Widespread adverse reactions to the UK government’s recent ‘mini-budget’ forced new Prime Minister Liz Truss to resign. The episode highlighted problems of macroeconomic policy coordination and the interests involved.
Macro-policy coordination
But macroeconomic, specifically fiscal-monetary policy coordination almost became “taboo” as central bank independence (CBI) became the new orthodoxy. It has been accused of enabling CBs to finance government deficits. Critics claim inflation, even hyperinflation, becomes inevitable.
Government finance ministries and CBs are the two main macroeconomic policy protagonists. Poor ‘macro-policy’ coordination has generated problems, including contradictory policy responses. This has meant more macroeconomic and financial instability, worrying markets and investors.
Fiscal policy – notably variations in government tax and spending – mainly aims to influence long-term growth and distribution. CB monetary policy – e.g., variations in short-term interest rates and credit growth – claims to prioritize price and exchange rate stability.
By the early 1990s, the ‘Washington consensus’ implied the two macro-policy actors should work independently due to their different time horizons. After all, governments are subject to short-term political considerations inimical to monetary stability needed for long-term growth.
Claiming to be “technocratic”, CBs have increasingly set their own goals or targets. CBI has involved both ‘goal’ and ‘instrument’ independence, instead of ‘goal dependence’ with ‘instrument independence’.
CBI was ostensibly to avoid ‘fiscal dominance’ of monetary policy. Meanwhile, government fiscal policy became subordinated to CB inflation targets. For former Reserve Bank of Australia Deputy Governor Guy Debelle, monetary policy became “the only game in town for demand management”.
Debelle noted that except for rare and brief coordinated fiscal stimuli in early 2009, after the onset of the global financial crisis, “demand management continued to be the sole purview of central banks. Fiscal policy was not much in the mix”.
Sub-optimal outcomes
But more than three decades of “divorce” between independent CBs and fiscal authorities have failed to deliver its promised benefits. Instead, monetary policy dominance has worsened financial instability.
Adam Posen found the costs of disinflation, or keeping inflation low, higher in OECD countries with CBI. Carl Walsh found likewise in the European Community.
For Guy Debelle and Stanley Fischer, CBs have sought to enhance their credibility by being tougher on inflation, even at the expense of output and employment losses.
Committed to arbitrary targets, independent CBs have sought credit for keeping inflation low. They deny other contributory factors, e.g., labour’s diminished bargaining power and globalization, particularly cheaper supplies.
John Taylor, author of the ‘Taylor rule’ CB mantra, concluded CB “performance was not associated with de jure [legislated] central bank independence”. De jure CB independence has not prevented them from “deviating from policies that lead to both price and output stability”.
The de facto independent US Fed has also taken “actions that have led to high unemployment and/or high inflation”. As single-minded independent CBs pursued low inflation, they neglected their responsibility for financial stability.
CBs’ indiscriminate monetary expansion during the 2000s’ Great Moderation enabled asset price bubbles and dangerous speculation, culminating in the global financial crisis (GFC).
Since the GFC, “the financial sector has become [increasingly] dependent on easy liquidity… To compensate for quantitative easing (QE)-induced low return…, [holders of safe long-term government bonds] increased the risk profile of their other assets, taking on more leverage, and hedging interest rate risk with derivatives”.
Independent CBs also never acknowledge the adverse distributional consequences of their policies. This has been true of both conventional policies, involving interest rate adjustments, and unconventional ones, with bond buying, or QE. All have enabled speculation, credit provision and other financial investments.
They have also helped inefficient and uncompetitive ‘zombie’ enterprises survive. Instead of reversing declining long-term productivity growth, the slowdown since the GFC “has been steep and prolonged”.
Workers’ real wages have remained stagnant or even declined, lowering labour’s income share and widening income inequality. As crises hit and monetary policies were tightened, workers lost jobs and incomes. Workers are doubly hit as governments pursue fiscal austerity to keep inflation low.
Dire consequences
The pandemic has seen unprecedented fiscal and monetary responses. But there has been little coordination between fiscal and monetary authorities. Unsurprisingly, greater pandemic-induced fiscal deficits and monetary expansion have raised inflationary pressures, especially with supply disruptions.
This could have been avoided if policymakers had better coordinated fiscal and monetary measures to unlock key supply bottlenecks. War and economic sanctions have made the supply situation even more dire.
Government debt has been rising since the GFC, reaching record levels due to pandemic measures. CBs hiking interest rates to contain inflation have thus worsened public debt burdens, inviting austerity measures.
Thus, countries go through cycles of debt accumulation and output contraction. Supposed to contain inflation, they adversely impact livelihoods. Many more developing countries face debt crises, further setting back progress.
Needed reforms
Sixty years ago, Milton Friedman asserted, “money is too important to be left to the central bankers”. He elaborated, “One economic defect of an independent central bank … is that it almost invariably involves dispersal of responsibility… Another defect … is the extent to which policy is … made highly dependent on personalities… third … defect is that an independent central bank will almost invariably give undue emphasis to the point of view of bankers”.
Thus, government-sceptic Friedman recommended, “either to make the Federal Reserve a bureau in the Treasury under the secretary of the Treasury, or to put the Federal Reserve under direct congressional control.
“Either involves terminating the so-called independence of the system… either would establish a strong incentive for the Fed to produce a stabler monetary environment than we have had”.
Undoubtedly, this is an extreme solution. Friedman also suggested replacing CB discretion with monetary policy rules to resolve the problem of lack of coordination. But, as Alan Blinder has observed, such rules are “unlikely to score highly”.
Effective fiscal-monetary policy coordination requires appropriate supporting institutions and operating arrangements. As IMF research has shown, “neither legal independence of central bank nor a balanced budget clause or a rule-based monetary policy framework … are enough to ensure effective monetary and fiscal policy coordination”.
Although rules-based policies may enhance transparency and strengthen discipline, they cannot create “credibility”, which depends on policy content, not policy frameworks.
For Debelle, a combination of “goal dependence” and “instrument or operational independence” of CBs under strong democratic or parliamentary oversight may be appropriate for developed countries.
There is also a need to broaden membership of CB governing boards to avoid dominance by financial interests and to represent broader national interests.
But macro-policy coordination should involve more than merely an appropriate fiscal-monetary policy mix. A more coherent approach should also incorporate sectoral strategies, e.g., public investment in renewable energy, education & training, healthcare. Such policy coordination should enable sustainable development and reverse declining productivity growth.
As Buiter urges, it is up to governments “to make appropriate use of … fiscal space” created by fiscal-monetary coordination. Democratic checks and balances are needed to prevent “pork-barrelling” and other fiscal abuses and to protect fiscal decision-making from corruption.
Anis Chowdhury is Adjunct Professor of Economics, Western Sydney University & University of New South Wales (Canberra campus). He served as a senior official at UN-DESA (New York) and UN-ESCAP (Bangkok). Prior to joining the United Nations, he was Professor of Economics at Western Sydney University.
Jomo Kwame Sundaram is a prominent Malaysian economist. He is senior adviser at the Khazanah Research Institute, visiting fellow at the Initiative for Policy Dialogue, Columbia University, and adjunct professor at the International Islamic University.
