Fiscal and monetary policy: debating optimal interactions

3 April 2024

By Jacopo Cimadomo and Demosthenes Ioannou

Governments and central banks reacted boldly to mitigate the economic damage of the pandemic and recent geopolitical conflicts. Euro area governments and the EU as a whole used fiscal policies to protect the living standards of European citizens. Meanwhile the European Central Bank raised interest rates by more than 400 basis points to fight the highest inflation since the introduction of the euro 25 years ago. Fiscal and monetary policies both have pros and cons when responding to shocks. That raises questions about the most effective tools and the right interaction between fiscal and monetary policy. For instance: what type of fiscal and financial environment makes central bank asset purchases most effective? Does fiscal spending make central banks’ fight against inflation harder? What combination of public spending and tax policies lead to fiscal consolidation and sound government budgets?

To discuss these issues we recently welcomed a host of excellent speakers to the Sixth biennial Conference on Fiscal Policy and EMU Governance at the ECB in Frankfurt.

How do fiscal and monetary policies interact, and how should they?

Olivier Blanchard (Peterson Institute for International Economics) argued that fiscal policy has more and better tools than monetary policy to stabilize output. Though there is “no magic solution”, it is necessary to fully exploit a range of potentially useful tools such as “quasi automatic stabilisers” that could respond to an aggregate measure such as the unemployment rate. These stabilisers could be designed to be neutral to debt and maintain debt sustainability.

At the same time, fiscal and monetary policies operate in an environment of constraints and limits. For one, the effectiveness of unconventional monetary policy tools depends on the economic and financial environment. Huixin Bi (Federal Reserve Bank of Kansas City) showed that the effectiveness of asset purchases aimed at maintaining price stability, is affected by sovereign default and liquidity risks. The presence of both risks dampens economic and financial conditions following an increase in government debt. But the magnifying effect from liquidity risks is potentially far more adverse for economic activity. This makes asset purchases by central banks markedly more effective when liquidity risks are present.

While the central bank focuses on the stability of the currency, governments’ fiscal policy operates to support among other things economic activity. However, as Vítor Gaspar (IMF) recalled, countries’ fiscal capacity is not unlimited. In this regard, and from a long-term perspective, he noted that the United States and China are witnessing upward trends in debt compared to the downward debt trajectories in Europe and the rest of the world. Debt dynamics depend among other things on whether fiscal deficits can finance themselves, a possibility that Christian Wolf (MIT) argued exists.^[1] But calculating this in advance depends on assumptions about, for example, the size of fiscal multipliers which are surrounded by uncertainty.

Moreover, governments’ attempts to counter negative (global) economic shocks with more fiscal spending may lead to inflationary pressures. Francesco Bianchi (Johns Hopkins University) argued that government spending explained much of the inflation rate increases witnessed in a set of OECD countries over the period 2020-22. He used the so-called “fiscal theory of the price level” – a theoretical framework which has been active for 30 years and which has drawn interest with the recent global surges in inflation and government spending.^[2]

What rules and institutions are most effective in the EMU?

Once fiscal policy has been deployed to counter economic weakness, budgetary consolidation is called for to avoid a debt overhang. But does this mean cutting spending or raising taxes? ECB Chief Economist Philip R. Lane talked with Silvia Ardagna (Barclays) about the main “ingredients” for successful fiscal consolidations. She was of the view that governments should focus more on business and indirect taxes rather than labour taxation, and that governments should cut current spending rather than public investment. Roberto Perotti (Bocconi University) challenged this widely accepted argument which leads back to the seminal paper of by Alesina, Favero and Giavazzi [LINK]. Fiscal consolidations based on public spending cuts may be preferable to consolidations based on tax increases. The debate illustrated the incompleteness of data sets that appropriately distinguish between the two approaches to fiscal consolidation.

No matter what type of budget consolidation one chooses, it is hard to neglect the political economy of fiscal policy when making decisions. Roel Beetsma (European Fiscal Board) and Jeromin Zettelmeyer (Bruegel) discussed the EU’s pending economic governance reform and in particular the new Stability and Growth Pact (SGP) rules. Beetsma emphasised the role of member states’ Independent Fiscal Councils (IFIs) in fiscal surveillance and called for “national ownership” to feature more prominently, ensuring adequate implementation of longer-term fiscal-structural plans. Zettelmeyer provided first calculations of the fiscal adjustment implied by the proposed new rules, which seemed very ambitious. They require high structural primary balances for some (high debt) euro area countries in the longer term. On a more theoretical tone, Geert Mesters (Universitat Pompeu Fabra) discussed the so-called fiscal-macro targeting rules, a new class of fiscal rules that could possibly be applied to the Stability and Growth Pact. These rules can simultaneously include fiscal ceilings to ensure fiscal discipline and at the same time leave more room for macro stabilisation. Providing a very practical additional angle, Eugena Gonzalez-Aguado (Toulouse School of Economics) argued that the application of rules and institutions in a monetary union also depends on the degree of fiscal policy (de)centralisation in a large continental economy like the EU that is composed of several member states. She highlighted that when a national government creates a higher level of nominal debt, it induces the centralised monetary authority to inflate more. Since the country-level fiscal authority does not take into account this adverse indirect effect of its actions on inflation, a negative fiscal externality arises which becomes more severe as the number of countries in the monetary union increases. This means that a fiscal union of countries is better for larger monetary unions like the euro area whereas a decentralised fiscal regime is better for small monetary unions.

But don’t forget: there is a broader structural framework in which macroeconomic policy operates. As European Commission Executive Vice-President Valdis Dombrovskis reminded the audience, there are numerous shorter and longer term (structural) challenges facing the EU economy that affect the macroeconomic environment both directly and indirectly. To overcome these, productivity enhancing investment and structural reforms were needed, including in support of the green and digital transitions. Given the geopolitical environment, this required the backing of an appropriate open strategic autonomy agenda and the fuller integration of banking and capital markets.

How do firms and households react to fiscal adjustments?

The reaction of specific economic agents to fiscal policy may be as important as the policy itself. In that vein, John Sturm Becko (Princeton University) noted that advanced economies feature complicated networks that connect households, firms, and regions. He showed how fiscal policy and its optimal targeting is shaped in such an environment. Notably, while the distributional effects of policy depend on the specific structure of the economy, maximally expansionary fiscal policy simply targets households’ marginal propensity to consume (MPC). At the same time, Nils Wehrhöfer (Deutsche Bundesbank) questioned if cash transfers to households are an effective policy instrument for stimulating demand, at least in the context of a pandemic. Using a novel dataset, he focused on the stimulus programme implemented by the German government during the COVID-19 pandemic and found that the first cash transfer had a significant effect on household spending (with a short-run MPC of about 12%), but that such effects waned thereafter.

The range of arguments and finer points made by the participants of this year’s Fiscal Policy and EMU Governance conference highlighted once again that the complex interaction of fiscal and monetary policies aimed at reacting to a host of (global) economic shocks requires continuous research and careful analysis which informs the decision making that in turn results in a macroeconomic policy mix aimed at best possible outcomes for price stability, economic activity and employment.

The views expressed in each blog entry are those of the author(s) and do not necessarily represent the views of the European Central Bank and the Eurosystem. Any possible errors in this blog regarding the work and views expressed by participants of the Sixth biennial ECB Conference on Fiscal Policy and EMU Governance, are solely our own.

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