provides the key ideas here. See also A. B. Atkinson, Public Economics in Action: The Basic
Income/Flat Tax Proposal (Oxford: Oxford University Press, 1995), who argues in favour of
a flat income tax structure for similar reasons.
There is also an argument against taxing the return on capital at all.
Atkinson and Stiglitz26 demonstrate this, under particular conditions,
when people work when young, and consume when young and when
retired. Under rather different assumptions, with numerical simulations
calibrated on the US economy, Lucas27 shows that the permanent
removal of a tax on capital income would not just lead to higher capital
and output and consumption in the long run, but that the gains from this
would actually outweigh the early cost (in utility terms) when consumption has to drop to pay for the extra capital. And Kaldor28 had recommended an expenditure tax (a shift to taxing personal income net of
net saving) which turns out to have possibly even more appeal than
Lucas’s thought experiment. Arguments of this kind may have dissuaded
Brown from reducing or terminating the tax-exempt (voluntary) savings
schemes for individuals he inherited from Conservative predecessors. But
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