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Portillo: Five Disciplines for Macro-economic Policy

Today I want to set out the framework of disciplines within which macro-economic policy would work under a Conservative government. I would also like to set out some radical ideas that would enable Britain during coming decades to meet many of the aspirations of the British people for better services and financial security, whilst keeping the burden of taxation at a level that can compete with other economies.

"Five Disciplines will apply to the next Conservative Government.

"First, we will have our own currency and interest rates will be set in Britain.

"Second, we will enhance the independence of the Monetary Policy Committee of the Bank of England.

"Third, we will establish a Committee of Economic Advisers to provide public advice to the Chancellor on the appropriateness of the government's fiscal stance.

"Fourth, we will appoint a National Accounts Commission to draw up proper national accounts, including a proper presentation of the government's long term liabilities.

"Fifth, as William Hague and I said in speeches last week, the growth of government spending will be restrained to within the growth rate of the economy as a whole.

The Global Economy

"Guiding all our policy-making is a clear appreciation that in a highly-competitive global economy, each country's economic policy mix is completely transparent. Investors make their judgments on the basis of virtually limitless data. There is no hiding place for bad policy, and policy errors will be punished rapidly by a desertion of capital and talent.

"The Labour government likes to claim that it has established a framework of rules governing its economic policies. On closer examination, those rules are less convincing than the claims made for them. In any case, global economic conditions over the last three-and-a-half years have been quite benign. We need more rigorous disciplines and ones that are more likely to serve in more adverse world economic circumstances.

Maintaining our own currency

"It is central to economic policy to know whether Britain is to have its own currency or not. The fact that the Labour Party doesn't know whether in the next parliament it would keep or scrap our autonomous monetary policy is a glaring gap at the heart of their economic policy.

"I will here mention just two economic reasons for believing we should remain outside the euro. First, the euro requires not just a single currency but also a single interest rate. The one-size-fits-all approach to interest rates causes problems. Since Europe's economies have not converged, the single interest rate may be quite wrong for some places. Presumably, both Ireland and Spain would have higher interest rates today to combat inflation, if they still had authority to set their own rates. Having the "wrong" interest rate is one of the most serious policy errors that can occur.

"Second, it is vital for us in a global economy to maintain maximum agility. We need to be able to change tax rates - for example - in response to competitive pressures from abroad. At present the Chancellor has the ability to change taxes instantaneously, by going to the House of Commons. My worry is that if we entered the single currency we would soon lose that agility. Remember that the European Union is proposing not merely a single currency, but economic and monetary union. Europe has so far shown itself often to be cumbersome and bureaucratic. Look at the Common Agricultural Policy. I have no confidence that a common economic policy would be anything like flexible enough to respond in a timely way to changing external circumstances.

"Maintaining our own currency will impose important disciplines on us. Movements in the pound will reflect on the quality of economic policy in Britain. Policy errors are likely to be reflected in currency volatility. We will have to make timely policy adjustments to changing economic circumstances. We will not have the luxury that some countries in the eurozone might feel, of being absolved from having to take action on the basis that responsibility for monetary policy has been ceded to the European Central Bank in Frankfurt.

"None the less, whilst remaining outside the euro provides Britain with necessary flexibility, I believe we should pursue policies that are prudent and transparent. I am therefore keen to increase the disciplines that we impose upon ourselves in order to increase the transparency of policy-making and the confidence that can be placed in it.

Independence of the Bank of England

"I thoroughly welcome the independence of the monetary policy committee of the Bank of England. But I believe we should enhance that independence as well as better define its accountability to parliament. Again we must be aware that the new arrangements have not been tested in difficult conditions. Now is the time to think about how we can improve on what the government put in place in a hurry and without consultation. The Conservative Party appointed a distinguished commission on the Bank and we will be guided by the findings, which were published earlier this year.

"It must be made clear that the responsibility for setting the inflation target rests with the Chancellor of the Exchequer, who is responsible to parliament. The MPC is required to make the interest rate decisions necessary to achieve the Chancellor's target. In the event that the target is missed - because of some major systemic shock - in our view it is the Chancellor who should prescribe the path of intermediate inflation targets that must lead back towards the long-term inflation target.

"There is little guarantee under present arrangements that the members of the MPC will necessarily be independent or the right people, though I have no complaints about those who have actually taken up positions. For there to be greater confidence in the process, the members should be appointed following a fully transparent procedure. To emphasise that they are not beholden to any government, their term of appointment should be longer than a parliament, and there should be no reappointment. They should report to a special committee of parliament on the manner in which they have carried out their duties.

"The MPC should be encouraged, if it sees fit, to comment on whether it would have made different interest rate decisions had the fiscal stance been different; in other words the members should be entirely free to comment on any inconsistency between monetary and fiscal policy.

"I believe the Chancellor's inflation target of two-and-a-half per cent to be appropriate at present. There is a range around it, and if the MPC goes outside the range it is required to write to the Chancellor to explain how that situation has arisen and how it will be corrected. We think that appropriate too. But if the MPC continues to undershoot the inflation target, we will have to consider both whether to lower the target and whether to narrow the range.

A Council of Economic Advisors

"There is at present a certain asymmetry between the presence of an independent body able to comment from a monetary perspective, and the absence of any such body on the fiscal side. We propose to establish a Committee of Economic Advisers - a sort of fiscal policy watchdog.

"This Chancellor of the Exchequer has done little to build up confidence that he can be trusted accurately to present the fiscal balance. He has disguised tax increases, and described certain items of public spending - such as payments under the working families tax credit scheme - as though they were reductions in tax, and has been criticised for it by both the OECD and the Office of National Statistics.

A National Accounts Commission

"The Chancellor claims to have two rules. The first, the sustainable investment rule, is not much mentioned these days, and the reason for that is clear. The precise description of the rule makes it clear that it isn't much of a rule at all, since it states that "other things being equal, a reduction in public sector net debt to below 40 per cent of GDP over the economic cycle is desirable". The qualification other things being equal makes it a far from rigorous rule.

"The second rule is the so-called golden rule. This states that over the economic cycle the government will borrow only to invest. Of course without any definition of investment and with no limits on that so-called investment, the rule doesn't translate into any sort of discipline at all. The government's spending review proposes raising 'net investment' to 1.8 per cent of GDP by 2003/4 and envisages that it could remain at this level thereafter. If net investment were to be 1.8 per cent of GDP in each year of say, a seven year cycle, then the government could borrow £160 billion without breaking the rule. If the government were to interpret investment as including all capital spending, then the figure for permitted borrowing would rise to £300 billion.

"Clearly, these two much-bruited rules do not in fact impose any discipline. It may be that any rules of this sort would suffer from the same drawbacks - either unachievable in a recession, or so loose as to be meaningless.

"What is needed by way of effective discipline is peer group review. Nothing could give greater confidence to the conduct of policy than for a Conservative Chancellor willingly to subject himself to public review and commentary by independent experts appointed, like the MPC, after a suitably transparent procedure. Like the MPC the Committee of Economic Advisers would publish minutes of their proceedings and be invited to comment on the consistency of fiscal and monetary policy, but their prime task would be to give a published opinion on the appropriate level of fiscal surplus or deficit.

"The Chancellor would not be obliged to act in accordance with the Committee's views, but clearly their opinions would carry weight and apply pressure, perhaps especially if over time its track record looked superior to the Chancellor's.

"There can be no discipline worth the name unless there is transparency, and that includes absolute precision about the components of the national accounts. It is quite wrong that the government should be free to define and re-define items as being public spending, or something different. Such definitions should be removed from the sphere of political decision-making. A National Accounts Commission should be established to take on that task.

"More broadly, it should draw up a proper balance sheet for the public sector. It may be a surprise for some to learn that the government is not bound by conventions and rules that apply to every public company - for example to account properly for the liabilities that it has incurred.

"The National Accounts Commission members would be drawn mainly from the accountancy profession, and their appointments would be handled through a transparent procedure. The creation of the Commission would add powerfully to the credibility of government information about the economy, and remove from the Chancellor any temptation to deceive himself about the balance of taxation and spending.

Government spending to rise within the growth rate of the economy

"The fifth discipline is that government spending should grow within the growth rate of the economy. This is the only genuinely sustainable policy that a government can pursue.

"The present government is committed for the next three years to increase government spending at 3.4% a year at a time when the underlying growth rate of the economy is between two-and-a-quarter and two-and-a-half per cent. The government needs to answer this question. Is this a policy for three years only, to be succeeded by a return to sustainable growth thereafter? That would mean turning on and then turning off the tap - which would be a bad policy of boom and bust. Or is the government committed to raising government spending faster than the growth rate of the economy even after the three year period, in which case taxes will clearly have to rise year after year?

"In either case the private sector will be subjected to crowding-out. The government will not wish to see economic growth faster than about two-and-a-half percent, so as not to risk overheating. But since the government controls 40 per cent of the economy, if that 40 per cent is planned to rise by 3.4 per cent, it follows that the 60 per cent in private hands must rise by less than 2 per cent. Government policy, by the use of tax and interest rates, is to restrict private sector growth to below 2 per cent.

"This would be a regrettable policy in any case. But it is particularly unfortunate since the rapid change in the pace of government spending is likely to lead to taxpayers' money being spent very inefficiently.

"Even if the government intended to revert to a sustainable policy after three years, it would find it difficult to do so once expectations had been raised and departmental budgets had swollen.

"I see no justification for this policy. Our economy is worth about £1000 billion today. A two-and-a-half per cent annual growth rate gives the nation an extra £25 billion of prosperity each year, enough for any government both to increase markedly government spending on public services, and to reduce taxes, leaving some of the extra prosperity in the hands of the people who created it.

"Put another way, the government proposes to raise government spending by £70 billion over three years. If it were to rise £62 billion, there would be significant increases in government spending on public services, accompanied by reductions in tax for those groups such as families and pensioners who are now paying too much tax.

"Last week William Hague and I described how we would modify the government's plans for increases in government spending so as to bring the growth rate down to within the growth rate of the economy over the second and third years of the comprehensive spending review period.

The conundrum ahead

"Although Labour is evidently committed to raising taxes, there are likely to be real constraints, at least in the medium term, on how much governments will actually be able to increase the tax burden. They will face increasing taxpayer resistance and an erosion of the tax base.

"We can see those forces at work today. Political pressures led the Labour Party to pledge itself not to raise the rates of income tax. The last Conservative government faced such a storm of protest when it extended the scope of VAT, that it seems unlikely that any government could propose such an extension in future. Stamp duty on shares and gambling duty are taxes that will be eroded as business moves via the internet to jurisdictions with lower rates of tax. We have seen the way that large numbers of people are avoiding high rates of British duty on alcohol and tobacco by buying abroad or in the grey market. Protests by taxpayers across Europe against the level of duty on petrol and diesel showed taxpayer resistance at its clearest, and make it hard for the government to raise extra sums there. I am pleased to say that governments cannot count on being able relentlessly to increase the tax burden on their people.

"None the less, it is clear that people wish to receive higher quality services and that they look for better financial and social security. The challenge for leaders is to find ways of satisfying those demands and concerns at a time when raising taxes is difficult and anyway undesirable.

"The Conservative Party is looking to the future and has proposed three options that directly address that conundrum, and which would lead to a radical change in the role of the state.

Properly funded retirement pensions

"Proper national accounts drawn up by the National Accounts Commission would reveal the true extent of the liabilities that the government has incurred to pay retirement pensions in the decades ahead. Once those liabilities have been highlighted, we can discuss whether we should take steps to relieve or eliminate them.

"At present retirement pensions are paid for on a pay-as-you-go basis: this year's pensions are paid out of national insurance contributions paid this year by those in work and their employers. The contributions are never invested, and so never grow. The pensions paid are consequently meagre.

"We would wish to give young people the option of paying their contributions into a fund that would be invested and grow until their retirement. That would be likely to provide future generations of pensioners with much better pensions. It would also over time sharply reduce the burden on future generations of taxpayers. We wish to consult widely on this proposal.

Endowed universities

"We have also proposed that in future if the government benefits from windfall receipts, for example from further sales of the bandwidth spectrum, those receipts should be used to endow some of our universities. I believe this would be a highly efficient use of money as we could expect such major grants, and such an important change in the status of universities, to attract large sums of private sponsorship and donation. Endowed universities would no longer depend on a drip feed of money from the government.

"One effect would be to reduce the size of the state and the level of government spending. Another would be to enable our universities to play a much more dynamic role in the economy, perhaps akin to the huge contributions made to the US economy by Stanford, Harvard or MIT.

A mixed economy in health

"Our third idea concerns health care. We have established a political consensus with the Labour Party on providing very significant additional funds to the National Health Service. But we believe that that shouldn't be the end of the discussion. Very few countries attempt, as Britain does, to bear almost the entire cost of health care on taxation alone.

"The signs are that it is very difficult to place such a huge weight of spending on a single financial leg - on taxation alone - and that is why Britain has fallen far behind others in the proportion of national wealth devoted to health spending.

"Our near neighbours in Europe have more mixed systems: for example, employers' and trade union health care schemes play a much more significant part in the total health budget. Such mixed systems have enabled other countries to spend significantly higher proportions of their national prosperity on health care. Conservatives believe that we should seek to supplement the extra investment going into the NHS by encouraging a more mixed supply of resources, thus increasing the total amounts spent by the nation on health, enabling us to have more doctors, nurses and hospitals.


"The Conservative Party has a very clear economic policy. Our macro-economic approach is defined by Five Disciplines which greatly increase the transparency of government policy-making, and significantly increase the discipline under which a Conservative Chancellor would perform. The last of those disciplines - constraining the rate of growth of government spending - is necessary not only to restore Britain's competitiveness, but also because we should in any case assume that the tax base will be constrained.

"Conservatives recognise that in order to match the public's expectations for better public services with the need to bring taxes down, radical changes must be made to supplement the role of the state. The plans we have for pensions, universities and health care show that we are thinking ahead, well outside the confines of a parliamentary term, proposing changes that will take effect over a long period. These are policies suited to the demands of the 21st century.

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