Macroeconomic stabilization, monetary-fiscal interactions, and Europe's monetary union

TL;DR: This paper reviewed models of business cycle stabilization with an eye to formulating lessons for policy in the euro area and described practical ways for the Euro area to be able to implement an effective monetary-fiscal policy mix.

About: This article is published in European Journal of Political Economy.The article was published on 2019-03-01 and is currently open access. It has received 19 citations till now. The article focuses on the topics: Policy mix & Fiscal policy.

Summary

1 Introduction

• Standard macroeconomic models explain why fluctuations in aggregate economic activity can be excessive and suggest that appropriate stabilization policy can dampen the undesirable variability.
• At the end of 2015, real per capita GDP of the euro area was 1.6 percent below its level eight years before, at the end of 2007, as a consequence of the Great Recession, the second recession of 2012-2013 and the subsequent slow recovery.
• Meanwhile, while national fiscal policies were accommodative in the immediate aftermath of the global financial crisis, they became non-accommodative soon thereafter, even in the member states with relatively strong fiscal fundamentals.
• Below the authors review standard business cycle models commonly used in academia and in policy institutions.
• The authors describe practical ways for the euro area to be able to pursue an effective stabilization policy.

2 Monetary policy alone may fail to stabilize economic activity and inflation

• Standard models and the recent experience of a number of advanced economies suggest that monetary policy alone may fail to stabilize economic activity and inflation satisfactorily due to the lower bound on nominal interest rates.
• In the face of small or moderate disturbances to the demand side of the economy, the central bank can stabilize economic activity and inflation by setting its policy rates such that the implied real interest 1.
• The real rate can be too high and economic activity and inflation too low – possibly for a long time – relative to what would be desirable.
• While forward guidance can help improve macroeconomic outcomes, its effects are bound to be limited if long-term interest rates are low to begin with.
• Buiter and Panigirtzoglou (2003) and Agarwal and Kimball (2015) write about the possibility of eliminating the lower bound constraint.

3 Monetary policy and fiscal policy together can stabilize economic activity and inflation

• Precisely at a time when the central bank’s policy rates are expected to stay at or close to the lower bound for an extended period of time, monetary and fiscal policy together can have a sizable impact on the economy.
• Households raise their demand for goods, and output and marginal costs increase.
• Suppose that fiscal policy makes the primary surplus rise with the real value of government bonds including government bonds held by the central bank, at least eventually.

4 Why achieving an accommodative fiscal policy stance is difficult in the euro area

• Achieving and maintaining an accommodative fiscal policy stance has proved difficult in the euro area, in the current institutions setting.
• In a country that issues its own fiat currency, the national fiscal and monetary authorities together can ensure that public debt is non-defaultable and the interest rates on public debt stay low as the fiscal accommodation unfolds.
• Reminiscent of the recent experience of several euro area member states, expectations of default or debt restructuring risk becoming self-fulfilling: a government that would have been solvent if the yields had stayed low can end up being insolvent, because it finds itself unable or unwilling to stabilize debt by increasing primary surpluses sufficiently after the yields have risen.
• 20 See Corsetti et al. (2013, 2014) for recent business cycle models that emphasize the link between government bond yields and interest rates faced by private agents.

5 A central bank’s balance sheet may need fiscal support

• The most important liabilities of a modern central bank are fiat currency and bank reserves.
• When the quantity of reserves is small, risks to the monetary authority’s balance sheet stemming from this source are typically low.
• Therefore, following a significant decline in the value of the central bank’s assets, it is possible that the present value of remittances will have to become negative if the present value of seigniorage is to remain consistent with price stability.
• In addition to the risk of the central bank losing control of the price level after a balance-sheet disturbance, ex-ante distortions could arise.

6 Way forward for the euro area

• The key lesson from the literature is that in the wake of a large recessionary shock accommodative monetary and fiscal policy together may be necessary to stabilize the economy satisfactorily.
• While addressing this question, it is important to recognize that successful stabilization policies can be run in different institutional settings, and therefore there is not a unique way for the member states of the euro area to proceed.

6.1 Fiscal coordination around a non-defaultable Eurobond

• And the structural primary budget in Portugal, to give another example, improved from -7.4 to 2.7 percent of GDP, coincident with a decline in GDP per capita by 3 percent.
• This box considers an example of a reaction function for national fiscal authorities in a monetary union that preserves fiscal discipline for each country while, at the same, allowing for accommodative fiscal policy in the wake of an adverse disturbance.
• In particular, country n raises its primary surplus when the country’s share in overall debt exceeds 𝜃𝜃𝑛𝑛 while reducing its primary surplus when the share falls short of 𝜃𝜃𝑛𝑛.

6.2 A benchmark to think about other proposals for reform

• The example of an institutional setup from Section 6.1 helps to think about other proposals for reform of fiscal decision-making in the euro area.
• Each member state would need to abandon some sovereignty in matters of fiscal policy (e.g., think of the fund’s strictly limited power to tax).
• A deep fiscal union with rules preventing accommodative fiscal policy would not help smooth out the business cycles.
• Table 1 summarizes selected other recent proposals for reform featuring Eurobonds or a euro area entity that would purchase national public debt.
• The fiscal criteria outlined here could envisage a slow reduction of national public debt levels over time until a steady state is reached.

6.3 An option for the near future

• Since a euro area institution able to issue non-defaultable debt already exists, the ECB, one could argue that the simplest solution would be for the ECB to act as the fund described here.
• Indeed, a policy mix consisting of the ECB keeping its interest rates low and expanding the monetary base in order to purchase national public debt – as implemented in the Public Sector Purchase Program – together with fiscal accommodation by the member states would have had sizable effects on the economy and remains a sensible short-term option.
• That being said, in the medium and long run the institutional structure including the fund, described here, appears preferable.
• The ECB does not have the ability to tax and therefore it cannot provide fiscal support for the balance sheet of the Eurosystem.
• Moreover, it seems desirable for an institution making decisions concerning fiscal policy Macroeconomic stabilization, monetary-fiscal interactions, and Europe’s monetary union – like the fund described here – to be subject to more direct democratic control than that applied to a central bank.

7 Additional considerations

• The argument for non-defaultable Eurobonds in this paper focuses on their role in business cycle stabilization policy.
• To reap these benefits to a significant degree, the market for Eurobonds would have to be very liquid, or, in other words, the fund described here would have to purchase large quantities of national public debt more or less continuously.
• It seems preferable for the fund, at least initially, to intervene only when a need for euro-area-wide fiscal accommodation has arisen and possibly without making large purchases.
• By contrast, other models have emphasized that monetary policy affects directly firms’ cash-flow and households’ wages and disposable income, in an environment where borrowing constraints are pervasive.
• In addition, the standard models the authors have focused on abstract from issues such as hysteresis effects and secular stagnation that have received attention elsewhere in the literature, including recently.

8 Conclusions

• In the wake of a large recessionary disturbance accommodative monetary and fiscal policy together may be necessary to stabilize economic activity and inflation.
• The authors also suggested an option for the short run that consists of the monetary accommodation already being implemented together with fiscal accommodation by the member states.
• 29 See, for instance, Krishnamurthy and Vissing-Jorgensen (2012).
• Blanchard et al. (2015) provide a more recent, empirical analysis.
• Macroeconomic stabilization, monetary-fiscal interactions, and Europe’s monetary union.

Figures

Table 1: The proposal in this paper compared with other proposals featuring Eurobonds or a euro area entity that would purchase national public debt

Frequently asked questions

Q1. What would be the first accommodative fiscal intervention for the euro area?

Macroeconomic stabilization, monetary-fiscal interactions, and Europe’s monetary uniondecline, relative to the baseline without the need for fiscal accommodation, and an accommodative fiscal stance for the euro area as a whole would result. 

Q2. What is the effect of a permanent expansion in the monetary base to finance purchases of government?

Then a permanent expansion in the monetary base to finance purchases of government bonds by the central bank increases private agents’ wealth relative to the primary surpluses (because the primary surpluses decline as the quantity of government bonds in the hands of private agents falls). 

Q3. What is the role of the central bank in coordinating agents’ expectations?

purchases of government bonds by the central bank may coordinate agents’ expectations on a desirable path for economic activity and inflation. 

Q4. What are the main issues that have received attention elsewhere?

In addition, the standard models the authors have focused on abstract from issues such as hysteresis effects and secular stagnation that have received attention elsewhere in the literature, including recently. 

Q5. What is the simplest solution for the ECB to act as?

One could argue that, since a euro area institution able to issue non-defaultable debt already exists, the ECB, the simplest solution would be for that institution to act as the fund described here. 

Q6. What would be the incentive for the national fiscal authorities to fulfill the fiscal criteria?

Ex ante, national fiscal authorities would have an incentive to fulfill the fiscal criteria so as to avoid interest rate premia and credit rationing. 

Q7. What is the key reason behind the improved outcomes?

The key reason behind these improved outcomes is more accommodative fiscal policy which, however, does not lead to increased spreads on government bonds thanks to the presence of the fund. 

Q8. What do the models and the historical record suggest that unconventional monetary policy can help stabilize the economy?

Macroeconomic models and the historical record suggest that unconventional monetary policy can help stabilize the economy but they also caution that, in some circumstances, forward guidance and balance-sheet policies may prove indecisive. 

Q9. What is the main reason for the asymmetric business cycle in the euro area?

The business cycle fluctuations in the euro area have in fact been asymmetric, in particular following the onset of the sovereign debt crisis in 2010, in that the macroeconomic outcomes have differed markedly across the member states. 

Q10. What is the main reason for using fiscal policy stabilization tools?

The possibility of asymmetric business cycles provides an additional reason, specific to the context of a monetary union, to use fiscal policy stabilization tools. 

Q11. What would be the need for an upfront, sharp decrease in the stocks of national public debt?

With the fund ready to issue nondefaultable bonds to purchase national public debt, there would be no need for an upfront, sharp decrease in the stocks of that debt. 

Q12. What is the way to get the benefits of a non-defaultable eurobond?

To reap these benefits to a significant degree, the market for Eurobonds would have to be very liquid, or, in other words, the fund described here would have to purchase large quantities of national public debt more or less continuously.