Bullard and the "Fiscalization" of Monetary Policy, by Tim Duy: I am struggling with the latest speech by St. Louis Federal Reserve President James Bullard. The speech is titled "The Global Battle Over Central Bank Independence," but in the process confuses fiscal policy stabilization as necessarily a threat to central bank independence, travels down a bizarre road that appears to be a misunderstanding of European monetary policy, and misses the obvious example of recent events in Japan.
Bullard begins with a description of the conventional wisdom of the relationship between fiscal and monetary policy. Basically, the former should focus on the medium- and long-run but is poorly suited for short-run stabilization. Such stabilization is the purview of monetary policy, or, more accurately, an independent monetary authority. Bullard quickly goes off the rails:
- The central banks in the G-7 encountered the zero lower bound on nominal interest rates.
- This led many to talk about the need for fiscal authorities to step up and conduct macroeconomic stabilization policy.
- However, the usual political hurdles asserted themselves and led to a hodgepodge of fiscal policy responses not particularly well-timed with macroeconomic events.
By itself, the zero bound did not give rise to increased interest in stabilization though fiscal policy. Instead, it was the inability of central banks to stabilize activity that raised the focus on fiscal policy. Consider the gap between private saving and investment:
Further, consider the gap across the era of the Great Moderation:
So, what's difference? The magnitude of the dislocation. While it is reasonable to believe that monetary policy is the preferable stabilization tool for relatively small perturbations in economic activity, it is not evident that the same is true for large perturbations, especially when the economy is at the zero bound. Indeed, it is the persistence of significant output gaps that triggered the interest in fiscal policy, not the zero bound itself. Does Bullard really believe that the US economy would be in better shape in the absence of a fiscal response?
It is also not clear what "political hurdles" Bullard is referring to, but I would say that the chief hurdle to effective fiscal policy is the rise of the austerians, those that believe that growth is achieved only by reducing deficits. One would think that by now the events in Europe had discredited this opinion as it is increasingly evident that fiscal multipiers are greater than anticipated, but Bullard is not about to be dissuaded.
Bullard cites evidence that monetary policy still provides effective stabilization policy:
- Inflation has generally stayed near target instead of falling dramatically.
Wow, really? He completely ignores evidence that inflation will not fall dramatically in the presence of downward nominal wage rigidities. Moreover, he completely ignores high unemployment or the persistent output gap. And even if you believe that monetary policy can effectively stabilize the economy, you probably are appalled that Bullard believes that the economy has been stabilized in spite of the inability of the Federal Reserve to stabilize the path of nominal GDP.
Bullard then takes a bizarre turn:
- Nevertheless, many see fiscal stabilization policy as desirable in the current context.
- One idea: Suggest that the central bank take actions that are cumbersome to accomplish through a democratically-elected body.
What are these actions? Bullard tries to further his case with recent European monetary policy:
- The European Central Bank recently announced an “outright monetary transactions” (OMT) program.
- This program has been widely interpreted as a promise to buy the sovereign debt of individual nations.
- A key element of the program is that purchases, should they occur, are conditional on the nation meeting certain fiscal targets.
- Purchases would be sterilized, so that the program is not the same as U.S.- and U.K.-style quantitative easing.
- The program has been regarded as “successful” so far.
Now Bullard seems to be saying is that when fiscal policymakers fail (as he assumes they will), then we will turn to monetary policymakers to enact fiscal policy. Now we have apples and oranges. I thought we were on the topic of whether or not fiscal policy can be used as a short-run stabilization tool. Only in an austerian fantasy-land is fiscal policy stabilizing the European economy. This isn't easy to sort out, but Bullard is saying that monetary policymakers in Europe are becoming fiscal policymakers. Bullard seems to be trying to make the argument that monetary policymakers are losing their independence in the process.
The problem is that if anything the opposite is true. It is the fiscal policymakers who are at the mercy of the European Central Bank. Bullard made a turn into the surreal world of European economic policy, where up is down. Bullard continues:
- This is “fiscalization” of monetary policy: Asking the central bank to take actions far outside the remit of monetary policy - The analog in the U.S. would be a promise to purchase, or even monetize, state debt in exchange for the state maintaining a fiscal program considered prudent by the central bank.
- Assistance like this from a central authority to a region is best brokered through the political process in democratically-elected bodies.
- In Europe, the ECB is in essence substituting for a weak pan-European central government.
Yes, the ECB is substituting for a fundamental structural problem in Europe, the lack of a fiscal authority (and doing it poorly, for that matter). This shouldn't happen in the US, where the Fed can pass the buck to Congress and the President. And I agree that monetary policymakers should resist crossing into fiscal policy. But Europe is a whole different world. The ECB acted kicking and screaming because if they didn't the whole European experiment would have collapsed at this point. The ECB was forced to actually do the job of a central bank by acting as lender of last resort of the fiscal authorities, and then only at the cost of insane austerity policy, the complete opposite of the needed European policy. Bullard goes further astray:
- Ordinary monetary policy provides or removes monetary accommodation in response to macroeconomic developments.
- There has been a large macroeconomic development in Europe: Eurozone recession.
- Yet, little direct action has been taken by the ECB in response to the recession.
- One could argue that the monetary policy response to the European recession has been muted compared to more ordinary circumstances.
- Why? By nearly all accounts, the monetary policy process has been bogged down by political wrangling over the OMT and other programs.
So Bullard is arguing that the ECB failed to focus on monetary policy, instead focusing on fiscal policy, and as a consequence Europe is in recession. But nothing prevented the ECB from enacting sane policy; fiscal authorities did not force them to raise interest rates. They chose poor policy time and time again by themselves. Indeed, I don't think Bullard shows any appreciation for the complexity of European economic policy. The ECB wasn't pulled into a role as fiscal policymakers as much as they were pulled into their role as monetary policymakers. The European experiment begins with major structural errors: A lack of fiscal authority, the central bank that does not believe that serving as a lender of last resort is within its mandate, and a bias toward fiscal austerity even in the face of deepening recession. The outcome was chaos. With no clear fiscal counterpart, standard analysis of central banks does not make any sense. Europe has simply been plagued by bad policy across the board.
Also, I am pretty sure that European central bankers will bristle at the implication that their response has been muted. Even I have to admit that they made great strides this year.
I am not even sure why Bullard went down the European road to begin with. The standard argument is that when fiscal policymakers encroach on monetary policy, the path of economic activity becomes unstable and inflationary. Europe is the case of monetary policy encroaching on fiscal policy. Why not take the more obvious example of the Bank of Japan, where monetary policy is looking poised to become a tool of fiscal policy?
In short, I find this to be a confusing speech. The title implies a threat to central bank independence, but he gives little reason to believe such a threat exists. The implementation of fiscal policy does not necessarily imply the lost of monetary independence. The monetary authority could still choose to lean against fiscal policy. That loss of independence would only be evident if monetary policymakers sustained an easy policy at the behest of fiscal policymakers in such a way that fostered higher inflation. Bullard gives no example of a monetary policymaker forced to act in such a way. Instead, he offers up the example of the ECB, which I would say has stripped fiscal policymakers of their independence, not vice-versa. Finally, he misses the obvious example of the potential loss of monetary independence, the Bank of Japan.