Monday, August 5, 2013

On monetary and fiscal policy dilemmas

Two sets of articles on monetary and fiscal policies highlight the dilemmas policy makers face when making a decision to choose between competing policy alternatives. As both cases highlight, a very good appreciation of economic history and local political economy can be invaluable in increasing the likelihood of getting decisions right.

1. Charles Plosser, the President of Philadelphia Fed, has been one of the strongest voices within the US Federal Reserve system against the quantitative easing policies that have seen the Fed's balance sheet balloon past $3.5 trillion. He has consistently argued that the Fed's extraordinary monetary policy measures have blurred the lines between monetary and fiscal policies, and thereby the roles of central banks and governments. He feels that it has politicized the Fed's mandate and laid it open to pressures to pursue similar policies in future. This, he feels, would take away from the central banks' primary mandate of maintaining the purchasing power of the national currency unit.

In this essay, he lays out a very compelling case to exercise caution on unconventional monetary policy actions like purchases of non-Treasury securities and lending to "insolvent" institutions which clearly are on credit policy territory. He calls for re-establishment of the boundaries between monetary and fiscal authorities and urges governments to take measures to address structural deficits,
Once a central bank ventures into fiscal policy, it is likely to find itself under increasing pressure from the private sector, financial markets, or the government to use its balance sheet to substitute for other fiscal decisions. Such actions by a central bank can create their own form of moral hazard, as markets and governments come to see central banks as instruments of fiscal policy, thus undermining incentives for fiscal discipline. This pressure can threaten the central bank’s independence in conducting monetary policy and thereby undermine monetary policy’s effectiveness in achieving its mandate...
Congress has mandated the goals of monetary policy to promote price stability, maximum employment, and moderate long-term interest rates. Asking monetary policy to take on ever more fiscal responsibilities undermines the discipline of the fiscal authorities and the independence of the central bank. Central banks and monetary policy are not and cannot be real solutions to the unsustainable fiscal paths many countries currently face. The only real answer rests with the fiscal authorities’ ability to develop credible commitments to sustainable fiscal paths. It is a difficult and painful task to be sure, but a monetary solution is a bridge to nowhere at best, and the road to perdition at worst — a world of rising and costly inflation and a weakening of fiscal discipline.
These concerns are very real. It surely is a judgement call between supporting unconventional monetary policies, and in the process running the real risk of distorting the incentives of stakeholders and risking the institutional credibility of central bank, and adhering to a conventional monetary policy stance, and being blamed for not having done enough to restore economic normalcy despite having some firepower to have done so. I guess this is where a good grasp economic history and local political economy assumes critical significance.

2. The Economist points to the latest addition to the debate on the magnitude of the fiscal multiplier. IMF's Olivier Blanchard and Daniel Leigh argue that the strong fiscal consolidation in many advanced economies has resulted in lower economic growth than expected, suggesting that fiscal multipliers were higher than originally assumed. By backing out the multiplier from the actual fiscal consolidation and growth rates, they find that it substantially above 1 early in the crisis. Clearly the amount of slack created by the Great Recession was much higher than estimated.

The article also points to another IMF paper by Ethan Ilzetzki and Co which examined the effects of fiscal policy in 44 developed and developing economies. They find that the fiscal multiplier of government consumption is higher in developed economies while that of government investment is higher in developing countries and is well above one; is relatively large in countries with fixed exchange rate and almost zero in countries with flexible exchange rate (where the effects of fiscal expansion leaks out, by way of both higher imports and depreciating currency); is lower in open economies than closed ones; and is zero in high-debt countries. Furthermore, they argue that the multipliers of government investments by developing countries may rise as their governments learn to more effective manage the exchange rate, thereby reducing the leakage of fiscal policy through the exchange rate channel.

Menzie Chinn has an excellent paper where he examines the effect of fiscal policy under various macroeconomic conditions - slack in the economy, monetary policy path, and public debt shares. As the graphic below shows, fiscal multipliers in the US have been found to be highest during recessions, exactly the time when they are needed.

In the context of the debate between fiscal expansion and consolidation, this speech by Jens Weidemann, President of the Bundesbank makes a cogent case for consolidation in view of the adverse public debt ratios in many Eurozone economies. Supporters of fiscal austerity, like Wiedemann, see the current problems as a "crisis of confidence in the sustainability of public finances" and claim that a "credible commitment to sound public finances", despite its short-term growth dampening effect, will inspire confidence and improve long-term growth prospects.

Again any clear cut view on either position is a judgement call that balances two sets of risks. Supporters of fiscal expansion run the risk of losing an opportunity to force governments to address their long-term fiscal problems besides not getting the menu, magnitude, and timing of fiscal policy instruments right, thereby worsening the fiscal balance when expansionary policies fail to yield the desired results. Similarly austerity advocates risk pushing the economy down a deep trough by not doing enough to get economic growth back on track when expansionary policies could have restored normalcy and then left governments to concentrate exclusively on getting the fiscal balance in order. A good understanding of economic history and political economy can increase the likelihood of getting the judgement right.

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