The most interesting thing about Labour’s new fiscal credibility rule is not the rule itself but the new thinking behind it, and what it signals.

John McDonnell has outlined a new budget methodology for Labour in power. It goes like this:

A Labour chancellor will have to show at every budget, according to Office of Budget Responsibility (OBR) calculations, that s/he can balance the books in five years’ time.

This applies only to current spending, not investment spending;

Therefore it’s entirely possible that Labour will run an overall budget deficit;

At the end of the parliament, debt will have to be lower as a percentage of GDP than at the beginning.

There’s another important bullet point but let’s leave it aside for now and analyse this.

The benefit of having a fiscal rule goes beyond the need to “convince the public” that Labour can be trusted with taxpayers’ money.

OECD governments in the neoliberal era have typically talked tough on debt yet run deficits in periods of growth, as well as during recessions. As a result overall debt has risen from 40 per cent of GDP in the 1970s to 80 per cent on the eve of the 2008 crisis.

There is, in other words, a “deficit bias” inherent in the way governments run free market economies – psychologically underpinned by the expectation of higher growth in the future and financial expansion. Governments of the left and right have metaphorically bought the Dukan diet book, but still kept a stash of Mars bars in their gym locker.

Academics Simon Wren-Lewis and Jonathan Portes explored in a paper (pdf) how a rule might optimally be designed to keep this under control, for a left government that believes in tax as the source of investment spending and redistribution. McDonnell has largely followed their conclusions.

The basic concept is to target the deficit on current spending over a rolling five-year period. This allows governments to respond to minor shocks by running a deficit now, while trusting to stimulus policies – higher spending, lower taxes, currency depreciation and lower interest rates – to correct the economy so that growth begins and borrowing to pay for current spending ceases.

This still allows borrowing for big-ticket infrastructure items to increase. And however you divide the deficit, this will still lead to a growing stock of debt.

So the biggest commitment McDonnell is actually giving is on debt: that it should be lower – as a proportion of GDP – at the end of a parliament than at the beginning.

This is significantly more than George Osborne achieved: Osborne took the debt from 54 per cent in 2009-10 to 78 per cent of GDP on the last OBR report.

But the most important thing about the plan as outlined is the potential change at the Office for Budget Responsibility. Moving the OBR out of Treasury control and turning it into a fiscal council, reporting to parliament is one thing.

The question is: what methodology will the OBR use?

Portes, for example, has criticised the OBR for consistently under-estimating the UK economy’s spare capacity – ie its ability to grow.

In addition, the OBR uses a relatively conservative measure when it comes to calculating the impact of fiscal stimulus or austerity on the economy – basically for every £1 cut from spending, the OBR thinks we get something like 50p off GDP growth.

Other methodologies are available. The IMF, for example, admitted that in the Euro crisis, the “multiplier” was significantly higher than 1 – meaning for every pound you cut, the economy contracts by £1.50 or more.

So if McDonnell as chancellor were to appoint someone like Portes as OBR chief the likely outcome would be a change in the OBR’s methodology.

It could, for example, move to a “fan chart” way of predicting the future that said: “If you run a deficit today, because you are borrowing to boost growth, then in 5 years’ time growth will be higher and your deficit will be wiped out. We can’t predict this with certainty but there’s a better than 50/50 chance we are right, so your deficit is allowable under the rule.”

The OBR current chooses to use Treasury methods when calculating the multiplier effects of fiscal policy. But if the Treasury were run by McDonnell, the methods there would be changed too.

Thus, the main takeaway from McDonnell’s speech this morning should not be the “rule”. It is that he’s giving himself considerably more scope in normal times to run a deficit – while at the same time reducing his absolute room for manoeuvre on debt, and making it dependent on the effectiveness of stimulus policies.

McDonnell – like others on the Labour left – was scarred by the illusory nature of Gordon Brown’s fiscal wizardry. Brown allowed the structural deficit to rise, moved his own goalposts, and played so fast and loose with budget reports that the arrival of the OBR felt to many of us like a truth and reconciliation commission.

Brown had run the Treasury as if – as his guru Greenspan had taught him – financial capitalism could expand forever. We don’t know whether Brown shared his mentor’s “shock” at finding “a flaw in the ideology” – because unlike Greenspan he has given no substantial account of his own time in charge.

Brown accepted the ultimate trade-off of third way neoliberalism. Britain would deindustrialise and move to a service economy, in which work became precarious and wages failed to keep up. But in return the booming financial sector would generate taxes to pay for family credits, and for extra spending on the NHS. Industry and vigour would never return to the old industrial communities of Britain but they would get Sure Start and child tax credits and a functioning NHS.

The current Labour leadership is determined to root its social justice policies in real growth, not financial froth. Today’s policy change reflects that, and McDonnell said it loud and clear in the speech.

Now for that crucial extra bullet point:

The whole rule-set outlined above can be suspended in times of acute crisis. Namely, when interest rates come close to zero.

Portes and Wren-Lewis are clear: when the central bank thinks there’s a 50 per cent chance of interest rates falling to zero...

“The fiscal authority should cooperate with the central bank in devising a fiscal stimulus package that is expected to allow interest rates to rise above this lower bound. This will imply a significant increase in debt, and the fiscal authority will at the same time need to demonstrate how its fiscal rule will change once interest rates are expected to rise again.”

By adopting this methodology, McDonnell has made a significant change to the “rules” followed both by Brown pre-2008 and devised by Ed Balls under the Ed Miliband leadership. His are the first set of fiscal rules that include a contingency plan for severe crisis.

Thus McDonnell is the first Labour Treasury chief in a generation to recognise that, in a period of acute stagnation or financial collapse, fiscal and monetary policy become fused.

If you cut rates to zero and have to print money there is a clear fiscal upside: the government can borrow at rates close to zero, or even negative interest rates. It gets a windfall if – as at present – the Bank of England passes interest on the bonds it holds straight back to the Treasury.

I read today’s speech as a signal that the economic policy of a future Labour government will rely heavily on state-directed investment (industrial policy) and where necessary monetary stimulus as well as fiscal expansion.

Labour is already well down the route of designing an industrial policy, guided by figures like Mariana Mazzucato, Joe Stiglitz and economists from the CRESC project at Manchester University.

So the missing piece of the next Labour government’s strategy is monetary policy.

As chancellor McDonnell would have the leeway to command the Bank of England, for example, to hit a 4 per cent inflation target, not 2 per cent. This 4 per cent target is being advocated today by a wide range of economists in the face of the current slowdown.

That would force the Bank to significantly raise quantitative easing (QE), or to pursue other unorthodox measures, like clear time-projections for zero interest rates, or buying up the debts of companies, mortgage lenders or student loans or even company shares.

Most of Labour’s thinking has been obsessed with fiscal policy, since both the right and left of the party wants to put the Brown legacy behind them; and because Labour’s economic traditions going back to 1931 are fiscally biased.

But until we see Labour’s thinking on monetary policy we don’t have even half the story.

All governments have explicit and implicit monetary policies – notwithstanding the independence of the central bank. The problem is, on a global scale, monetary policy is running out of steam.

In their worst nightmares, central bankers are beginning to ask whether QE was – instead of a bridge between two crises – a “pier” leading to the high jump into a sea of stagnation.

The pressing economic question for Labour – not just in 2020 but now – is: what would you do about that?