Liz Truss’s tax cuts are not inflationary – The Telegraph

The Conservative leadership contest has revolved around Liz Trusss challenge to the Treasury orthodoxy that Rishi Sunak has embraced; I very much agree with her challenge. Unfortunately my arguments - and hers - have been misinterpreted, not least by the former chancellor in Mondays BBC debate. Mr Sunak wrongly claimed that I had argued that Ms Trusss policies would mean that interest rates would have to go up to around seven per cent.

The Truss programme centres on promoting growth through supply-side reform - including cutting regulation and lowering taxes. To make it work, there has to be government borrowing to finance any temporary excesses of spending over tax revenues. This tax-smoothing function of borrowing has to be consistent with the long run constraint that the debt ratio must come down again to a safe level of around 50 per cent. Spending will then match tax in the long run.

Short run fiscal rules can obstruct the vital tax-smoothing function of debt and borrowing, They produce policies such as the damaging proposed rise in corporation tax. Ms Truss rightly wants to reverse it, together with the wage-cost boosting rise in National Insurance contributions.

Fiscal deficits - the current balance of government spending minus revenue - can be used to regulate demand in the economy. What the Truss programme proposes is that this should be used to stabilise output, going up when recession threatens and down in booms. Today rising interest rates threaten a recession. Tax cuts can support demand and thus avert it.

Monetary policy has the job of controlling inflation, mainly by moving interest rates around but also by directly printing or reducing money through buying or selling market-held bonds. Currently, with inflation close to double digits, the Bank of England is raising interest rates. It is having to decide continuously how far to raise them to get inflation back down to its two per cent target; the Banks money tightening or loosening responds to inflation and output.

Research shows us that in modern economies the most successful policies for stabilising inflation, output and interest rates are a combination of a fairly tough monetary policy with a fiscal policy that stabilises output. This is because then people and firms know that inflation will not be tolerated, so they act to restrain their wages and prices; but they also know that recession will be avoided so they keep on spending in a way that keeps growth on course. This stops inflation from rising too much and also stops output from slumping. It keeps interest rates stable - with the Bank not needing to raise them too much when inflation shocks hit and not being pressured to lower them to zero as it did (with bad side-effects on saving and the survival of zombie firms) after the financial crisis.

So the Truss programme promises greater stability in output, inflation and interest rates. A fiscal policy that supports the economy now is not inflationary and would not push up interest rates. The opposite is true: by reinforcing the Banks freedom to get on top of inflation, it contributes to both lower inflation and lower interest rates. This is why my research group is forecasting that next year the economy will keep growing, inflation will come down to around five per cent and interest rates will rise to around three per cent.

Why are the Treasury, Rishi Sunak and a lot of City economists so against these ideas? Their minds are closed to the findings of research into the modern economy, which have highlighted the effects of government policies on productivity and growth (endogenous growth); and which also have explored how policy rules affect private agents behaviour through their expectations and best responses (optimal policy).

Sadly, most City economists do not do this research themselves. Their models, if they have any at all, are simply adding-up programmes into which they put some air-plucked numbers. The Treasury has disengaged from research on the economy and left it to the Bank; the OBR does no modelling research. This all needs to change. The first priority is to get policies right. Ms Trusss programme does just that.

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Liz Truss's tax cuts are not inflationary - The Telegraph