Some Incomplete Monetarist Arithmetic

Some Incomplete Monetarist Arithmetic

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In 1981, Sargent & Wallace published their now-famous research paper Some Unpleasant Monetarist Arithmetic. It demonstrated the difficulty that central banks have in controlling inflation when governments are hell-bent on fiscal profligacy. Coming after the fiscal and monetary policy disasters of the 1970s, it seemed like a breath of fresh air. Its recommendation of "monetary dominance" - that fiscal policy-setting should be constrained by the inflation target of the monetary authority - became the standard for "good practice" in macroeconomic management for the next thirty years.

Even today, its shadow lies long. Gavyn Davies recently suggested that the Bank of India needed to establish monetary dominance in order to get inflation under control. And Pozsar and McCulley incorporated its findings into their paper on helicopter money, although they only applied it to the circumstance where inflation was out of control due to fiscal and monetary profligacy. Indeed Sargent & Wallace themselves only apply their analysis to that situation. In effect, they assume that fiscal authorities will always be profligate unless disciplined by a monetary inflation target, and that unconstrained deficit spending will always result in higher inflation.

But the situation in developed countries today is the polar opposite. Today, we have fiscal authorities setting budgetary plans for forthcoming years that are designed to reduce, not increase, deficit spending. The UK's Chancellor of the Exchequer recently announced his intention to contrive an absolute surplus by 2020, on top of existing fiscal plans aiming to achieve a primary surplus by 2018. Once an absolute surplus is achieved, not only is there no deficit but the outstanding stock of debt starts to reduce.

Nor is the UK Government the only fiscal authority looking at long-range spending cuts and tax rises to balance the budget and reduce outstanding debt. Almost every country in Europe is doing the same, either voluntarily or under pressure from Brussels and the EU fiscal compact. And the US government is under pressure from Republicans to impose greater fiscal discipline in the short-run, and from the IMF to do the same in the longer run. Only Japan is bucking the trend at the moment, and even there indirect tax rises are proposed to reduce reliance on deficit spending. In the developed world, at the moment, profligate fiscal authorities are a thing of the past. If anything, fiscal policy in many countries is too tight, not too loose.

At the same time, monetary authorities are pursuing the loosest monetary policy in history in an attempt to stop asset prices falling through the floor and economies grinding to a halt. They have long since given up the fight against inflation: deflation and unemployment are their concerns now (plus of course financial stability). Market monetarists' argument that a determined central bank can always generate inflation is turning out to be wrong in practice. The fact is that no central bank anywhere has yet succeeded in deliberately raising inflation. Nor can they, when their efforts are constantly being undermined by fiscal authorities hell-bent on austerity regardless of the economic circumstances, not to mention campaigns by pressure groups complaining about the effect of loose monetary policy on asset returns. Depressing the value of money is incredibly unpopular, and central banks are not immune to public opinion.

And that brings me to the unfortunate conclusion that we do not have monetary dominance in developed countries. What we actually have is fiscal dominance - but not as envisaged by Sargent & Wallace.

Governments, elected by wealthy voters concerned about the future value of their assets, announce plans to cut spending progressively over several years. Importantly, these plans take no account of the economic circumstances, despite the known fact that fiscal austerity in a recession deepens and prolongs the downturn and may perversely force deficit spending to increase.  Remember that the inflation target, for nearly all central banks (the ECB is an exception) applies on the downside as well as the upside: inflation falling below the target is as bad as inflation rising above target.  Government spending cuts and tax rises that result in inflation falling well below target despite the central bank pursuing very expansive monetary policy - as is currently happening in the US - indicate that the monetary authority does not have control of inflation. The UK's experience also demonstrates this, though in a different way: indirect tax increases and rises in administered prices caused above-target inflation that the central bank was unable to choke off because of the expectation - clearly stated by the Chancellor in a speech at the Mansion House - that fiscal contraction would be offset by loose monetary policy.

Sargent & Wallace's paper was a child of its time. In 1981, it seemed impossible to imagine that a fiscal authority would willingly inflict pain on its citizens for year after year to eliminate deficit spending and reduce debt. Even monetary tightness was a novelty: the Volcker Shock was exactly that - a shock - to Wall Street and Main Street alike. So the paper is deeply flawed due to Sargent & Wallace's inadvertent political bias. In failing to consider the possibility that monetary authorities might have to discipline fiscal authorities that were causing deflation through inappropriate fiscal austerity, their work was incomplete.

It is by no means certain that monetary authorities have the means to impose discipline on austerity-addicted governments. Sargent & Wallace demonstrated that restricting seigniorage income to the fiscal authority by strictly controlling the size of the monetary base was an effective brake on fiscal expansion, since the fiscal authorities were then constrained by the market's willingness to buy government debt at an affordable price. No such restriction is possible on the downside, since expanding seigniorage income simply enables governments to meet deficit and/or debt reduction targets more easily (and therefore encourages more aggressive targets), and markets generally look favourably on the debt of governments imposing fiscal austerity. So governments that set targets for deficit and/or debt reduction independently of the central bank's inflation target (and its unemployment target, where that exists) simply are not subject to monetary discipline.

In fact the situation is even worse. Not only are such governments unconstrained by the central bank's inflation target, they expect the central bank to offset the deflationary effect of their policies with loose monetary policy. In effect, the size of the monetary base is driven by fiscal policy, not monetary - much as it is when fiscal dominance by a profligate government forces the central bank to monetize debt.

And that brings me to the scariest part of this analysis. Sargent & Wallace's paper demonstrated that when there is fiscal dominance by a profligate fiscal authority, not only is the central bank unable to control inflation but its attempts to do so by tightening monetary policy actually make inflation worse. I have not done the maths to prove this (are there any quants out there who fancy a research project?), but if fiscal dominance reverses the effects of monetary policy when the fiscal authority is profligate, it seems reasonable to suppose that it might also do so when it is austere. In which case a very large monetary base created to offset the effects of fiscal contraction could itself be deflationary. This is consistent with research that suggests that excess reserves on bank balance sheets may actually cause tighter credit conditions. Empirically and logically, it seems that loose monetary policy may be counter-productive when coupled with tight fiscal policy. But we really could do with a robust theoretical framework for this.

Maybe it is time for someone to complete Sargent & Wallace's research.

Related reading:

Some Unpleasant Monetarist Arithmetic - Sargent & Wallace

India needs to end fiscal dominance over the central bank - Gavyn Davies, FT (paywall)

Helicopter Money - Pozsar & McCulley

Now, George, about this surplus - Flip Chart Fairy Tales

Joseph, John and Gideon - Coppola Comment

Exit-path implications for collateral chains - Peter Stella, Vox

QE: there's a problem with the transmission - Seeking Alpha (with amazing comment stream)

The base money confusion - FT Alphaville

Inflation, deflation and QE - Coppola Comment

Give Bernanke a long enough lever, and a fulcrum on which to place it, and he'll move NGDP - Moneyness


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Monetary policy isn't gaining traction, not so much broken transmission channels but collateral constraints. Central banks actually cannot 'print money' they can only lend out the front door against what comes in the back, so to speak.

Central banks cannot direct monetary policy toward the public b/c the public has no collateral to offer the central banks. Those who have collateral don't need or want monetary policy to be excessively easy, in fact they are ultimately ruined by easing, zero-returns and 'ordinary' workings (wrackings) of the credit cycle.

Fiscal ease is constrained by the loss of public confidence in the managers as the debt numbers relentlessly increase. FDR during the 1932 election campaign had to sell himself as a hard-nosed advocate for a balanced Federal budget, there are certainly those who promote the same thing in Greece today. Of course, such nonsense never works; no public sector deficit, no private sector surplus ... that is, no wealth for tycoons.

A brilliant article, as usual. Commentators such as Warren Mosler have pointed out that very low interest rates on government debt and purchase of such debt by central banks is equivalent to fiscal contraction as it removes income from the government/central bank to the private sector.

The CB could increase interest rates, reserve requirements or capital requirements when lending is expanding too fast. Or like you said the gov could increase taxes. There is a limit of how much people want to get into debt anyway which will limit debt creation. If money is equity created by cb alongside debt created money, equity created money will dominate.

Commercial bank money could get its name changed so it isn't misrepresentaed as CB money. It could be named "US dollar claims".

The problem with PM's proposal is that the committee hands the money over to the gov once it determines how much to create. The gov can then do whatever it wants it seems. It still has to figure out how effectively use these new funds and it can still send it to cronies or whatever it wishes. Handing directly to public will take the burden off gov, remove any corruption and make the system participatory.


I agree it’s desirable to keep politicians away from the printing press, but under a merged system that’s easily done by having decisions on how much new money to create (i.e. how much stimulus to impart) in the hands of an independent committee of economists, like the BoE MPC.

In fact decisions on stimulus are already largely in the hands of such committees: there’s central bank interest rate committees like the above, plus there are various fiscal responsibility committees springing up round the world.

The system I’m suggesting has actually been set out in this work:

Another problem with a non merged system is that occasionally it would be necessary for governments to run surpluses, i.e. rein in money from the private sector and “unprint” it. Nothing wrong there in theory. But it would involve the central bank sending demands for hard cash to all and sundry. A few million wouldn’t have the ready cash.

That would be as popular as the poll tax or bedroom tax: two measures which may have been logical, but proved unpopular.

In contrast, reining in money from the private sector via a tax increase is something everyone is used to.


It would be easy to administer. Things on this scale already happen. Government departments keep records of social security numbers, drivers licenses or tax file numbers in places like Australia. People without a bank account can get one off their commercial bank, or have cheques sent to their address or pickup cash from the CB.

Consolidating fiscal and monetary policy is not a good idea. Its like consolidating the judiciary with the executive arm. A separation of powers is necessary to not overburden the government and also to limit misuse of power to create money. Also creating a mechanism so people can directly interact with the public will make people more educated about economics and instill greater confidence in the system.

Danny Cooper,

I more or less agree with the PRINCIPLE behind your idea, but not with the details. That is, you propose the central bank should “conduct policy directly with the public”. That would work, but the administration would be difficult: imagine the Bank of England having to keep bank account details of everyone in the country. And what about those with no bank account?

I suggest a better idea is simply to merge monetary and fiscal policy: e.g. if there is a recession, the government / central bank machine should print and spend more money (and/or collect less tax). That way, new money automatically flows into the pockets of whoever government thinks most deserves it: benefit claimants, contractors building motorways, or whatever.

Positive Money and most proponents of Modern Monetary Theory advocate the above “merge” policy.

That merge could meet with stiff resistance from academic economists because the monetary versus fiscal debate has kept hundreds of them employed at the taxpayers’ expense in their ivory towers writing papers and books that don’t need writing.

Monetary policy is completely dysfunctional. The central bank needs to bypass the blocked credit channel and conduct policy directly with the public.

If the central bank expands money directly into people's accounts to achieve its targets demand will increase more than expanding reserves to banks. Banks have a lower propensity to consume than people. Peoples balance sheets will also improve making them more accessible to credit.

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