How to synchronize monetary policy with fiscal policy on the eve of the elections? What will save the State Budget from politically motivated expenditure expansion which is at odds with economic capacity? And will a higher discount rate really help to curb inflation? Today, the country’s future economic development and the Ukrainians’ wellbeing depend on whether or not the Government, the Parliament, and the National Bank of Ukraine manage to find the right answers to these questions in the run-up to the double elections in 2019. These and other questions were raised by the Center for Economic Strategy and VoxUkraine in their conversation with Stockholm School of Economics Professor Lars Svensson. The Professor visited Ukraine in May this year to attend an NBU conference.
Lars Svensson worked at the Directorate General Research of the European Central Bank and at the Research Department of the International Monetary Fund. In 2007 – 2013, he was Deputy Head of Sveriges Riksbank, Sweden’s Central Bank.
– On the conference in Kyiv you spoke about the Nash equilibrium in monetary and fiscal policies. What is it and why is it important?
– The Nash equilibrium is a particular kind of game-theory equilibrium. Suppose you have two players. Each player has distinct objectives. Each player’s actions have an effect on the both players’ objectives. In a so-called coordinated equilibrium, the players jointly choose their actions so as to best achieve their combined objectives. In a so-called Nash equilibrium, each player instead chooses his or her own action so as to best achieve his or her own objectives, while taking into account the actions (but not the objectives) of the other player. So, in a Nash equilibrium, there is separate decision-making by each player to achieve their own objectives while taking into account the actions of the other.
When it comes to monetary policy and fiscal policy, we can think of the central bank being one of the players and the government being the other player. The central bank controls monetary policy (the interest rate) and has price stability and full employment as the objective. The government controls fiscal policy (taxes and government spending) and has objectives in the form of preferences over different types of spending and taxes and may also prefer a balanced budget.
There is a considerable interaction between monetary policy and fiscal policy. Fiscal policy has an impact on inflation and employment. And monetary policy determines the interest rate and has an impact on employment, output, and inflation in the economy. This in turn has a substantial effect on the government’s expenditures, taxes, and budget balance. If there is more unemployment and less employment, the government has to pay more unemployment support and receives less taxes. If interest rates are low, the government’s interest rates payment on its public debt is smaller. And so on.
There is a considerable interaction between monetary policy and fiscal policy. Fiscal policy has an impact on inflation and employment. And monetary policy determines the interest rate and has an impact on employment, output, and inflation in the economy. This in turn has a substantial effect on the government’s expenditures, taxes, and budget balance.
With such strong interaction, one might think that that monetary and fiscal policy should be determined jointly and at the same time, taking both the objectives of fiscal policy and those of monetary policy into account. But the historical experience strongly indicates that this doesn’t work very well. One reason is that, if the government has control over monetary policy, it is tempted to abuse it for short-run political purposes. For instance, a more expansionary monetary policy before an election with more employment and less unemployment will make the government more popular and more likely to win the election.
But, with some lag, after the election, inflation will be higher and a problem. You tend to get either too high inflation or volatile stop-go-policy if you let the government determine monetary policy. So, the historical experience strongly indicates that it is much better to separate the two policies, and have monetary policy be done by an independent central bank, with a clear objective such as an inflation target and full employment. This corresponds to the two policies being conducted separately as in a Nash equilibrium.
– Talking of the concerns about employment. How to synchronize anti-inflationary monetary policy with it?
– Full employment is not something that we can determine in the same way as one can determine an inflation target. In principle, independent monetary policy can achieve any given inflation target over time, such as 2% or 3% or 4%. The inflation target is something that the central bank can choose freely and then achieve.
But what the full employment level is is not something that the central bank can choose freely and then achieve. Instead, the full employment level, that is, the maximum long-run sustainable employment level, depends on structural factors that determine how the labor market works. These factors are not directly observable and may change over time. Therefore, the employment level corresponding to full employment has to be estimated under uncertainty and the estimates may need to be revised over time.
Give the estimate of full employment, monetary policy can aim for it at the same time as aims for the inflation target. More precisely, monetary policy can aim to limiting the deviations of inflation from the inflation target and the deviations of employment from full employment.
Give the estimate of full employment, monetary policy can aim for it at the same time as aims for the inflation target. More precisely, monetary policy can aim to limiting the deviations of inflation from the inflation target and the deviations of employment from full employment.
Thus, it is important to understand the difference between the inflation target and full employment. Monetary policy can stabilize the employment level around the full employment level, but it can normally not change the full employment level. To increase the full employment level, you need structural policies, for example, labor-market policies that make the labor market and wage-setting process work better.
History shows that monetary policy works best if it is done by an independent central bank. But it may be problematic in a democratic society to give so much power to an authority like the central bank that is run by unelected officials. The central bank can affect inflation, it can affect employment and unemployment, and this has a big impact on people’s welfare.
The solution is to do this as an explicit delegation by the parliament or the government to an independent central bank to conduct monetary policy with explicit objectives that are determined in a democratic way by the parliament or the government. The reason for the delegation is to more effectively achieve the democratically determined objectives. In that sense, the parliament or the government has to agree to this particular way of doing monetary policy.
Furthermore, the central bank must be accountable for achieving the objectives. Its policy needs to be regularly evaluated by independent experts to make sure that its policy does not deviate from its objectives.
– Price stability is set as the main target of National Bank in Ukraine. The parliament or the government intervention may appear potentially damaging because of elections or other political reasons. What exactly do you mean by “the parliament or the government has to agree to this particular way of doing monetary policy”? To what extent should the power delegation stretch?
– What I mean is that the legislation that establishes the central bank, its independence, and its objectives, is decided upon in a democratic way by the parliament. In this way the parliament accepts that this kind of delegation is the best way of achieving price stability and full employment and the delegation gets democratic legitimacy.
Then, to achieve credibility, you may need to put more emphasis on stabilizing inflation around the inflation target and less emphasis on stabilizing employment around the full employment level. When the central bank becomes more experienced and the inflation target is more credible, it is then possible to put more weight on full employment. This seems to be a natural development that inflation targeting regimes go through.
So far here I have mentioned full employment as an objective of monetary policy together with price stability. This is appropriate for an advanced economy like Sweden when you have had the inflation target for some time and achieved credibility for the target, in the sense of private-sector inflation expectations being aligned with the target. But when you start with inflation targeting in an economy and thus have a new not-yet established policy regime, the inflation target may not be very credible. Then, to achieve credibility, you may need to put more emphasis on stabilizing inflation around the inflation target and less emphasis on stabilizing employment around the full employment level. When the central bank becomes more experienced and the inflation target is more credible, it is then possible to put more weight on full employment. This seems to be a natural development that inflation targeting regimes go through.
I am not an expert on the Ukrainian economy, but for a young inflation-targeting regime it may make sense to emphasize the inflation target more than full employment until the policy regime has become more established.
– Who should set the target? Should it be the Central bank or should it be discussed with parliament or government?
– That’s a good point. There are essentially two alternatives. First, in some economies, for example, the Eurozone, the US, and Sweden, the central-bank legislation says price stability and the central bank decides what precise numerical inflation target is consistent with this. Second, in other economies, such as Canada, New Zealand, and the UK, the inflation target is either decided by the government or in an agreement between the government and the central bank. Of course, in such an agreement one would think that in practice it is the government that has the last word.
There are essentially two alternatives. First, in some economies, for example, the Eurozone, the US, and Sweden, the central-bank legislation says price stability and the central bank decides what precise numerical inflation target is consistent with this. Second, in other economies, such as Canada, New Zealand, and the UK, the inflation target is either decided by the government or in an agreement between the government and the central bank. Of course, in such an agreement one would think that in practice it is the government that has the last word.
It seems from experience that both cases can work well. The second case has the advantage that the government is automatically behind the inflation target because it has agreed to it and even taken the initiative to it. So, the government cannot complain later if inflation is reaching the target. It also gives more democratic legitimacy to the target.
A disadvantage with the second case is that there is a temptation to make the inflation target an election issue. That has happened in New Zealand – many years ago a political party wanted to raise the inflation target and made it an election issue. But there is no way the general public can have an informed view of what is the appropriate target level for inflation. This is a highly technical issue and is not a suitable election issue.
– What can be the implications of that political intervention in monetary policy for Ukraine?
– As far as I can see, it would make sense for Ukraine to follow the European Union and the Eurozone and have central-bank legislation similar to that of the Maastricht Treaty, especially if Ukraine wants to become a member of the EU. The Maastricht Treaty mentions price stability and two other objectives – balanced growth and full employment, with price stability being the primary objective. With Ukrainian legislation in line with the Maastricht Treaty, the National Bank of Ukraine would determine the numerical inflation target that it deems consistent with price stability.
– Some countries such as New Zealand or Australia have strong fiscal rules, they calculate the ceiling of government spending. What is the reaction of politicians for this indicator and how it helps to discipline government and politicians in their attempts to rise state budget costs?
– Sweden has a strong fiscal policy framework, too. The reason we got this fiscal policy framework is that we had a terrible crisis in the early 90s. We had a fixed exchange rate, expansionary fiscal policy and an overheated economy with high wage and price inflation but a gradual loss of competitiveness. There was a lot of construction, housing prices were rising, lending standards were low. We eventually had a big recession and a banking crisis with several banks going bankrupt, mostly due to losses from commercial property, very little due to mortgages. The national debt grew, the budget deficit was up to 13% of GDP. This was a terrible experience, with very high unemployment. After that experience we’ve got two big policy improvements.
The reason we got this fiscal policy framework is that we had a terrible crisis in the early 90s. We had a fixed exchange rate, expansionary fiscal policy and an overheated economy with high wage and price inflation but a gradual loss of competitiveness. There was a lot of construction, housing prices were rising, lending standards were low.
First, we got flexible exchange rates, inflation targeting, and much better monetary policy. Second, we got a fiscal policy framework and a much better fiscal policy. With the framework, fiscal policy is sustainable.
The fiscal policy framework has a budget surplus target, currently 1% of GDP over the business cycle. It will be 1/3% of GDP from 2019. Then there is a “public debt anchor” according to which debt to GDP shall not deviate too much from 35%. The framework also includes 3-year government-expenditure ceilings and local-government budget balance.
Importantly, this framework has been accepted by both the government and the opposition in parliament. Before elections, parties have even competed in having a fiscal policy being consistent with the framework. So far, when the opposition has won the next election, it has accepted the previous government’s expenditure ceilings. Altogether, this makes fiscal policy sustainable.
– Nowadays it is far from the situation in Ukraine.
– Yes? But a fiscal policy framework is important to make fiscal policy sustainable. If you can get it to work, it’s great.
Furthermore, the Swedish framework has a tight government top-down budget approach. Under a bottom-up approach you collect what the different ministries and authorities want and then just add it up and you get a much too big total number at the end. But under the top-down approach you start from the top and allocate budget resources to different functions in the budget. Then you split it up into more and more detail. But you keep the total; it is set at the beginning.
Furthermore, there is considerable external monitoring and evaluation of the framework and the outcome. There is both national and international monitoring. There is an independent Fiscal Policy Council, appointed by the ministry of finance but quite independent, consisting of academics and experts. They write an annual report on to what extent the government is following the fiscal framework. Then there is the National Audit Office, an authority under the parliament, which also scrutinizes the government. There is also the Financial Management Authority, an authority under the government, which looks at how efficiently the government uses its money.
There is an independent Fiscal Policy Council, appointed by the ministry of finance but quite independent, consisting of academics and experts. They write an annual report on to what extent the government is following the fiscal framework. Then there is the National Audit Office, an authority under the parliament, which also scrutinizes the government.
Finally, there is the National Institute of Economic Research, also a government authority, but quite independent. They also scrutinize the government’s fiscal policy and report whether it stays within the framework or not. They have now and then severely criticized the government for deviating a bit from the framework.
This was the national monitoring. There is also international monitoring, from the IMF, the OECD, and the European Commission, which regularly comment on the framework and the fiscal policy.
In addition, there is considerable freedom of information – essentially all relevant documents in the government are available to the general public. Journalists and other interested parties can just ask to see the documents. Almost everything’s is public.
– What if the government doesn’t follow these rules?
– There are no direct sanctions, but of course the government will be heavily criticized. The authorities mentioned can write (and have written) critical reports, and these get a lot of attention in the media and by the opposition in the parliament, with severe criticism of government. There are rather intense debates about the budget in parliament. In principle, if the government deviates from the framework, the parliament could have a lack-of-confidence vote on the minister of finance or all the government. Probably the government side in the parliament would support the government. But it would nevertheless be a big scandal and a loss of faith and reputation. It would look really bad if there was a major deviation from this framework. And, of course, the framework came after a very bad experience. Many people accept that we need the framework to avoid another bad crisis.
– Is it possible to realize inflation targeting policy with this contradiction of fiscal policy and monetary policy?
– It depends on how bad fiscal policy is.
– Assuming it is very bad.
– What magnitude of the deficit are you thinking of?
– The hidden deficit can skyrocket. The official deficit is close to the IMF’s target of 3% of GDP. But we have huge quasi-budget spending like increasing the government debt by inflating the money into state own banks. Let’s assume that the deficit is 5–6% GDP.
– Well, a 5-6% deficit is bad, but it does not make it impossible to do reasonable monetary policy, I would say. It is getting more difficult or even impossible when you have deficits of 10%, 15%, or 20%.
– So, getting back to the monetary policy. We have the situation when we don’t have a free movement of capital between Ukraine and the rest of the world. We have capital flows restrictions. If we lift them, would the monetary policy of increasing interest rates to curb inflation be more effective or less effective?
– It would arguably be more effective because you would have a stronger exchange rate channel. So, when you raise the interest rate, it is more expensive to borrow to finance investment. But if also the currency appreciates, it’s more difficult to export because exports become less competitive, and it is easier to import because imports become less expensive. Of course, that cheaper import is also competing with the local industry.
So, when you raise the interest rate, it is more expensive to borrow to finance investment. But if also the currency appreciates, it’s more difficult to export because exports become less competitive, and it is easier to import because imports become less expensive.
In the same way, if you want to ease policy and lower the policy rate, it is easier to borrow; it is easier to finance investment. But also, if you have a weaker currency, exports become more competitive and imports become more expensive. That adds to your inflation. The exchange rate channel for a small open economy is quite important, and the more trade you have the more it matters. In Sweden it matters a lot.
– So, to sum-up, is it important to have capital control lifted for effective inflation targeting?
– Well, it does make monetary policy more effective.
– You said that the amount of public debt denominated in foreign currency restricts the monetary policy. In what way does it restrict?
– If you raise the interest rate and the currency appreciates, this debt is worth more in Ukrainian currency. Corporations with much foreign currency debt became weaker. They may even go bankrupt. Given this, capital controls to prevent too much foreign-currency debt may be a good thing.
– Does it mean that the central bank should take into consideration the impact it has on the debt while making the decision on the interest rate?
– The central bank should take into account all the different channels through which interest changes affect inflation and employment. The impact of interest changes on households’ consumption and firms’ investment depends among other things on their balance sheets and debt. But I don’t think you should use monetary policy to try to affect the magnitude and growth of debt of households and firms. For such purposes, macroprudential policies provide the right tools.
– We had a discussion about the level of policy rate. Some economists argue that the rate being too high prevents economic growth and makes inflation even higher. They argue that because the companies borrow money at the high interest rate, their expenditures grow, and that is why they increase prices for their goods.
– All practical experience says that if your raise the policy rate, inflation falls, not rises. But there is a crazy idea pushed by some people – especially John Cochrane. This is the so-called neo-Fisherian view: If you want inflation to rise, you should just raise the nominal interest rate. And then trust the Fisher equation (and, importantly, that the real interest rate is sticky and that inflation expectations adjust quickly).
The Fisher equation says that the real interest equals the nominal interest rate less inflation expectations. Suppose that you believe that the real interest rate does not move much and is thus sticky. Suppose you also believe that inflation expectations adjust quickly. If you then raise the nominal interest rate, the Fisher equation says that inflation expectations will rise. Then, with higher inflation expectations, actual inflation will also rise.
But in the real world, inflation expectations usually adjust slowly and are thus sticky. If you raise the nominal interest rate but inflation expectations are sticky, the real interest rate will rise. The economy will be less stimulated, aggregate demand will fall, the currency will appreciate, inflation will fall, and inflation expectations will eventually fall rather than rise.
In the real world, inflation expectations usually adjust slowly and are thus sticky. If you raise the nominal interest rate but inflation expectations are sticky, the real interest rate will rise. The economy will be less stimulated, aggregate demand will fall, the currency will appreciate, inflation will fall, and inflation expectations will eventually fall rather than rise.
Thus, in the real world, inflation expectations are usually sticky and the real interest rate is not, counter to the neo-Fisherian view.
Do you know the Swedish dramatic experience of monetary policy in 2010-2014? It provides a natural experiment and test of the neo-Fisherian view.
– Please, tell us about it.
– I was a Deputy Governor and Member of the Executive Board of the Riksbank for 6 years, 2007-2013. In the summer of 2010, the majority of the Executive Board decided to raise the interest rate from 0.25 to 2 basis points in 12 months. This in spite of June 2010 inflation being close to the inflation target of 2% but the inflation forecast being below the target. Furthermore, the current unemployment rate and the unemployment forecast were high above the Riksbank’s estimate of the long-run sustainable unemployment rate.
What happened? According to the neo-Fisherian view, inflation should have risen. But it fell from around 2% down to zero. The krona appreciated a lot, and unemployment, which was high but on its way down flattened out and even increased. My colleague Karolina Ekholm and I dissented against this policy, but we were in minority. I left the Riksbank in 2013 to a large extent in protest of the bad monetary policy.
In the spring of 2014, about a year after I left, the majority of the board apparently realized that the situation with inflation far below the target and unemployment high above the long-run sustainable unemployment rate was unsustainable. They made a dramatic turn-around of policy and quickly lowered the interest rate down to first zero and then minus 0.5%.
What happened? According to the neo-Fisherian view, inflation should have fallen further. But inflation started to increase toward the target, the krona depreciated a lot, and unemployment started to come down.
This experiment was a dramatic failure of an attempt to “normalize” monetary policy, in the mistaken sense of normalizing the interest rate. Instead, it is inflation and employment that should be normalized, not the policy instrument.
The experiment furthermore shows that monetary policy in Sweden works according to the textbook. If you raise the interest rate, inflation falls and unemployment increases, and vice versa if you lower the interest rate. Finally, the experiment disproves the neo-Fisherian view.
– This is a great story. Thank you so much for your time.
– Thank you too.
