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.

The ECB as a Lender of Last Resort to Governments

John McHale rightly points out that in my earlier post on the European Commission’s justification for austerity, I said little about the Lender of Last Resort to governments (LOLR) issue. What I did say is that OMT should have been established much earlier, and that this might have allowed Ireland and Portugal to continue to sell government debt to the markets at tolerable interest rates, which in turn might have allowed them to implement budget consolidation at a less damaging pace. (Whether they would have taken that opportunity is another matter.)

However this begs an obvious question, which is how OMT conditionality should operate. One possibility is that the ECB imposes as least as harsh conditions as the current Troika. Alternatively the ECB passes responsibility for imposing conditions to the Troika, and the Troika continues to do what it has already done. It would be wrong to say nothing would be gained as a result. If OMT works and the governments continue to borrow from the market, then we avoid some of the toxic intergovernmental lending that is in danger of tearing the Eurozone apart. However we will still have excessive fiscal deflation.

Do we need any conditionality at all? Unfortunately we do. To offer OMT unconditionally would take us back to the pre-2007 situation, where default was not thought possible. It revitalises the arguments that gave rise to the disastrous Stability and Growth Pact and the more recent Fiscal Compact. As Charles Wyplosz and others have emphasised, it is very difficult to run any kind of system where component parts have autonomy to borrow without having the discipline of default, unless you resort to a degree of central control that is not feasible for the Eurozone.

Conditionality should not come naturally to any independent central bank. There is no significant example of a country delegating fiscal decision making to an unelected body, and even if it did so there are reasons not to use a central bank for that task. But before addressing this dilemma, we should establish what the nature of conditionality should be.

The remit of the central bank should be short run macroeconomic stabilisation and long run price stability. OMT can be justified under this remit, as I argued here, because if a country finds itself in a bad market equilibrium, this will have a negative impact on the monetary transmission mechanism and short run macroeconomic stability. Conditionality can also be justified under this remit, because a complete failure of fiscal control in one country in a union when default is not allowed will compromise monetary policy for the union as a whole. (One of my own papers with Campbell Leith looks at this in a two country case. [1]) By complete lack of fiscal control, I essentially mean that a government is insolvent at a level of interest rates consistent with normal monetary policy. [2]

In other words, all the ECB needs to worry about is whether fiscal policy is sustainable in the long run. It should have no concern about which of the many possible sustainable fiscal paths a government chooses - that is up to the national government. There is a analogy with the well established rules for central bank support of private banks. If the bank is solvent but suffering from liquidity problems, support should be unequivocal and unlimited. If the bank is insolvent, no support should be forthcoming. [3]

The problem with this analogy is that solvency for a government involves a political as well as a technical judgement. Suppose a government submits fiscal projections that are sustainable. This could involve government debt initially rising but stabilising at some high level. If it then starts falling again so much the better. There could be two things wrong with this projection. The first is technical: for example growth assumptions may be too optimistic or tax receipts given growth are too optimistic. The second is political: the plan may involve cuts in spending, or increases in taxes, that are unlikely to be realised because the political costs are too high.

No central bank should like to be in a position where it has to make these political judgements. It would like to offload the problem on someone else. The obvious someone else is the market, but that will not work because all the market tells you is that there exists a bad equilibrium, and not whether a good equilibrium exists. To use Keynes’s famous analogy, the market is judging who the market thinks is beautiful, and not who is actually beautiful. The ratings agencies seem ‘market like’, but are in effect just a bunch of people with a (perhaps informed) opinion, and a not very good track record.

Who else could the ECB delegate conditionality to? Delegating to EU heads of state would be a bad idea, for reasons that I hope are obvious. [4] Delegating to the Commission seems too close to that. A better possibility would be the IMF. The IMF certainly knows all about this issue: see this research for example. However all of these agencies have a recent track record that does not inspire confidence. An acid test is how any arrangement would have worked in the case of Greece. What should have happened, as soon as the true extent of Greece’s fiscal problems had become clear, is that whatever body the ECB had delegated its conditionality assessment to should have concluded that default was more likely than not, and therefore OMT should not have been provided.[5]  

I have an alternative suggestion, which regular readers will not find surprising. A number of Eurozone countries now have fiscal councils, whose very job is to assess the sustainability of fiscal policy. They are the obvious people to ask. Putting such an important question to the relevant national fiscal council may be politically unwise - could that council survive a decision that led to default? It would be better, for this and other reasons, for fiscal councils to act as a group in advising the ECB on the sustainability of national fiscal plans. That way expertise could be pooled, and experience shared.

Let me be quite clear what I am suggesting here. As soon as a country specific default premium began to emerge on a Eurozone member’s government debt, the ECB would ask the collective of Eurozone fiscal councils whether they thought current fiscal plans would result in a sustainable level of debt. If they did, the ECB would announce that OMT would apply to that country i.e. it would buy whatever quantity of that debt that could not be sold to the market. That decision could be reviewed annually until the default premium faded away. If the fiscal councils collective did not think current fiscal plans were realistic and sustainable, OMT would not be forthcoming. In these circumstances, there would be no bailing out by the Eurozone or IMF, and default would almost certainly follow.

The Commission plays no part in this. However, I think the Commission still has a very important role to play. The ECB, as part of the role it should have in preventing deficient aggregate demand in the Eurozone as a whole, should publicly state that because of the zero lower bound they cannot use monetary policy to fulfill this function. They should ask the Commission to coordinate fiscal actions to provide additional support to demand. In doing this, the Commission would clearly not ask that much of countries on OMT, so most of the ‘burden’ would fall on others, like Germany or the Netherlands.

Which brings me back to my previous post, and why I think what I said there was quite compatible with LOLR issues. Now some commented on that earlier post that it was not politically feasible, by which they mean Germany would not countenance it. I am sure that is right, although what has disappointed me (and others - see Kevin O’Rourke) is that the election of Hollande did not emboldened countries like France and Italy to provide any kind of counterweight to German views.

One of the advantages of being an academic is that your advice does not have to be bound by what is politically feasible. It is important that someone sets out what is best as they see it, and others can then modify it to satisfy political constraints. However the problem in this case is not so much that fiscal stimulus rather than austerity, and the ECB acting as a LOLR, are not in the German national interest. I think you could make a case that they are in fact in Germany’s long term national interest, because a well functioning Eurozone is in their interests. The problem seems more that policy makers throughout Europe have two economic blindspots. [6] Those blindspots are the fallacy of austerity at the Zero Lower Bound, and the necessity of a LOLR. What I will not do is give advice which accepts that those blindspots cannot be removed.

 

[1] See also Canzoneri, M. B., R. E. Cumby and B. T. Diba (2001), “Fiscal Discipline and Exchange Rate Systems”, Economic Journal, No. 474, pp 667-690.

[2] Using Eric Leeper’s terminology, it means the fiscal authority is active: for a discussion of the active/passive idea and its application to the ECB and OMT see here.

[3] One problem with the Bagehot dictum is contagion: if an insolvent bank is allowed to fail, this may create a liquidity (or even solvency) crisis for others. These contagion arguments have much less weight when it comes to countries in the Eurozone, once OMT has been established and the conditionality involved is clear and non-political.

[4] See, for example, Cyprus. Colm McCarthy describes it well here (HT Kevin O’Rourke)

[5] This may be a little unfair on the IMF, who almost certainly came under intense political pressure from the Eurozone to provide funds before the inevitability of default was conceded. I do not know whether this assistance, which allowed default to be delayed, was provided against the better judgement of some of those in the Fund.

[6] See a shrill Kevin O’Rourke here.