Monetary and fiscal cooperation: the case for a state dependent assignment

In December last year Mark Carney said

“In a global liquidity trap, central banks cannot be the only policy makers who do “whatever it takes.” There are clear gains from coordination, with other policies – particularly fiscal policy”

I of course agree, as would most academic macroeconomists. So would any sensible informed fiscal policy maker. But of course this didn’t happen in the Global Financial Crisis from 2010 onwards in some key major economies, including the UK.

Carney’s statement, which follows similar statements by the central bank governors of the Fed and ECB, goes against what I have called the ‘consensus assignment’. The consensus assignment has monetary policy looking after the stability of aggregate demand and inflation, while the fiscal authority looks after government debt. In the UK at least this consensus assignment is deeply embedded in the way the media thinks about policy.

In 2009 George Osborne gave a speech in which he said

“[New Keynesian] Models of this kind underpin our whole macroeconomic policy framework – in particular the idea that by using monetary policy to manage demand and control inflation you can keep unemployment low and stable. And they underpinned the argument David Cameron and I advanced last autumn – that monetary policy should bear the strain of stimulating demand….”

This is a statement of the consensus assignment. The irony of it was that shortly before the speech was given UK interest rates hit their lower bound.

Is the consensus assignment still the best way to run policy after short interest rates hit their lower bound? In 2010, in Europe and the UK at least, central banks acted as if it was. Indeed they went as far as to advise fiscal policymakers to embark on austerity. Carney’s statement is an implicit acknowledgement that central banks had been wrong to do that.

The trouble with unconventional monetary policy is not that it does not work, but it does not work reliably. The scandal in 2010 was that while the Bank of England was suggesting in public that unconventional monetary policy could replace conventional interest rate policy, in reality they had little clue how much effect any change in unconventional monetary policy would have. An unpredictable and unreliable instrument is not a good basis for a policy regime when a better instrument is available, and that better instrument is fiscal policy. I think negative interest rates fit into this category of unreliable instruments, simply because we cannot for obvious reasons assume linearity.

So how do we ensure as far as we can that fiscal policy makers will not repeat the mistakes of 2010 in the next recession? The first best would be to have better fiscal policy makers, but alas that is not always possible. There are three widely discussed possibilities.

1. The first is MMT. This in effect reverses the conventional assignment, with fiscal policy doing the demand and inflation stabilisation in all states of the world. If that happens debt looks after itself. I am not in favour of MMT, because I think independent central banks have been very successful at controlling inflation, and a government using fiscal policy would be less successful.
   
   
2. The second is Helicopter Money. If you are prepared to call Helicopter Money (HM) monetary policy, this preserves the consensus assignment by giving the central bank a new tool. HM is more reliable than unconventional monetary policy, because HM is just like a tax cut, and we have a lot of data on the impact of tax cuts on consumers. Like tax cuts, HM will not work if all consumers are Ricardian, but they are not.
   
   

HM is only possible with the agreement of the government, preferably well before it is actually needed. Two key things have to be agreed. The first is the distribution mechanism, where I suspect some governments would prefer something other than a reverse poll tax. The second is an agreement to back the central bank, by which I mean supply it with the assets it requires to claw back at least some of the HM when the economy recovers. The only difference between HM and a bond financed fiscal expansion is that probably some or all of the bond issuance is delayed until after the economy recovers.

Central banks worry that governments will renege on their commitment to back the central bank. My response is that any government that would not back their central bank so it can fight inflation is also a government that would be prepared to abolish its independent central bank, so the concern is of no interest. I suspect also central banks think HM looks like fiscal policy to most people, and they shouldn’t be doing fiscal policy.

I would add a further point on HM. It will not stop a government using what I call ‘deficit deceit’ in a recession: pretending the deficit is too high and requires spending cuts, because the government wants to scare people into accepting a smaller state than would be popular otherwise. HM would avoid this fiscal consolidation influencing output because its demand effects would be offset by the central bank. But a shrinking of the state beyond anything that is popular in normal times is also almost certainly sub-optimal, and can have devastating political as well as economic implications, like those we have seen in the UK, and you could argue HM encourages this.

3. The third, and most likely, is central bank advice. If the central bank thinks that a recession is coming where rates will hit the lower bound, it advises the fiscal authority that some fiscal expansion is required. This is fine if we are trying to combat a fiscal authority that is just ignorant on these matters. The central bank could also convince a fiscal authority that was worried about financing its debt, by for example agreeing to monetise the expansion needed by doing the corresponding amount of QE, or more simply to neutralise any failure by private agents to buy debt.
   
   

My concern here is with a government that said thanks for the advice, but we prefer to focus on reducing the deficit using spending cuts. Would the central bank be prepared to make its advice public? It might not do so if it was concerned that the government would reciprocate by starting to tell the central bank what do so. You could therefore argue that this strategy could be either ineffective, or may threaten central bank independence.

So how can you stop a government that is determined to use the rising deficit in a recession to shrink the state? Of course you cannot, but you can try and create the conditions that will put maximum political pressure on it not to. I suggest above that HM fails to do this, and central bank advice is unlikely to either.

What would be more effective is for macroeconomists and central banks to start being honest about the consensus assignment. As a near optimal policy regime that assignment is dead. Instead macroeconomics suggests what could be called a ‘state dependent assignment’. In most states of the world, central banks stabilise the macroeconomy just as they do now. However in an economic downturn of sufficient size (where ‘sufficient’ is to be defined) the assignment flips, and fiscal policy makers are in charge of stabilisation. In non-technical language, fighting recessions becomes the government’s job.

I think this is something that most academic macroeconomists and some central bankers have accepted implicitly but not explicitly. One reason is I think pedantic. Of course in the state dependent assignment the central bank does not stop trying to stimulate demand in a recession by at least keeping rates low, but there are compelling political economy reasons to highlight the responsibility of governments in this respect.

Those familiar with Jonathan and my paper on fiscal rules will recognise our knockout when rates hit their lower bound as one operationalisation of a state dependent consensus assignment. But it is not an ideal mechanism because switching the assignment should depend on forecast events. Others, like the IPPR and Resolution Foundation, have suggested alternative schemes that come under the umbrella of a state dependent assignment. There is a great deal of work required to figure out the best mechanisms, and also to think about who has control over when switches (both on and off) happen, and whether there is a role for the central bank and/or fiscal council in advising the government on effective stimulus packages.

To conclude, central banks are now recognising that fiscal stimulus is required in significant economic downturns. This is in contrast to the GFC, when many fiscal policy makers enacted austerity. One of the reasons they were able to enact austerity was the dominance of the traditional consensus assignment in the mind of the public. Our most effective way of preventing this happening again is to make a state dependent assignment the new consensus assignment.

How did the UK austerity mistake happen

As the Global Financial Crisis (GFC) and consequent recession were in progress, the Labour government looked at how fiscal stimulus could be used to moderate its impact. This would increase the budget deficit that was already rising as a result of the recession, but they knew that cutting interest rates alone would be insufficient to deal with this crisis, and that you do not worry about the deficit in a recession. That is Econ 101, i.e. basic macroeconomics, and it is 100% correct.

Here Osborne and his advisors saw a political opportunity. Before the recession, fiscal policy had been all about meeting the government’s fiscal rules about debt and deficits, because monetary policy looked after smoothing the business cycle. There had been much discussion about the extent to which Gordon Brown had been fiddling these rules. Osborne could therefore make political capital over the rising deficit, particularly if he could suggest the deficit represented fiscal profligacy rather than the result of the recession.

But what about Econ 101? The advice he was given (I suspect) was reflected in a speech he gave in 2009. This gave a short account of the history of macroeconomic thought, and described how the New Keynesian model underpinned his macroeconomic policy. It said that in today’s world the consensus is that monetary policy not fiscal policy dealt with moderating booms and recessions. Yet it failed to mention that this idea no longer worked when nominal interest rates hit their lower bond. And that unconventional monetary policy was powerless in the New Keynesian model. The speech was given a month after interest rates hit their lower bound.

The speech also said nothing about expansionary austerity, or the need to appease the markets. That would all come later. This also suggests that Osborne's focus on the deficit was a simple but devastating macroeconomic error, a result of just not doing your homework. It was an incredible error to make, as the fact that interest rates had hit their lower bound was all over the financial press. If the media had been in touch with academic economics they would have pounced on this black hole in the speech. (Maybe this is complete coincidence, but his main economic advisor had previously worked at the IFS, where as I have said elsewhere they do not do macro. [1])

As an economic choice his policy was crucially out of date, but as a political choice it was almost brilliant. The line he pushed on the deficit came to dominate the media narrative, which I was later to describe as media macro. It did not win the 2010 election outright, but it went on to win the 2015 election. I say almost brilliant, because it has proved the undoing of his successor. The economic damage done by cutting government spending at the one and only time monetary policy could not offset its impact was immense. I think it is no exaggeration to call it the most damaging UK macroeconomic policy mistake in my lifetime as an economist.

It was damaging in part because politics drove two additional features of his policy after he became chancellor in 2010. First, the austerity policy would have had less economic impact if most measures had been delayed until later into the 5 year term of the coalition government. But that would have meant deep cuts before the next election, and Osborne could see that would do political damage. Second, although the fiscal rule did not require it, public investment was cut back sharply in the first few years, because investment is often easiest to cut. As I say in that 2015 post, those cuts in public investment alone could have reduced GDP by 3%.

By 2010 you need to introduce other actors who played a part in these mistakes. The Treasury did what the Treasury unfortunately often does, and put public spending control above the macroeconomic health of the country. The Governor of the Bank of England pretended that losing his main instrument didn’t matter, even though I’m told the MPC had almost no idea what impact unconventional monetary policy would have. If either institution had acted better perhaps the damage done by the austerity policy could have been moderated, but we will never know.

But the main damage was done when the Conservatives were still in opposition. Did the policy of opposing fiscal stimulus start off as a policy to reduce the size of the state under cover of deficit reduction: what I call deficit deceit? Or was it just something to beat Labour with: the first in what proved to be a long line of bad economic judgements simply designed to wrongfoot his opponents. Without the actors involved telling us, I think it is impossible for us to tell. However there are two things I think we can clearly say.

First, if it started as ignorance rather than deceit, it turned into the latter as Osborne prepared to repeat the policy all over again before the 2015 election, while at the same time cutting taxes. Second, if it started as ignorance it is far too kind to call it a mistake. It is similar to someone who has never learnt to drive taking a car onto the highway and causing mayhem. It reflects a cavalier attitude to economic expertise that has, I have argued, its roots back in the early days of Thatcherism.

[1] This advice served him well in other respects, such as establishing the form of his fiscal rule (which would help limit the impact of austerity after 2011) and creating the OBR.