Fiscal tightening + monetary stimulus = ‘borderline insanity’?

December 12, 2012

It’s a curious pattern being repeated around the industrialized world. Governments are trying frantically to tighten their belts even as the monetary authorities loosen their purse strings. This week in the United States is a perfect example: the Fed looks set to extend its bond purchase program even as Washington fails to reach an agreement to avoid the dreaded “fiscal cliff.”

It’s the sort of dissonant policy that is unlikely to yield very constructive results at a time when the U.S. economy is struggling to achieve a meager 2 percent growth rate.

Thomas Lam, group chief economist at OSK-DMG inSingapore:

The current one-sided policy mix of fiscal tightening and monetary easing is problematic (for example, the UK experimented with this approach –  fiscal consolidation and monetary accommodation – and it clearly failed to generate a sustained recovery).  In some cases, it’s borderline insanity –  it’s like you’re trying the same or broadly similar approach but hoping for a different outcome every single time.

Lam says some countries have the room to stimulate growth in the short-term, and should not miss the opportunity to do so.

A one-size-fits-all fiscal policy approach (in the current context, fiscal tightening is the norm) is not only misguided but extremely dangerous for the global economy as it remains more-or-less stuck in the mud. Policymakers, especially in economies with subdued sovereign risk premiums (like in UK, US, Germany and Japan for instance), need to consider the notion of fiscal flexibility – a combination of near-term, though temporary, fiscal boost coupled with the commitment of longer-term fiscal tightening.

Without some degree of fiscal flexibility, monetary policy bears the entire brunt of keeping an economy above water. And eventually, the costs of pursuing nonstandard monetary policy would outweigh its benefits. To be sure, while central banks never run out of ammunition in theory, there are limits to monetary policy in reality.

Indeed, when politics overshadow economic objectives, like in the current environment, the economy suffers eventually.

For Roberto Perli, senior managing director of policy research at the International Strategy and Investment Group, there is something inherently more unpredictable about fiscal matters:

Fiscal policy (or any policy that emanates from a very polarized body such as the current U.S. Congress) is inherently uncertain because it is decided as part of complex political negotiation process between parties with very different starting positions, priorities, and interests. Monetary policy, in contrast, is conducted by a single, dedicated, non-partisan institution.

Experience, academic literature, and even common sense suggest that transparency and predictability to the extent possible is fundamental to the success of both fiscal and monetary policy. But transparency and predictability are hard to achieve in fiscal policy for the reasons above and possible instead in monetary precisely because of the lack of competing interests inside the FOMC (there are competing opinions as to how to achieve a common objective but by and large not competing objectives).

Still, that doesn’t mean policymakers shouldn’t at least try to develop a framework that would set boundaries for fiscal policy in a way that would increase its readiness, effectiveness and public acceptance, says Eric Leeper at the University of Indiana. Leeper authored a paper called “Monetary Science, Fiscal Alchemy,” which he presented at the Federal Reserve’s annual Jackson Hole conference. He also believes monetary policy will have less of an impact in an environment of budgetary chaos, concluding in a telephone interview:

It may well be that the effectiveness of monetary policy is being damaged by the uncertainty over fiscal policy.

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