The FTPL version of the Neo-Fisherian proposition

Probably for macroeconomists

The Neo-Fisherian doctrine is the idea that a permanent increase in a flat nominal interest rate path will (eventually) raise the inflation rate. It is then suggested that current below target inflation is a consequence of fixing rates at their lower bound, and rates should be raised to increase inflation. David Andolfatto says there are two versions of this doctrine. The first he associates with the work of Stephanie Schmitt-Grohe and Martin Uribe, which I discussed here. He like me is not sold on this interpretation, for I think much the same reason. (There is a closely related discussion of the Neo-Fisherian doctrine by John Cochrane, which I will refer to in a subsequent post on Woodford’s recent idea of reflective equilibrium.) But he favours a different interpretation, based on the Fiscal Theory of the Price Level (FTPL).

Let me first briefly outline my own interpretation of the FTPL. This looks at the possibility of a fiscal regime where there is no attempt to stabilise debt. Government spending and taxes are set independently of the level or sustainability of government debt. The conventional and quite natural response to the possibility of that regime is to say it is unstable. But there is another possibility, which is that monetary policy stabilises debt. Again a natural response would be to say that such a monetary policy regime is bound to be inconsistent with hitting an inflation target in the long run, but that is incorrect.

A simple example is a model without sticky prices where bonds are denominated in nominal terms, and a monetary policy that involves a constant nominal interest rate. A constant nominal interest rate policy is normally thought to be indeterminate because the price level is not pinned down, even though the expected level of inflation is. In the FTPL, the price level is pinned down by the need for the government budget to balance at arbitrary and constant levels for taxes and spending.

The idea still works even with sticky prices and indexed debt, as my EJ paper with Tatiana Kirsanova shows. Here the budget is balanced, after a positive shock to debt say, by a period of above target inflation which reduces real government debt through lower real interest rates. This raises a somewhat pedantic point about David’s post. I’m not sure the path he shows for inflation, with no inflation surprises and no period of lower real rates, would be sufficient to stabilise the government’s budget constraint. Unless I have missed something, a period of higher inflation is required to do this. 

However I have a much more serious problem with this FTPL interpretation in the current environment. The belief that people would need to have for the FTPL to be relevant - that the government would not react to higher deficits by reducing government spending or raising taxes - does not seem to be credible, given that austerity is all about them doing exactly this despite being in a recession. As a result, I still find the Neo-Fisherian proposition, with either interpretation, somewhat unrealistic.

Simplistic theories of inflation

After I wrote this I saw that Frances Coppola has a post that covers some of the same ground, but the point I want to make is different.

One of the things that made monetarism so popular until governments actually tried it was its simplicity. You can express this simplicity in many ways, but most involve the idea that there is a stable demand for the real value of money (M/p), so if you can control M you must control p. Never mind that the immediate influences on inflation were much more complicated: if you knew what M was, you would know what p would be. If you controlled M you would eventually control p.

There are lots of problems with this idea. I talked about the difficulty in explaining prices by just using money in this post. The difficulty of finding the ‘right’ definition of money is not a technical problem but a feature: because money can be saved as well as buy goods (the medium of exchange is also a store of value) focusing on its role in buying goods (‘hot potatoes’) is misleading. But even if there was a stable long run demand for money for some definition, the usefulness of this becomes questionable if we cannot say what the future quantity of money will be.

This becomes blindingly obvious if money is base money and we think about Quantitative Easing. Printing base money under quantitative easing does not imply hyperinflation because the expansion in the monetary base will be reversed once the recession is over. Knowing what base money is becomes useless as a tool for saying what future prices will be. (For those more technically minded who still think there is a Pigou effect, I discussed why the Pigou effect has disappeared from modern macro here. It is based on the same point.)

The Fiscal Theory of the Price Level is potentially another simplistic theory of inflation. This works from the identity that the real value of government debt must equal the discounted value of primary surpluses (taxes less government spending). It also can be used in a naive way: treat future primary surpluses as fixed, and any increase in nominal government debt must lead to higher prices. But, as Chris Sims explains in this nice exposition at Lindau, future primary surpluses are not fixed. If debt increases, future primary surpluses can increase to pay the interest on that additional debt, and more.

There may be some that say that we cannot trust politicians to do that. To which I say which planet have you been on for the last five years? As Brad DeLong reminds us for the US, this recession has been unusual in the zeal that governments have shown in rapidly reducing primary deficits, and of course in the Eurozone this zeal - embodied in the fiscal compact - has led to a second recession. Chris Sims raised the possibility that so great has this zeal been that even though nominal debt has risen, the price level might fall to make the identity hold.

One lesson I would draw from this is that the Fiscal Theory of the Price Level, like monetarism, is not a terribly helpful way of thinking about future inflation. The idea that we can take one variable, or one equation, and distil from that the future price level is a fantasy. What is surprising is that this fantasy has been, and still remains, so attractive for some economists.

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.

Active and Passive at the ECB

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.  

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[1] The Wikipedia entry on the FTPL is poor.

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?