Winner of the New Statesman SPERI Prize in Political Economy 2016

Tuesday 16 July 2013

Fiscal backing

In an earlier post I went through the logic of why we do not think higher government debt necessarily causes inflation, even if that debt is denominated in nominal terms, as long as the central bank does not monetise that debt. As I argued there, talk of monetisation is largely unnecessary: we just need to say that the central bank uses interest rates to control inflation, and can therefore offset the impact of any increase in government debt.

However, as Mervyn King said, central banks are obsessed with budget deficits. This seems to contradict the previous paragraph. Are there some ways in which central banks would either lose the power to control interest rates, or be forced to abandon any inflation targets, as a result of fiscal policy? 

In the previous post the thought experiment I considered was a sustainable increase in the level of government debt. By sustainable I mean that the fiscal authorities raise taxes (or cut spending) to service this higher level of debt. But suppose they do not: suppose the budget deficit increases because spending is higher, but there is no sign that the government is prepared either to cut future spending or raise taxes to a sustainable level.

In 1981 Sargent and Wallace published a well known paper which said that, in this situation, the central bank could in the short term control inflation, but in the longer term inflation would have to rise to create the seignorage to make the government budget constraint balance. In other words, to keep the economy stable the central bank would eventually be forced to monetise. This was later generalised by the Fiscal Theory of the Price Level (FTPL). If the government did not act to stabilise debt itself (which Eric Leeper called – a little oddly - an active fiscal policy, and which others - including Woodford, Cochrane and Sims - have called even more confusingly a non-Ricardian policy [1]), then the price level would adjust to reduce the real value of government debt. Fiscal policy determines inflation.

One of the critiques of this theory is that the government budget constraint appears not to hold at disequilibrium prices. See, for example, Buiter here, and a response from Cochrane. I do not want to go into that now. Let’s also concede that if the monetary authority does either follow a rule that allows the price level to rise (by fixing the nominal interest rate for example), or tries to move interest rates to both stabilise debt and inflation (as in my recent paper with Tatiana Kirsanova), then the FTPL is correct.

The case I want to focus on here is where the central bank refuses to do either of those things, but carries on controlling inflation and ignoring debt. Suppose the government is running a deficit which is only sustainable if we have a burst of inflation which devalues the existing stock of government debt, but the central bank refuses to allow inflation to rise. You can say it does this by fixing the stock of money, or by raising the rate of interest - I do not think it matters which. This is an unstable situation: interest payments on the stock of debt at the low price level can only be paid for by issuing more debt, so debt explodes. In this situation, we have a game of chicken between the government and central bank.

Now the game of chicken would probably end when the markets refused to buy the government’s debt. That would be the crunch moment: either the central bank would bail the government out by printing money, or the government would default, which forces it to change fiscal policy. But in Buiter there is an elegant equilibrium outcome: the market just discounts the value of debt by an amount that allows the central bank to set the price level, but for the government’s budget constraint to hold at that price level. We get partial default. This discount factor becomes the extra variable that solves for the tension that both fiscal and monetary policy are trying to determine the price level.

You could quite reasonably suggest that such a central bank could not exist, because the government has ultimate power. It can always instruct the central bank to monetise the debt. However suppose the central bank actually managed the currency for a whole group of nations, and could only be instructed to do anything if they all agreed to do so. Furthermore that central bank was located in the one country in that group that would never contemplate monetisation, so it would be immune to pressure ‘from the street’. That central bank should be pretty confident it could win any game of chicken. [1]

Has any of this any relevance to today’s advanced economies? It seems to me pretty clear that these governments are not playing any game of chicken. Quite the opposite in fact: they are being far too enthusiastic in doing what they can to stabilise debt, despite there being a recession. So we certainly do not seem to be in a FTPL type world. Instead monetary policy right now retains fiscal backing.

Yet in a way we are having the wrong conversation here. Rather than trying to convince central banks that their fears are groundless, we should be asking whether monetary policy should – of its own free will – raise inflation to help reduce high levels of debt. I agree with Ken Rogoff that it should, and have argued the case here. Yet however optimal such a policy might be, the chances of it happening in today’s environment are nil. It looks like we may have to go through a lost decade before we are allowed to contemplate such things. 

[1] I guess a rationale for calling this fiscal policy ‘active’ is that stable regimes in Leeper require one partner to be active and the other passive. So in the normal regime monetary policy is active and fiscal passive, and this flips in a FTPL regime. In a FTPL regime, Ricardian Equivalence no longer holds (because taxes are not raised following a tax cut) – hence the label non-Ricardian.

[2] In this situation, would buying that government’s debt ‘show weakness’ in the game? If we follow Corsetti and Dedola and treat reserves as default free debt issued by the central bank rather than money, then not at all. Instead the central bank is giving the fiscal authority the best chance it can to put its house in order, by removing any bad equilibrium, but it retains the power to force default at any point. We no longer have Buiter’s method of resolving that game, but only because the central bank has the means which could force a win. As long as the government believes that the central bank would prefer the government to default rather than see inflation rise, the government should back down.


  1. Clearly pricing in will take place. But for both existing debt as for still to be issued debt (mainly most likely roll overs and not 'new' (extra) debt).
    And pricing in will happen earlier. It will happen when markets see that that it is a possible outcome (and it will get worse when that outcome is more disastrous or more likely).
    It is likely (but not necessarily) an event in several steps (and subsequently so likely will be government's readjustments). For old debt likely the lendors bears the burden, but for new debt (including roll overs) the government is on via higher interest demands.

    On government ordering (basically mainly the UK). In most other countries CBs have their mandate via formal law. Which also requires parliaments to approve the ordering (as it likely should be by way of change of legislation(a problem at the moment in the US).

    Look at what happened with bondprices when the FED increased its inflationtarget a half year ago or so.
    Look at what happens in Japan with yields just the last months (becasue of an increased inflation target).
    And basically the 'taper' it starts to look like the FED has partly lost its grip on interestrates (while inflation doesnot looks to be a problem).
    Probably caused by the fact that there are several unbalances at the same time. Which makes efective policies very difficult. In that respect it is clear to see why CBs donot like at all unbalances it is difficult enough already to control interest and inflation under 'normal' circumstances.

  2. Another thought experiment: Suppose the Mexican central bank has issued 100 pesos, against which it holds US bonds worth $100, so that 1 peso=$1. If the US runs big deficits, and US bonds lose half of their real value, then the peso will lose half of its real value. The central bank's fear of US deficits is well-justified, and of course its actions will have no effect at all on US debt.

  3. The irony is that inflation targets should have taken the politics out of economic stabilisation, whereas in fact governments have been shown in the UK and US to have gained electoral support for damaging the economy early in their electoral cycle, turning the whole process into a psychodrama, and then allowing the economy to grow by not doing what they were doing previously!

  4. Prof Simon,

    I followed your Mervy King links and discovered that his reason for backing austerity was, to quote, that “the steady reduction in the very large structural deficit over a period of a parliament cannot credibly be postponed indefinitely”. (Lord Mayor’s Banquet speech, 2010).

    That’s a bit like saying that on a car journey, applying the brakes and bring the car to a halt cannot be postponed indefinitely, ergo the brakes should be applied now.

    The time to apply the brakes is when the objective of the journey has been achieved: arrival at the destination. And the time to cut the deficit is when the deficit has achieved its objective: full employment. The size and duration of the deficit needed to achieve that is irrelevant. Or as Keynes put it, “Look after unemployment and the budget looks after itself”.

    Keynes was right and King was wrong.

    As to King’s claim that “central banks are obsessed with budget deficits..”, in the US, it’s Congress that suffers from deficit phobia rather than the Fed, isn't it?

  5. The actual irony is that the cost of living targets needs to have obtained the particular national politics beyond fiscal stabilisation, whilst in fact governments are said in england and also All of us to have obtained electoral help pertaining to damaging your economy at the outset of their particular electoral routine, switching the complete process right into a psychodrama, and then enabling the economic system to develop by not doing what you were doing earlier!
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