Efficient coordination of monetary and fiscal policies is crucial for sustainable long-run economic performance. This was the topic of this year Annual Research Conference of the National Bank of Ukraine organized jointly with the Bank of Poland in cooperation with the government of Canada, IMF and KSE. It is crucial to have an ‘optimal’ degree of coordination – while remaining independent, fiscal and monetary authorities take into account each other’s policies. The optimal degree of coordination may increase in times of crisis.
The institution responsible for monetary policy in most countries is the Central Bank. The main goal of the monetary authority is to achieve and maintain price stability, and the main conventional instrument for this is interest rate set by a Central Bank. If the Central Bank commits to following the stabilizing policy and if general public trusts its actions, the interest rate changes communicated to the public affect expectations of economic agents about future prices. For instance, if trusted monetary authority decreases the key interest rate, public perceives this to be a sign of expansionary monetary policy and thus expects higher inflation in the future. These expectations stimulate demand (if I expect that something will be more expensive tomorrow, I’d better buy it today) and thus boost the economy.
To counter the 2008 crisis followed by the Great Recession, central banks of many developed countries cut interest rates to zero or nearly zero very fast. Soon it turned out however that even lowering interest rates to zero was not enough to counteract the recession. As the power of conventional monetary policy was exhausted, many central banks were forced to utilize unconventional monetary policies such as Quantitative Easing (QE) to increase liquidity and stimulate demand.
However, a Central Bank is not the only institution that has the power to intentionally influence the macroeconomic situation. The other key player who shapes the overall outcome of the stabilization policies is the fiscal authority.
The set of goals of fiscal policies conducted by governments is very broad. Besides stabilization of the economy, fiscal authority is concerned with the reallocation of resources, managing inequality and supporting long-term growth. The instruments for achieving these goals include taxation and government spending policies, minimum wage regulations and a broad range of legislation addressing country- or region-specific issues.
Besides stabilization of the economy, fiscal authority is concerned with the reallocation of resources, managing inequality and supporting long-term growth. The instruments for achieving these goals include taxation and government spending policies, minimum wage regulations and a broad range of legislation addressing country- or region-specific issues.
The 2008 crisis and the history of coping with its consequences via policies implemented by different institutions brought to the front the issue of coordination of fiscal and monetary policies, especially in the times of crisis. It is intensively discussed among both academics and policy-makers.
Francesco Bianchi (Duke University) shows that lack of coordination of fiscal and monetary policies has dire consequences for an economy. One of the legacies of the Great Recession is huge debt accumulation in developed economies (EU, US). To reduce the debt burden, fiscal adjustments will be needed – reduction of budget deficits or even running surpluses to reduce debt. At the same time, fiscal authorities may be unwilling to implement these fiscal adjustments but would hope to benefit from higher inflation which would reduce their debt burden. This is in conflict with a long-term goal of central banks of keeping inflation low. The conflict between fiscal and monetary authorities will eventually result in either a spiral of low output, high inflation and high debt (if a central bank gives up to fiscal pressure) or in a prolonged recession coupled with low inflation and high debt (if the central bank retains its low-inflation policy).
The main result of Dr. Bianchi paper is that a central bank cannot stabilize inflation without fiscal backing. And policy proposal that stems from it is that policy-makers agree to inflate away just the amount of debt that results from the recession itself and then revert to standard policy rules. This policy is particularly useful in times when the monetary policy is constrained by the zero lower bound.
Both Michael Weber (University of Chicago) and Jesper Linde (Sweriges Riksbank) discuss the possible usage of non-conventional fiscal policies to mitigate recessions. Michael Weber points out that fiscal policy can help manage public expectations. For instance, the announcement about government plans to raise the VAT at some moment in the future may induce people to spend more on durables today (since after the VAT increase the goods will be more expensive). The effect can be even stronger if it is paired with a reduction of income taxes – so that people retain more income to spend. Jesper Linde states that this policy is less efficient than ‘traditional’ fiscal expansion (like increased government investment) but can also stimulate demand, especially if coupled with income tax policies.
The main idea of the policy panel discussion on coordination of fiscal and monetary policies was the need to find a balance between independence of the two institutions and their not undermining each others’ policies. Speakers also expressed an opinion that coordination should increase in times of crisis while at ‘normal’ times each authority takes other’s policy as given.
Koba Gvenetadze (National bank of Georgia) shared an experience of Georgia on the role of fiscal policy in the development of inflation targeting. He pointed out that independence of the National Bank of Georgia and no fiscal dominance were important preconditions for introduction and maintaining of inflation targeting regime. Mr Gvenetadze noted that coordination of fiscal and monetary policies is essential for efficient liquidity management. Cooperation with fiscal authorities was an important ingredient of the adoption of inflation targeting framework that has led to better monetary outcomes for Georgia.
In support of this point of view, Lars Svensson (Stockholm School of Economics) noted that each policy needs to be conducted independently but as a best response to the policy conducted by the other party (a Nash equilibrium). Independence and accountability of each authority are historically shown to be the best framework for the long-term stability. Nevertheless, he admitted that in crisis times their coordination may be a more fruitful approach. Jerzy Osyatinsky (Narodowy Bank Polsky) stressed the importance of fiscal policies when monetary authorities exhaust their ammunition (i.e. when interest rates hit the zero lower bound). He also noted that the most successful policies to fight inflation were income distribution policies (e.g. in Germany, Austria, Scandinavian countries). Other examples include fighting deflation via a wage increase and affecting interest rates by government investment. Thus, fiscal policy has a higher impact on monetary indicators than a conventional theory suggests.
Mojmir Hampl (Czech National Bank) stressed that legal central bank independence is necessary but not sufficient condition for an efficient monetary policy. Mr Hampl argues that independence is a state of mind. A truly independent Central Bank should have the courage to act against public preferences. However, at the same time it should constantly explain its actions to the public to restore general support of its actions.
Ukrainian Financial Stability Council where fiscal and monetary authorities exchange their views on the latest and future economic developments is an example of independent but coordinated fiscal and monetary policies.