Fiscal and monetary policy—renewed international debate

Robert Dolamore, Economics

Key issue
The global financial crisis has sparked renewed international debate about the roles and conduct of fiscal and monetary policy. While the strength of Australia’s macroeconomic framework is generally acknowledged, this debate may nonetheless provide important insights.

The global financial crisis (GFC) has prompted renewed international debate about the roles and conduct of fiscal and monetary policy. The International Monetary Fund (IMF) has been at the forefront of this debate as economists try to identify the lessons from the GFC for macroeconomic policy. This note briefly sketches some of the key ideas from this debate.

This note is intended to be read in conjunction with the brief The Tools of Macroeconomic Policy—a Short Primer, which explains many of the economic terms used here.

The pre-GFC consensus

In the years prior to the GFC a consensus developed about the roles fiscal and monetary policy should play in economic management. Monetary policy was seen as the appropriate policy instrument to stabilise short-run fluctuations in aggregate demand. Monetary policy can be adjusted relatively quickly and if delegated to an independent central bank is less susceptible to the influence of political considerations.

In contrast, discretionary fiscal policy was seen as having less of a role in short-run demand management. Among other things, discretionary actions are less nimble than monetary policy and therefore less suited to managing ‘normal’ fluctuations in activity. The effectiveness of discretionary actions tends to be blunted because their formulation and implementation can lag economic developments and are susceptible to political influence. Further, such measures are not easily reversed when they are no longer justified by economic conditions.

Generally, fiscal policy was seen as more appropriately focused on the medium to longer term. For example, fiscal policy can help address medium term structural issues and ensure the long term sustainability of public finances.

However, this was not seen as precluding a role for the automatic stabilisers. The automatic stabilisers can cushion short run fluctuations with practically no information and implementation lags, and relatively short impact lags. Importantly, if the automatic stabilisers are left to operate symmetrically over the economic cycle, they should not contribute to any structural deterioration in the budgetary position.

A post GFC re-think

The use of fiscal stimulus measures in response to the GFC has given greater prominence to discretionary fiscal policy as a countercyclical tool. It has been suggested that during the crisis fiscal policy had a ‘sleeping beauty’ moment—with conventional monetary policy rapidly reaching its limits and with the financial system experiencing acute problems, the ‘forgotten’ tool of discretionary fiscal policy was ‘rediscovered’ as a way of supporting aggregate demand.

However, the GFC has clearly shown much depends on whether there is sufficient fiscal space to enable governments to run larger budget deficits. The scope to use fiscal policy as a countercyclical tool, even if this involves no more than allowing the automatic stabilisers to work, may be significantly curtailed by weak public finances. For example, if a government is running large structural deficits and the level of public debt is already high, a large budget deficit makes it vulnerable to changing market sentiment. This underscores the importance of budget discipline even in the good times.

There is also likely to be pressure for a stronger focus on, and transparency about, the underlying structural position of government budgets. There is a risk that even favourable cyclical or one off factors can create problems by masking a deteriorating structural budgetary position that ultimately has to be addressed when the ‘good times’ end.

Among other things, the IMF has floated the idea of designing better automatic stabilisers with a view to strengthening fiscal policy as a countercyclical tool. This might include developing rules that allow some types of government transfers or taxes to vary based on pre-specified triggers tied to the state of the economic cycle.

Internationally, the debate about monetary policy has focused on what it should target and the instruments that should be used. Some argue the GFC has shown monetary policy should target more than low and stable inflation, and officials need to utilise a broader array of instruments than just official interest rates. In relation to the former the concern is that of itself low inflation is not sufficient either to ensure financial stability or maintain a low output gap and robust growth. Options in this space include requiring central banks to more explicitly target financial stability (with possible proxies for financial stability including measures of leverage, credit aggregates and asset prices) and economic activity.

The GFC has also sparked a re-think about the limits of conducting monetary policy primarily through changes to official interest rates. A concern here is that official interest rates are too broad an instrument to deal with the situation where an asset price bubble is developing in one part of the economy but inflationary pressures in the rest of the economy are relatively subdued. In this scenario raising interest rates may successfully dampen the bubble but risks constraining economic activity more generally.

Reflecting this concern, some argue policymakers should use ‘macroprudential’ instruments to help contain imbalances. These are tools (such as capital adequacy requirements, loan to valuation ratios and capital controls) that are more typically thought of as being part of the tool kit of financial market regulators. However, as macroprudential instruments influence aggregate demand through the availability of credit in the economy, there may be potential to actively use them to help stabilise fluctuations in economic activity.

As an analogy for the need for more fiscal space, it has been suggested there is a need for more nominal interest rate room. Controversially, the IMF has floated the idea of setting higher inflation targets (perhaps around 4%) with a view to giving central banks more scope to cut interest rates to support aggregate demand in the face of a severe economic shock and lessen the risk of hitting the zero interest rate bound.

It remains to be seen if any of the ideas that have been floated about macroeconomic management following the GFC ultimately stick. Australia came through the GFC better than most countries and the strength of our macroeconomic framework is generally acknowledged. Nevertheless, the current international debate may still provide opportunities to learn from the experience of others, even if this reflection simply reaffirms the importance of those aspects of macroeconomic policy that served Australia well going into the GFC. This seems all the more important given it is unlikely the next economic crisis will coincide with a once in a lifetime terms of trade boom.

Further reading

O Blanchard, G Dell’Ariccia and P Mauro, Rethinking macroeconomic policy, IMF staff position note, SPN/10/03 International Monetary Fund, February 2010.

O Blanchard, G Dell’Ariccia and P Mauro, Rethinking macro policy II: getting granular, IMF staff discussion note, SDN/13/03, International Monetary Fund, April 2013.

J Stiglitz, ‘Macroeconomics, monetary policy and the crisis, Macro and growth policies in the wake of the crisis, IMF conference, Washington, DC, 7–8 March 2011.

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