7th July 2011 – The Greek Sovereign Debt Crisis and the Art of Political Deception Part 5 – Structural Gamesmanship: Monetary and Fiscal Dominance

The Greek Sovereign Debt Crisis and the Art of Political Deception Part 5 – Structural Gamesmanship: Monetary and Fiscal Dominance

Trichet's Euro

Introducing the Central Banks

Let’s pick up where we left off from the last piece, I introduced you to a couple of white papers written by Ardy and Leblond about a decade ago and made a couple of observations:

In conclusion, there are really only two things I wish you to take from this piece:

1. the nature of deficit reductions and what Leblond referred to as temporary versus structural factors.
2. the quirkiness of Ardy’s final comment. “With responsibility for monetary and fiscal policy split there is the possibility for a policy game to develop between the fiscal and monetary authorities (Nordhaus, 1994).”

Ardy then goes on to suggest that, not only are Central Banks and Governments politically intertwined, their motivations and intentions may at times be quite different, at times even in conflict. It is here that “the game” gets a little more intense and Monetary-to-Fiscal dynamic becomes more complex. Today I will expand a little on the role of the Stability and Growth Pact in a monetary sense. We will also examine why and how the ECB’s mandate is different to the Fed’s – and why it is not always constructive to compare policies between the two, even in a modern globalized economy. Let’s continue with Ardy, I recommend you look at the paper to get all the references etc, [emphasis mine]:

There is still no single fiscal authority for the creation and adjustment of the overall fiscal stance of the eurozone. This has one possible advantage in that there is no direct institutional competitor for the ECB. However, this advantage is at the cost of a serious policy gap at the European level, given the necessary interdependence between a stable monetary policy and fiscal policy (Sims, 1999).

With responsibility for monetary and fiscal policy split there is the possibility for a policy game to develop between the fiscal and monetary authorities (Nordhaus, 1994). This will be the case if they have different preferences.

The fiscal authorities might desire a combination of unemployment and inflation which is below those shown to be possible by the output-inflation trade-off. The monetary authority’s objective by contrast is singular price stability. There are assumed to be two instruments of economic policy: monetary policy represented by the interest rate; and fiscal policy represented by the public sector deficit. If short-run inflation is determined by a simple Phillips curve relationship between output and inflation, the authorities’ preferences can be expressed in terms of different combinations of the public sector deficit and interest rates.

Rules of the Game

In fact these two differentials in fiscal versus monetary policy preference can be represented in quite a neat little graph. Let’s imprint this Philips curve on the brain.

Fiscal vs Monetary Reaction Functions (Source: Ardy 2000)

Ardy does a good job of explaining this graph so let’s permit him to continue [emphasis mine].

…the Mi line shows the interest rate which the monetary authority will set for each level of public sector deficit so as to achieve price stability. The Fd line shows the public deficit which the fiscal authorities will set for each level of interest rates so as to maximise their preference for low unemployment and low inflation. Since the monetary authority is more inflation-averse, its preference will be for a higher interest rate (lower output) for a given public sector deficit. The fiscal authority by contrast will prefer a higher public sector deficit (more output) at a given interest rate.

Given these preferences of the monetary and fiscal authorities, the outcome of this game will be determined by the extent of cooperation or independence of decision-making. The preferred outcome for the fiscal authorities is the point of fiscal bliss and for the monetary authorities the point of monetary bliss. So the cooperative solution would be represented by the heavy contract curve between these two points, representing a compromise between the preferences of the two authorities. In the non-cooperative case the monetary authority has one primary objective, the control of inflation; so it simply reacts to the fiscal authorities’ deficit by setting the interest rate along the Mi function. The fiscal authority, in trying to raise employment by expanding the public sector deficit, will realise that this will have an effect on interest rates; so the fiscal reaction function is less steep than the Fd line. The non-cooperative Nash equilibrium will occur where the two reaction functions intersect. The result is a higher deficit and a higher interest rate than are desired by either party. The fiscal authority is trying to reduce unemployment by expanding the deficit, but the monetary authority is raising the interest rate to combat inflation.

Purist monetary policy focuses really only on one objective: price stability and its monetary considerations. It does not include employment maximization (the Fed’s other mandate) which is a more political, fiscally-influenced, mandate. Never-the-less, we see that monetary and fiscal objectives follow similar principles, yet slightly different trajectories. The important recognition being that, while granting a degree of independence to the central bank is deemed preferable, there must also be some form of coordination between fiscal and monetary policy in order for “independent” monetary to be effective. This means there needs to be a linkage between the government and the central bank, firstly in the sense of a subjective political relationship but, more importantly, structurally as well.

Fiscal versus Monetary Dominance

In the US, the relationship binding monetary policy to fiscal policy is cutely coded with the Fed’s second mandate of maximization of employment. This mandate-tweak heavily aligns the Fed’s commitments and motivations with those in Washington. But note, this has modification occurs on the side of the central bank not the government. I’m not saying it is wrong or right but we must recognize that it is a structural politicization of the Fed. Due to this additional, more politically-motivated, mandate (the Fed’s) monetary policy dominance, is in effect, sacrificed for (the Government’s) fiscal policy dominance. Washington’s mandate is not moved towards the monetary objective, instead the Fed’s mandate is moved, from monetary purism, towards Washington’s political objectives – the distinction is subtle, but very important.

To ratify this thesis let’s pick up where Ardy left off…

Where there are differences in preferences between the monetary and the fiscal authorities there are two types of non-cooperative regime that can be distinguished: monetary dominance; and fiscal dominance (Canzoneri and Diba, 1996). With monetary dominance the central bank is committed to price stability and forces the government to adjust its spending and taxes. Fiscal dominance would imply that the government decides its net deficit and that the central bank will ultimately print money to finance these deficits.

Bingo. This lack of monetary dominance neatly explains my observation of the Obama administration (and other previous administrations!) effectively “front-running” the Fed with deficit-inducing policy and expecting the Fed to mop up the mess with money-printing.

You should be connecting the dots now, dear reader. Let’s turn our focus to Europe and the ECB. Fundamentally, the same objectives exist in Figure 1, above. But there are some important distinctions. The mandate of the ECB is kept unequivocally simple: price stability, nothing else, just price stability. This is the first disassociation of European monetary policy to European politics and fiscal policy. But, as we have come to understand, somewhere there must always be a concrete linkage between fiscal and monetary policy and this needs to be more than subjective assumption – it needs to have structural existence.

In its desire to preserve the sacrosanct independence of the ECB, instead of choosing to coerce the central bank mandate towards more political, fiscal motivations, like the Fed, the European constitution has opted to do the reverse. Instead the fiscal policies of government(s) are politically constrained to converge towards the ECB’s, more purist, monetary reaction function. Thus deficits are structurally discouraged via a legislation (the Stability and Growth Pact and Excessive Deficit Procedure – highlighted in previous comments) aimed squarely at the fiscal responsibility of Member State governments – who must thus concede power at the margin to the Monetary Domination of the ECB. Let’s continue with Ardy…

The excessive deficit procedure can be seen as reinforcing the market belief that the primary surplus will respond quickly to rising debt, thus heading off any need for inflationary bail-outs. Thus the SGP can be seen to reinforce the ECB’s credibility by providing an additional mechanism to ensure monetary dominance. It also helps to limit the possibility of a leadership battle between the monetary and fiscal policy, which can be costly, as shown by the contradictory policy pursued by the German government and the Bundesbank after German unification.

Ardy then goes on to talk about the practicalities (and failures) of such monetary independence and dominance in his conclusion:

The ECB, as a new central bank, faces a problem as regards its legitimacy and credibility, a problem exacerbated by its unique institutional setting, in particular the lack of an EU level counterpart fiscal authority. The SGP goes some way to answering this problem by reinforcing the monetary dominance of the ECB over the fiscal prerogatives of national governments. Where the SGP fails is by not providing a mechanism to achieve aggregate fiscal outcomes that are compatible with monetary policy.

But it is his final sentences which are the most poignant [emphasis mine]…

…it could be argued, the greater independence of the economic policy achieved through EMU lessens the potential impact on the eurozone economy of fiscal policy errors. Thus, although the need to coordinate monetary and fiscal policy remains largely unresolved, it has not so been revealed as a fundamental flaw in the design of EMU. More severe tests are yet to come, particularly an economic downturn, when the system’s ability to respond to a recession would call into question the lack of a mechanism in EMU to coordinate monetary and fiscal policy.

We are in the midst of, what Ardy refers to as a “severe test” of the independence of the ECB and structural soundness of its monetary authority. Here we observe, in full gory detail, the guts of the European economic model. But the conclusions we have drawn have helped us to understand many of the questions that modern monetarists seem to have difficulty understanding with respect to market action and the characteristics of European monetary policy (versus, say, traditional American policy).

• The first thing we notice is that it is dangerous to compare the two central banks, not only are their mandates different so is their authority and (as I will explain later), consequently, their ultimate responsibilities are vastly different.
• The most vocal, authoritative, constant and “visible” member of European politics is not the head of the Commission or Parliament or the Economic Financial Committee, but Mr Trichet himself – the President of the ECB.
• American central banking has always been politically entrenched and subordinated to fiscal authority – with only a few exceptions (Volcker 1981).
• Greenspan’s post-Volcker actions could be interpreted as an ideological agenda but also, interestingly, as a habitual reversion of dominance back to fiscal authorities. A surrender, not of individual weakness but, almost, of structural duty.
• The ECB continues to sound hawkish (even today), much to the horror of international pundits, not because it has lost the plot but because:
• it has a unique and fundamentally unambiguous mandate of purely and only price stability
• credibility over monetary independence and monetary dominance is absolutely imperative in a Eurozone of diverse nations.
• the ECB is the supranational, fiscal Don.

Would The Real Fiscal Authority Please Stand Up

Yes, that’s right, The Don, The Godfather, The Top Dog of pan-European politics is not a politician but a Central Banker!

In previous comments I asked: who was ultimately responsible for convergence, who was ultimately responsible for doling out punishment to fiscal profligates? The answer is that the ECB, in its brutally relentless pursuit of a single mandate, will ultimately hand down justice to fiscal crimes via a monetary policy devoid of any political influence, localized or otherwise. Ambitious, yes, but it’s also quite handsome. Complicated cross-dynamics with the transmission system (banking sector) aside, it is not hard to understand why the ECB continues to spout hawkish rhetoric in the face of regional sovereign meltdowns at the periphery. Trichet’s seemingly contrarian communications are to warn Europeans at large that the ECB absolutely has no authority towards employment, poverty or any other political agenda. The iron fist of monetary dominance will not be compromised no matter how fiscally wrecked “your” balance sheet is.

An Offer You Can’t Refuse

“I’m gonna make him an offer he can’t refuse” – Vito Corleone

One needs to look at European central banking from a completely different perspective to American central banking. It is almost as though they are two entirely different types of organisation. It is, thus both unintuitive and ironic that, by trying to enforce a less political mandate, the ECB, ultimately, becomes the apex political authority. Sure, fiscal authorities need to be accountable for their own profligate actions but ultimately the ECB is accountable to something far greater: the credibility of the entire economic structure of the European Monetary Union. This responsibility supersedes even the solvency, credibility and, if need be, the stability of entire Member States. The ECB has not lost the plot, on the contrary, it is adhering consistently to its clearly defined role right down “to the letter” and thus adamantly preserving the independence, credibility and, importantly, its “dominance”, which is structurally bestowed upon it. But bluntly, the argument Trichet correctly poses is:

“I’m gonna make you an offer you can’t refuse”…don’t even try to call my bluff on this one… the credibility damage we face by giving in to political pressures (loss of dominance) would be far greater than the damage if we simply had to puke our Greek paper and let it default all over your (German/French) banking system… we’ve done our bit with unwavering steadfastness – now you (fiscal authorities in the EU) step up to the plate or bear the consequences.

Whether he is bluffing or not is a matter of conjecture, but this could be Trichet’s finest hour. It is worth noting that despite the most calamitous year ever for the European Monetary Union, the Euro is still up 15% on the US Dollar over the year – and for good reason. If Member States can agree a compromise and the ECB can emerge with its reputation relatively undamaged (and it is all relative in the context of fiat currencies) this will be a triumph not just for the peripherals but also for European economic policy and the Euro’s status as a currency of some repute. True, if things go awry it could be a disaster for the European dream, but if things go right, the next few quarters could also be a moment of shining glory for the ECB and, indeed, its currency.

Let the games begin.

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