In memory of Dr. Andreas Höfert

Dominance and the “flation” debate

The debate about whether the ultimate outcome of the 2007-08 financial crisis will be deflationary depression or inflationary stagnation is ongoing. Empirical evidence won’t help us here. Some countries, especially in the European periphery, have GDPs well below where they were in 2007, unemployment rates over 20% and internal devaluation leading to deflation. Other countries, like the UK, are stagnating as inflation runs above the once-stated objectives of their central banks.

This state of affairs, with some countries experiencing deflation while others are hit by inflation, can be explained by the complex interplay between fiscal and monetary policy. This interplay in turn is colored by which policy dominates the other. Though this idea might seem strange in a world of independent central banks, US economists Thomas Sargent and Neil Wallace demonstrated in a seminal article more than 30 years ago that fiscal and monetary policies cannot be set independently of each other.

In other words, the first-mover advantage is crucial to understanding how things will unfold. If fiscal policy is in the driver’s seat, a government can “order” the central bank to monetize part of its deficit spending. When monetary policy has the upper hand, a central bank can “force” a government to practice austerity. However, the power of one policy over the other is never absolute. Should a government abuse debt monetization, it risks letting inflation run rampant. A central bank imposing too much austerity can cause debt-to-GDP ratios to soar and ultimately lead the country into default.

Making central banks independent of the government has been one way of avoiding damaging fiscal dominance. But such independence is also not absolute.

The US Federal Reserve and the Bank of England (BoE) justify their quantitative easing operations and government bond buying by pointing to their lackluster economies. However, they are also helping their governments keep a lid on debt. Given the staggering debt totals of both countries, which exceed 100% of GDP in the US and 90% in the UK, a marked rise in interest rates could spell disaster, considering that neither country is achieving the necessary primary surpluses to return it to a sustainable debt path.

The Bank of Japan (BoJ) has now joined the club of fiscally dominated central banks. While the former BoJ governor expressed reservations about overly expansive monetary policy, Prime Minister Abe made it clear upon taking office that the BoJ should increase its inflation target from 1% to 2% and use unlimited means to achieve it. In a nutshell, this is what the BoJ announced it would do last week. To underscore who is in charge, Abe threatened to revoke the “independence” of the BoJ.

Institutionally, the European Central Bank is more independent than the Fed, the BoE and the BoJ, simply because you have to convince more than one government (actually 16 plus Germany) to change policies or enforce fiscal dominance. It’s hardly surprising then the European periphery is currently battling restrictive fiscal and monetary policies with the ECB (backed by inflation-sensitive Germany) in control. Its stance is: first get your house in order and then we’ll ease monetary conditions. But even in Europe monetary dominance is not unlimited. A country always has the ultimate option of leaving the Eurozone, which would jeopardize the future of the currency.

We should understand Mario Draghi’s comment last year that he would do “whatever it takes” to save the euro in this context. Outright Monetary Transactions, the bond-buying program of the ECB, has austerity strings attached to it. But if a country’s threat to leave the Eurozone were to become serious, those strings would undoubtedly be loosened.

It’s safe to conclude that, even in the Eurozone, fiscal dominance will ultimately prevail. And it’s clear that, in the long run, inflation will be the final outcome of the financial crisis.