Some Incomplete Monetarist Arithmetic
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.
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