When monetary policy needs to incorporate fiscal policy

April 13, 2012
INET meetings, where the big theme this year seems to be an attempt to rope in everyone from anthropologists to neuroscientists in an attempt to solve the big economic problems which are proving intractable to economists.

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I’m in Berlin this week, at the annual INET meetings, where the big theme this year seems to be an attempt to rope in everyone from anthropologists to neuroscientists in an attempt to solve the big economic problems which are proving intractable to economists. But still, it’s the economics and finance folk who are top of the agenda. And since George Soros is footing a large part of the bill for this conference, he and his latest op-ed are getting star billing. Sadly, however, most of the delegates have been at the conference all day and therefore haven’t had the opportunity to read Mohamed El-Erian’s speech in St Louis, which is equally germane.

The two, in fact, complement each other quite nicely. El-Erian’s main point is that central banks can’t solve the crisis on their own; Soros has an intriguing idea which addresses that fact, and attempts to add some fiscal-policy bite to the operation of monetary policy.

The EU’s fiscal charter compels member states annually to reduce their public debt by one-twentieth of the amount by which it exceeds 60% of GDP. I propose that member states jointly reward good behavior by taking over that obligation.

The member states have transferred their seignorage rights to the ECB, and the ECB is currently earning about €25 billion ($32.7 billion) annually. The seignorage rights have been estimated by Willem Buiter of Citibank and Huw Pill of Goldman Sachs, working independently, to be worth between €2-3 trillion, because they will yield more as the economy grows and interest rates return to normal. A Special Purpose Vehicle (SPV) owning the rights could use the ECB to finance the cost of acquiring the bonds without violating Article 123 of the Lisbon Treaty.

Should a country violate the fiscal compact, it would wholly or partly forfeit its reward and be obliged to pay interest on the debt owned by the SPV. That would impose tough fiscal discipline, indeed.

None of this is easy, but the big-picture idea is a good one, which is to tie monetary policy much closer to fiscal policy, so that fiscal policymakers are no longer capable of leaving all the dirty work to central bankers. In this case, if I understand him correctly, Soros is suggesting that the ECB buy up a large chunk of national sovereign debt every year. If any given country is following the EU’s fiscal-compact rules, then the interest on its debt gets rebated to the country; if it isn’t, then the ECB keeps the interest payments for itself.

If you look at what’s happened since the crisis of 2008, elected policymakers have generally turned to central banks and said “hey, we’re bound by all manner of real and imagined constraints, so please can you do what’s necessary in the short term, since we can’t.” This was quite explicit at the height of the crisis, when Hank Paulson felt quite comfortable telling Ben Bernanke what he needed to do. And then, of course, a couple of months later, Barack Obama appointed Tim Geithner, the country’s second most important central banker, as his Treasury secretary. The effect was to ensure that the central bank would always act in line with what the government wanted — and indeed that is exactly what has happened.

But that course of action has unintended consequences. For one thing, it makes the central bank politically unpopular. And for another, it tends to increase imbalances, including income and wealth inequalities, rather than decrease them. The way that El-Erian sees it, monetary policy during a crisis is like a bridge loan: it’s a short-term way of plastering over the gap, while a longer-term fiscal solution is put together. But if that longer-term fiscal solution isn’t put together, then the world’s central banks will just have built a “bridge to nowhere”, and ultimately made things worse rather than better.

El-Erian gives the world’s central banks an either-or choice: if they don’t manage to build a world where they’re rowing with the fiscal-policy tide, they’ll end up finding themselves “having to clean up in the midst of a global recession, forced de-leveraging and disorderly debt deflation”.

I’m not entirely sure I buy all of the analysis here. Central banks’ policies during the financial crisis were necessary, whether or not fiscal authorities end up doing their bit. While a future fiscal recession would be bad, it’s not at all obvious that we would have been better off just letting the world fall off a cliff at the end of 2008.

But it’s certainly true that central banks aren’t in full-on crisis mode right now. The problems they face — none greater than unemployment, in both its long-term and its youth flavors — are not the kind of things which happen suddenly and need to be addressed with massive and instantaneous liquidity programs. Indeed, they’re the kind of things which really ought to be addressed with fiscal policy. Monetary policy is a blunt tool, and, as El-Erian says, central banks can’t engineer “good inflation”, in things like house prices, without “bad inflation”, in things like oil prices.

And so long as central banks continue to push their zero-rate policies alongside unorthodox measures like LTRO and QE, politicians will find the pressure on themselves being lifted, even as the central banks get most of the market attention. As Ryan McCarthy says, the CNBC types are much more obsessed with the Fed than they are with Treasury: fiscal policy simply isn’t seen as economically important in the way that monetary policy is. Not even in an election year.

El-Erian’s main point is a pretty subtle one: bimodal dynamics mean that that we’re now moving towards a topsy-turvy world where good policy can be bad policy. “A good portion of policy making” he says, “and important underpinnings of conventional portfolio management, are based on a traditional bell curve governing the distribution of expected outcomes.” What that means is that if the central bank makes things better, that’s all good.

In a world where the outcome distribution is not a bell curve, however, the right action for a central bank is not nearly as clear-cut. Think of a bimodal distribution with two peaks: a bad one on the left, and a good one on the right. In that world, loose monetary policy will, at the margin, push the outcome to the right: it will make a good outcome better, and a bad outcome less bad. El-Erian’s point is this: what if, at the same time, by taking pressure off politicians, that kind of monetary policy makes a good outcome less likely, and a bad outcome more likely? If loose monetary policy pushes both peaks a little to the right, but at the same time makes the left-hand peak significantly larger than the right-hand peak, it can still be a very bad idea.

It’s an intriguing idea — but it’s also one which is pretty much impossible to model. And yet, the message of INET, or at least one of them, is that economists should be doing exactly that. Central bankers don’t like to try to anticipate the effect that their actions will have on politicians. But if they don’t, the politicians won’t play ball. And if the politicians won’t play ball, there’s nothing the central bankers can do on their own to avert a major fiscal crisis.


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