Quantitative Easing and Fiscal dominance

Unfortunately I cannot find the written source (if any exists), but I am sure I have heard Mervyn King say, probably before he became Governor, that the one thing central bankers hate more than inflation are budget deficits. One rationale for this attitude is that central banks see themselves as playing a game with the fiscal authorities. Governments may be tempted, because they are not benevolent, to occasionally ignore debt when setting fiscal policy. If the monetary authority monetises that debt, this behaviour may be encouraged. This matters because an outcome where the fiscal authority always ignores debt is very bad.
 (It is very bad if the central bank gives in, because it will lead to inflation. If the central bank does not give in, it is very bad either because it leads to a debt explosion and default, or – if you follow the Fiscal Theory of the Price Level - because you get inflation anyway. I do not think it matters in this context which bad it is – see McCallum and Nelson for an example from this debate.)

If we want to prevent this very bad outcome, so the argument goes, it is important that the monetary authorities do nothing to encourage this fiscal policy behaviour. In purely macroeconomic terms, there may well be occasions when it is efficient to use interest rates to help reduce the debt stock – particularly when the debt stock is high. One half of what I call the consensus assignment – that monetary policy should have nothing to do with debt control – therefore needs to be justified by arguments with a more political economy flavour. This particular political economy argument is the one I helped put forward in more detail here.

This concern about not doing anything to encourage ‘fiscal indiscipline’ is likely to be particularly acute at the moment because of Quantitative Easing. Printing money at a time of large budget deficits can be interpreted as fiscal dominance, so it becomes all the more imperative that the monetary authority draw a line in the sand by insisting that QE is temporary, and reinforcing that by sticking rigidly to their inflation targets.

The trouble is that what the world economy needs right now is a bit of what looks like fiscal dominance. (Brad DeLong thinks along similar lines here.) We need a temporary increase in inflation above target. As I have argued before, by focusing on inflation, and ignoring the output gap, central banks are not maximising social welfare as we normally understand it. So how do you convince central banks that their concern about fiscal dominance needs to be set to one side?

One of the potential strengths of the UK monetary policy regime is that you do not have to. The inflation target is set by the government. As I have said before, I do not know why the UK government (and the opposition) is not even thinking about changing the 2% target. If the answer is that it would be politically too difficult to sell, that becomes a very strong argument against democratic control of macroeconomic policy!

 Where central banks do have control of the inflation target, one argument that could be used is that it is quite unusual for governments to persistently and completely ignore debt when setting fiscal policy (see this research for example). Unfortunately I do not think this line will be very persuasive. Quite unusual does not mean never: see Greece most recently. Even in the US, when a good part of one of the main political parties shows a similar disrespect for numbers and facts as some in the Greek government showed before 2007, anything is possible.

The argument I would use with central bankers is this. Fiscal dominance becomes a problem when the output gap is zero or positive, and not when we have demand deficiency. So allow inflation to rise conditional on the existence of a significant negative output gap (or high involuntary unemployment). This could be done through a nominal GDP target, but it does not have to be done this way.

As regular readers of this blog will know, one of my persistent themes is that with fiscal policy we should separate short term issues of stabilisation from long term issues of debt control. Having a fiscal stimulus in a liquidity trap need not compromise long term fiscal discipline. When the long term problem gets mixed up with short term stabilisation, we get bad results. Exactly the same is true for monetary policy and long term fiscal policy: we should not let an obsession about fiscal discipline distort what we do on short term stabilisation. Central bankers understand that questions of moral hazard have to be put to one side in a banking crisis, so why is it so difficult to see that the same point applies in a macroeconomic crisis?