I’ve been away and busy at the IMF, so did not respond
immediately to this speech
from ECB Executive Board member Benoît Cœuré on the new
OMT policy. In econblog terms, the speech would be described as wonkish, but I
think the ideas I want to focus on are reasonably intuitive. They are worth
exploring, because they illuminate the key issue of conditionality.
In a classic paper, Eric Leeper
distinguished between active and passive monetary and fiscal policies, within
the context of simple policy rules. The concept of an active monetary policy is
by now familiar: monetary policy should ensure that real interest rates rise
following an increase in inflation, so that higher real interest rates deflate
demand and put downward pressure on inflation. Leeper’s use of active and
passive for fiscal policy is a little counterintuitive. A passive fiscal policy
is where, following an increase in debt, taxes rise or spending falls by enough
to bring debt back to some target level. If neither taxes nor spending
respond to excess debt, debt would gradually explode as the government
borrowed to pay the interest on the extra debt. This is the extreme case of
what Leeper calls an active fiscal policy.
Now you might be forgiven in thinking that the only policy
combination that would bring stability to the economy was an active monetary
policy (to control inflation) and a passive fiscal policy (to control debt).
This would correspond to what I have called
the consensus assignment. However Leeper showed that there was another: an
active fiscal policy combined with a passive monetary policy. A simplified way
of thinking about this is that it represents the opposite of the consensus
assignment: fiscal policy determines inflation and monetary policy controls
debt, because debt becomes sustainable by being reduced through inflation. This
idea, which became known as the Fiscal Theory of the Price Level (FTPL)[1],
is very controversial. (For once, divisions cut across ‘party’ lines, with John
Cochrane and Mike Woodford both contributing to the FTPL.) However for current
purposes you can think of the FTPL policy combination as being a form of fiscal
dominance. You can also think of this combination as being inferior to the
consensus assignment from a social welfare perspective (see this post).
So why did Cœuré invoke Leeper’s definitions of active and
passive in his speech? To quote:
“central bank independence and a clear focus on price stability are necessary but not sufficient to ensure that the central bank can provide a regime of low and stable inflation under all circumstances – in the economic jargon, ensuring “monetary dominance”. Maintaining price stability also requires appropriate fiscal policy. To borrow from Leeper’s terminology, this means that an “active” monetary policy – namely a monetary policy that actively engages in the setting of its policy interest rate instrument independently and in the exclusive pursuit of its objective of price stability – must be accompanied by “passive” fiscal policy.”
Now OMT involves the ECB being prepared to buy government
debt in order to force down interest rates so that fiscal policy becomes
sustainable. To some that seems like fiscal dominance: monetary policy is being
used in a similar way to the FTPL, in order to make debt sustainable. Cœuré
wants to argue that with OMT we can get back to the consensus assignment,
because OMT will allow fiscal policy to become passive again.
Now current fiscal policy in the Eurozone can hardly be
described as ignoring government debt, as in the polar case of active fiscal
policy outlined above. However, for fiscal policy to be passive it has to
counteract the tendency for debt to explode because of debt interest payments.
If interest rates are very high, because of default risk, this may require
destructive and perhaps politically impossible rates of fiscal correction. In
other words, default risk forces fiscal policy to be active. Although this
problem is just confined to one part of the Eurozone, as Campbell Leith and I
showed here,
this is sufficient to force monetary policy to become passive if it wants to
preserve stability.
I think this is a very clever way of describing OMT to those
who believe this policy goes beyond the ECB’s remit. OMT is necessary to allow
fiscal policy to become passive in countries subject to significant default
risk, and therefore for monetary policy to ensure price stability. The
argument, like the FTPL, is controversial: many of those who dislike the FTPL
would argue that an active monetary policy is sufficient to ensure price
stability. This analysis also ignores the problem of the Zero Lower Bound (ZLB)
for nominal rates, which one could reasonably argue forces monetary policy to
become passive. For both reasons I did
not use this argument in my post
on conditionality, but without length constraints I would have.
I want to make two final points which Cœuré does not. First,
a feature of passive fiscal policy at ‘normal’ (largely default risk free) levels
of real interest rates is that debt correction does not have to be very rapid,
and as Tanya Kirsanova and I show here,
it should not be very rapid. Almost certainly the speed of debt correction
currently being undertaken in periphery countries is more rapid than it needs
to be to ensure a passive fiscal policy at normal interest rates. The current Eurozone
fiscal rules also probably imply adjustment that is faster than necessary. As a
result, no additional conditionality is required before the ECB invokes OMT. Second,
this analysis ignores the problem of the ZLB, which is as acute for the
Eurozone as it is elsewhere. Cœuré says that OMT is not Quantitative Easing
(QE), but does not explain why the ECB is not pursuing QE. It has taken the ECB
about two years too long to recognise the need for OMT – let’s hope that it
does not take another two before it realises that for monetary policy to stay
active in the sense described above, it also needs QE.
You can also think of this combination as being inferior to the consensus assignment from a social welfare perspective (see this post).
ReplyDeleteI read the post, and it argued for slow adjustments. Is that the sense that this policy is inferior -- because the active policy needs to be nimble? In that case, as much of the budget deficits are due to reduced revenues and increases in benefit payments, should we raise tax rates during downturns in order to have more slowly changing deficit stances?
But if I am misreading the reason why fiscal dominance is generally inferior to monetary dominance, then please specify the reasons.
When I read it, I assumed the reason is that increasing government expenditure has diminishing marginal benefits (the 101st school doesn't give as much benefit as the 100th) and increasing tax rates has increasing marginal costs (deadweight costs of distortions increase roughly with the square of the tax rate), so we generally want to smooth both G and t over time.
DeleteBe interesting to see if Simon gives (roughly) the same answer.
(I had to click the link to learn what "OMT" meant. "Outright Monetary Transactions" = buying government bonds in the secondary market. All the new names we are learning for what we used to call "Open Market Operations" (except OMT is a sterilised OMO, presumably via banks).)
When I read it, I assumed the reason is that increasing government expenditure has diminishing marginal benefits
DeleteOK, but
1) Reductions in risk free rates also have diminishing marginal benefits, in the sense that risk premia go up as risk free rates fall
2) Cutting nominal rates "works" to cut real rates because of price rigidities, but the same rigidities should work to allow nominal income flows to work, without needing to build any schools at all. E.g. the government can purchase unused labor output or unused consumption goods, or goods that are not newly produced (e.g. land).
Separating fiscal from monetary policy makes little sense for the following reasons.
ReplyDelete1. Interest rate cuts and QE are distortionary: they skew spending towards investment, and for no good reason.
2. There is no relationship between central bank base rates and credit card rates.
3. The lags involved in monetary policy are roughly the same as for fiscal.
4. In the case of the UK (but not the US), interest rate cuts and QE withdraw monetary base from the private sector because half of BoE profits are not returned to the Treasury: they disappear into a black hole in the BoE. Thus interest rate cuts and QE are possibly DEFLATIONARY.
5. There are a HUGE NUMBER of costs associated with any investment (energy consumption, associated labour costs, etc).Thus the effect of say a 2% change in the base rate is near irrelevant.
6. At the start of a recession, there is a SURPLUS of capital equipment. Thus more investment is exactly what is NOT needed.
7. The Radcliffe report in the 1960s poured cold water on interest rate adjustments.
8. The effect of interest rate adjustments is countered by flows of foreign exchange into and out of the country.
9. Interest rate cuts exacerbate bubbles.
10.QE increases inequalities.
Now can someone give me a similar list of simple clear reasons for SEPARATING fiscal and monetary policy?