Cross-country experience shows the subservience of monetary policy to fiscal policy until the early 1980s, with central
banks’ financing of government deficits often introducing an inflationary bias. With increasing independence for
monetary policy in the advanced economies in the 1980s, the move towards rule-based fiscal policies and the adoption
of inflation targeting by central banks across many countries including emerging markets, the fiscal-monetary
mix progressively became better, thereby enabling countries to switch towards market-based monetary and debt
management practices. Some central banks like the European Central Bank (ECB) avoided any form of ex ante
co-ordination between monetary and fiscal policies, recognising that it could undermine its independence and its
mandate for price stability. Fiscal-monetary co-ordination entered a new phase when the global financial and euro
area sovereign debt crises led central banks to adopt unconventional measures and expand their balance sheets
through purchases of long-dated securities and unimpaired loans, thereby blurring the distinction between fiscal
and monetary policies, while governments undertook bailouts and nationalisation of several financial institutions,
leading to a blurring of fiscal-financial policies. With adverse feedback loops between the sovereign and banking
sectors threatening global recovery and financial stability, scheduling a timely exit from unconventional monetary
policies is the foremost challenge as sovereign debt levels are soaring and growth concerns loom large in advanced
countries. With governments’ inability to stabilise debt levels or even finance deficits at reasonable interest rates,
monetary policy is confronting a new phase of fiscal dominance. A need, therefore, has arisen for credible fiscal
consolidation plans and co-ordination strategies to ensure an optimum fiscal-monetary mix that is consistent with
growth, inflation and financial stability.
I. Introduction
2.1 Interaction between fiscal and monetary
policies to facilitate the attainment of macroeconomic
objectives has been a central as also one of the more
complex relationships in theory and practice across
various countries. There have been significant
developments beginning with the early debate of the
1960s about the relative effectiveness of monetary
and fiscal policies in stabilising demand pressures,
culminating in a broad consensus supporting coordinated
effort on the part of fiscal and monetary
policy authorities to deal with huge deficits and high
inflation.
2.2 During the 1960s and 1970s, the Phillips
curve paradigm dominated monetary economics.
The basic premise was that there existed not only
a short-run but even a long-run trade-off between
inflation and output. This led to a viewpoint that central
banks could achieve higher growth on a sustainable
basis, if they permitted inflation to be a little higher.
The shortcomings of this reasoning were, however,
brought out by the stagflation of the 1970s. These
developments brought about a renewed focus on
price stability as a key objective of monetary policy.
In the subsequent decades, emerging market and
developing economies (EMDEs) also showed an
improvement in terms of achieving the objective of
price stability, as had been the case in advanced
countries. A consensus seemed to have been
emerging that fiscal-monetary co-ordination needs
to work towards ensuring low and stable inflation,
which is conducive to growth and stability. However,
with the occurrence of several episodes of crisis
including the recent global financial crisis, it has
become clear that monetary policy could not afford
to treat asset prices and credit cycles as exogenous
when they, in fact, are significantly influenced by the
policy stance. Therefore, there is a lot of academic
interest to understand how macroeconomic, fiscal
and monetary policies put together can help to
mitigate the build-up of financial imbalances.
2.3 The objective of this chapter is to trace the
developments in macroeconomic theory in respect
of fiscal-monetary co-ordination and examine the
experience of advanced and EMDEs in this area
for pursuing broad macroeconomic objectives of
economic growth and inflation. The chapter also brings
forth the issues of increasing importance of financial
stability that have a bearing on fiscal-monetary co-ordination,
particularly during the post-crisis period.
This chapter is organised into four sections. Section
I describes the traditional targets and instruments
approach of Tinbergen and Theil and draws attention
to the challenges of fiscal-monetary co-ordination,
particularly in situations of multiplicity of objectives,
associated trade-offs, changing relative policy
efficacies and effective shortage of independent
instruments to pursue the objectives. Section II covers international experiences in fiscal-monetary
co-ordination to highlight both the commonality and
differences in challenges experienced across the
advanced economies, including the euro area and
EMDEs. Section III focuses on issues emerging in
the context of fiscal-monetary co-ordination after
the recent global financial crisis. In particular,
this section highlights the issue of contagion and
negative feedback between the vulnerability of
public finances and the financial sector that has
been evident in advanced countries, particularly
the euro area. It also sets out a way forward for
possible arrangements for co-ordination between
fiscal and monetary authorities spanning both face-to-face and arm’s length co-ordination. Section IV concludes the chapter by analysing both theoretical
developments and cross-country experiences that
are relevant to the Indian perspective, as discussed
in the remaining chapters of the report.
II. Macroeconomic Theory
Traditional Orthodoxy: Macroeconomic management
through fiscal policy in the lead, backed by an
accommodative monetary policy
2.4 Historically, the need to have
macroeconomic policy intervention for resolving deficiency of aggregate demand emerged in the
context of the Great Depression of the 1930s.
Since governments could regulate aggregate
economic activity through fiscal policy instruments
of taxes and expenditure, while central banks could
potentially do so indirectly through influencing
interest rates, by providing additional liquidity,
thereby driving investment demand, a need arose
to co-ordinate the two arms of policy-making to
optimise macroeconomic outcomes. The traditional
Keynesian policy prescription called for a lead role
for fiscal policy to address economic slackness
under the Great Depression and meet post-World
War II reconstruction needs. Monetary policy played
a secondary role by either accommodating fiscal
policy through funding of government deficits or
assisting it through direct financing of developmental
expenditures. Accordingly, the intermediate target
of central banks like the US Federal Reserve Board
(Fed) during this period was to keep interest rates
at a low level over the long-run with the primary
objective of “maintaining the value of government
bonds”. Originally, an active fiscal-passive monetary
interface was premised upon two factors. First,
monetary policy effectiveness was perceived to be
low in situations of high unemployment rates co-existing
with a liquidity trap, when interest rates
could not be lowered through monetary measures.
Second, central bankers also accepted a secondary
role for monetary policy as spending decisions
of consumers and firms were considered to be
influenced more by expectations than the rates of
returns on assets.
2.5 By the 1960s, with cheap money fuelling
inflation, monetary policy started regaining some
importance. Pigou (1943) set out a channel, viz.,
wealth channel, whereby changes in the real
quantity of money can influence aggregate demand
even if interest rates remain unaltered. Further, the
“practical and political feasibility” of fiscal policy in
fine-tuning demand management began to be viewed
with scepticism on the back of sluggish adjustment
of government expenditures to economic activity and
political inertia in tax adjustments, as experienced in the US. Nonetheless, the policy lever remained tilted
in favour of fiscal policy on two counts. First, the
price stability objective of monetary policy continued
to hold a low key in comparison with the fiscal policy
objective of promoting full employment. Second, with
limited efficacy in controlling real magnitudes (real
interest rates, unemployment rates and growth rate
of real national income) through nominal quantities,
monetary policy was found to be most suitable for
pursuing the price stability objective by keeping
money supply growth moderate and bereft of large
swings (Friedman, 1968). It was held that monetary
policy could reduce interest rates only temporarily
by increasing the money supply growth along a
negatively sloped liquidity preference curve. Interest
rates would not only revert to higher levels after a
time lag as rising income levels increased demand
for liquidity, but also rise further, reflecting the
declining real quantity of money supply on account of
the increasing price level. Eventually, expansionary
monetary policy by building expectations of rising
prices would lead to rising nominal interest rates over
the long-run. Friedman argued that higher monetary
growth could only temporarily reduce unemployment
below its ‘natural’ rate as unanticipated increase
in demand would lead to a faster rise in selling
prices than that warranted by the cost of factors of
production, including wages. With nominal wages
adjusting to rising prices, real wages increase to
their initial levels, with unemployment returning to
its natural rate. Thus, monetary policy could reduce
unemployment rate below its natural rate only
temporarily at the expense of higher inflation, while
the trade-off withered off in the long-run.
2.6 With a breakdown of the fixed exchange rate
system and OPEC oil price shocks simultaneously
generating acceleration of inflation and high
unemployment in the US and other economies
in the 1970s, it was recognised that the Phillips
curve trade-off between these two variables does
not hold in the long-run. Against the backdrop of
these developments, monetary policy was assigned
the task of controlling inflation through monetary
targeting.
Imperatives for Fiscal-Monetary Co-ordination under
Upper Limits to Bond Financing of Fiscal Deficits,
Paucity of Policy Instruments and Rule-based
Policy-making
2.7 By the early 1980s, Sargent and Wallace’s
‘some unpleasant monetary arithmetic theory’
brought a new perspective of fiscal-monetary co-ordination
in the context of financing of fiscal deficits
through the creation of base money and issuance
of bonds (Sargent and Wallace, 1981). Arguably, if
the government independently set its inter-temporal
path of fiscal deficits to be financed through a
combination of base money creation and issuance
of bonds, any rise in fiscal deficit would necessitate
a corresponding rise in real stock of bonds held by
the public in order to restrict growth in base money.
If interest rate on bonds were higher than the growth
rate of the economy, eventually an upper limit of real
stock of bonds relative to the economy would be
reached, as the real stock of bonds would increase
faster than the growth rate of the economy. Given
that any further increase in fiscal deficit would have
to be financed through increases in base money, the
ability of monetary policy to control inflation would
be negated in the long-run even under a monetary
targeting regime. Further, bond financing of deficits
during the current period could raise interest burden,
deficits and interest rates in future, fuelling further
monetisation of deficit.
2.8 Extending Tinbergen and Theil’s traditional
target-instrument approach, Blinder (1983) argued
in favour of fiscal-monetary co-ordination as, in
reality, targets outnumber the independent policy
instruments available to achieve them and fiscal and
monetary authorities may have different objectives,
operating models and forecasts of the economy.
Typically, an economy’s objectives (levels of output,
inflation, share of investment in output, distributional/
allocative efficiency objectives and so on) were found
to multiply faster than the number of independent
policy instruments (taxes, government expenditure
and money supply) needed to achieve them. Game
theoretical studies showed that if the government
(aiming at reduction in unemployment) and the
central bank (aiming at reduction in inflation) pursued different objectives and reacted to macroeconomic
conditions independently without taking into account
the other authority’s response, a Nash equilibrium
would yield both fiscal deficit and interest rates higher
than those considered desirable by either authority
(Blinder, 1983; Nordhaus et al., 1994). Due to lack
of agreement and the existence of uncertainty about
the ‘correct’ policy-mix in practice, Blinder was in
favour of the central bank being vested with greater
discretionary power to ensure a check against the
government’s short-run considerations. To avoid
the sub-optimal Nash equilibrium, Blinder favoured
the independent setting up of fiscal rules based on
allocative considerations. The central bank would
have to accommodate expansionary fiscal deficits
during recessionary phases, but reverse monetary
expansions once the economy returned to its full
employment norm and the government balanced
its budget to avoid the inflationary consequences of
money creation.
2.9 Against the backdrop of co-existence of
high fiscal deficits and high real interest rates
in the US (‘tax cuts’ of 1962-65, ‘new economic
policy’ of 1971, the ‘Carter stimulus plan’ of 1977
and ‘Reagan’s supply-side policies’) and in other
countries such as Germany (after its unification),
and its implications for private investment and
long-term growth of potential output. Against this
backdrop, Nordhaus favoured having a transparent
and rule-based monetary policy that would provide
a frontier within which fiscal policy could maximise
its utility. It was shown that the resultant lower fiscal
deficit and real interest rates improved utility for both
the policy authorities and led to higher investment
than the Nash solution, though not necessarily
affecting inflation or unemployment. Further, as
central banks started to interact with private sector
wage and price setters through the announcement
of firm and credible rules, a low-inflation equilibrium
could be established. Under a dynamic situation,
the fiscal-monetary policy mix was shown to
improve if government reduced fiscal deficits in
anticipation that the consequent contractionary
impulse would be offset by a monetary expansion
in the short-run. However, the central bank can delay its monetary policy response till it becomes
confident of the irreversibility of a modified fiscal
stance. Alternatively, under a ‘result-oriented’ policy
framework, fiscal deficit reduction would generate a
monetary response through the lowering of interest
rates in the next period (rather than the same
period) to offset the economic slowdown occurring
in response to fiscal contraction in the previous
period.
New Channels of Fiscal Constraints on Monetary
Policy
2.10 Emerging as an alternative view during
the 1990s, the fiscal theory of price level (FTPL)
postulated that the price level is primarily determined
by government debt and fiscal policy, with monetary
policy playing an indirect role (Leeper, 1991; Sims,
1994; Woodford,1994). This theory clashed with the
monetarist view that considered money supply as
the primary determinant of price level and inflation. In
terms of FTPL, even in the absence of the imposition
of seigniorage targets set by the government, fiscal
policy could constrain central bank in controlling the
price level. With the government’s inter-temporal
budget constraint as an equilibrium condition, the
price level would have to adjust endogenously for
equating the real value of nominal stock of bonds
to the present value of the given sequence of future
primary balances of the government. Buiter (2000)
argued that the FTPL’s contention of general price
level serving the role of a public debt revaluation
factor leads to contradictions and anomalies.
Subsequently, the FTPL proponents clarified that
the theory regarded inter-temporal budget constraint
as an important factor and not necessarily the
only factor determining price level. For instance,
Woodford (2003) indicated that under an interest
rate peg, money and prices do move together.
Others emphasised that in the ‘conventional’
FTPL theory, fiscal policy specification matters for
the behaviour of both money and price level and
move together in equilibrium (Gordon and Leeper,
2005). Empirical studies, however, showed mixed
results with Cochrane (1998) finding FTPL theory to
hold for the US since 1960, while Canzoneri et al. (2001), based on post-war US data, pointed out that
monetary policy rather than fiscal policy determined
the price level. Nonetheless, the recognition of the
impact of fiscal policy on price level under the FTPL
supported the need for greater fiscal-monetary co-ordination
to tackle inflation, which was hitherto
regarded as a monetary problem.
2.11 Other channels of fiscal policy constraining
the conduct of monetary policy include the impact
of fiscal deficits on interest rates and interest
spreads, particularly, for emerging markets. While
the conventional theory argued that higher fiscal
deficits raise intermediate and long-term interest
rates, empirical studies revealed mixed results.
Some studies established the impact of fiscal
variables on country premiums, while other showed
that the fiscal policy could constrain monetary policy
through its impact on exchange rates. Under a high
capital mobility and flexible exchange rate situation,
deterioration in the fiscal situation could lead to a
temporary appreciation of the exchange rate. In
contrast, under low capital mobility, the exchange
rate may depreciate, following higher imports and
widening of the current account deficit on account of
fiscal expansion (Zoli, 2005).
Open Economy Extensions
2.12 Extended to open economy levels, the
literature on fiscal-monetary co-ordination delved
into the welfare implications (in terms of aggregate
utility) of the operation of policy instruments, which
also provided the micro-foundations of fiscal-monetary
interactions in a monetary union. The role
of fiscal policy began to be re-examined after the
formation of the European Monetary Union (EMU),
particularly when it was felt that monetary policy
could lose its flexibility as currencies of constituent
member countries merged. The emphasis, therefore,
shifted to assessment of the role of fiscal policy as
a stabilisation tool, welfare gains from international
fiscal co-operation and the interaction of such gains
with the monetary policy regime. Assuming that fiscal
policy operates through government expenditure
and that international elasticity of substitution
between goods differs from unity, studies found that as activist fiscal policy would lead to potential
welfare gains from fiscal policy co-operation across
countries, provided monetary policy was set cooperatively
as under a single monetary regime
(Lombardo and Sutherland, 2004).
Extensions of Policy Mandate from Price Stability to
Financial Stability
2.13 The lessons learnt from the spike in inflation in
the 1970s brought a renewed focus on price stability
as a key objective of monetary policy. With the
empirical analysis showing the absence of any long-run
trade-off between inflation and unemployment,
the policy focus shifted to the use of monetary
policy for addressing inflationary concerns. Low and
stable inflation was viewed to be consistent with the
objective of stabilising output around its potential
level, as monetary policy affected inflation indirectly
via its impact on aggregate demand. Accordingly,
while many central banks in practice continued
to attempt to stabilise output, they found it useful
for their public mandate to be restricted to price
stability alone, since this reduced their vulnerability
to political pressures for expansionary monetary
policy. Thus, monetary policy gained in importance,
leading to institutional changes in some countries
including the creation of independent central banks.
While price stability remained a key objective of
monetary policy, central banks in EMDEs have
generally tended to follow multiple objectives,
especially as they are usually assigned a key role
in promoting economic development. Besides,
exchange rates often emerge as a key policy issue
in EMDEs that are relatively more open. Empirical
evidence suggests that central bank interest rates in
EMDEs often react more strongly to changes in the
exchange rates rather than changes in the inflation
rate or the output gap (Mohanty and Klau, 2004).
2.14 The usefulness of inflation targeting (IT)
frameworks in both advanced and emerging
economies continues to be a matter of debate.
While it is true that many IT economies were able
to control inflation during the 1990s, countries that
did not adopt IT have also not performed badly
on this front. Paradoxically, the 1990s – a decade of price stability – witnessed several episodes of
financial instability, suggesting that price stability
by itself is not sufficient. Globalisation and financial
integration of economies with the rest of the world
have posed new challenges for monetary policy.
Large movements in capital flows and exchange
rates affect the conduct of monetary policy on a
daily basis. Large and sudden changes in exchange
rates also have implications for financial stability.
Under these circumstances, the scope of monetary
policy goes beyond the traditional trade-off between
inflation and growth, with financial stability issues
presenting a new challenge to the monetary
authority. These developments have also given
rise to a debate about how monetary policy could
contribute to financial stability. While price stability
is considered necessary for financial stability, there
is no consensus on whether price stability, per se,
would be sufficient to guarantee financial stability
(Cukierman, 1992; Gameir et al, 2011; Issing, 2003;
Mishkin, 1996; Schwartz, 1995). One view is that
the central banks should focus exclusively on price
stability, as it is difficult to identify potential sources
of financial instability. It is held that asset price
misalignments are difficult to identify ex ante, and
even if they can be identified, it is debatable whether
monetary policy could prick these bubbles (Bean,
2003; Bernanke, 2003; Bernanke and Gertler, 2001;
Filardo, 2004). An alternative view supports proactive
tightening of monetary policy and monitoring
of various indicators such as credit and monetary
aggregates by the central banks to identify incipient
financial imbalances (Borio and Lowe, 2002;
Cecchetti et al., 2000; Crockett, 2001). More
generally, given the limitations of monetary policy,
effective regulation and supervision of financial
institutions have assumed more importance in the
context of financial stability.
III. Fiscal-Monetary Co-ordination:
International Experiences
2.15 Evolving macroeconomic theory has brought
forth several dilemmas inherent in the fiscal-monetary
interface spanning a continuum from absolute fiscal
dominance to monetary dominance, which, to an
extent, was evident across countries up to the 1990s. Progressively in recent years, however, policy
regimes have ceased to reflect either extremes of
fiscal dominance or full monetary independence. As
corroborated by policy responses to the economic
slowdown in 2001 and the recent global financial
crisis, fiscal-monetary co-ordination is considered
critical when uncertainty surrounds the impact of
either of the policies or when limits to conventional
policy-making are reached. While the choice of
policy regimes across countries reflects specific
institutional histories, the effectiveness of any regime
depends upon the degree of fiscal-monetary co-ordination.
The extent to which fiscal and monetary
policies respond to inflation and unemployment, and
the degree to which the policymakers co-ordinate
their policies, have important implications for the
effectiveness of these policies. In the absence of co-ordination,
the independent decisions of monetary
and fiscal authorities may either result in duplication
of efforts or, when they are setting their instruments
in opposite directions, negative externalities could
emerge. Thus, it is expected that fiscal-monetary
co-ordination in general would improve welfare as
reflected in the phase of Great Moderation since
the 1990s. The co-ordination between policymakers
takes place through various modes, viz., (i) exchange
of information, (ii) mutual acknowledgement of the
existence of the probable behaviour of the other
policymaker; (iii) joint decision-making between
policymakers (full co-operation, i.e., collusion); (iv)
agreement on a sequence of moves between the two
authorities identifying one of the two policymakers
as the leader, and the other as the follower. This
section traces fiscal-monetary co-ordination across
select advanced economies and EMDEs over the
years.
Policy Co-ordination in Advanced Economies
2.16 In advanced economies, fiscal policy
dominated as a tool for macroeconomic stabilisation,
while the monetary policy role was largely supportive
during the immediate post-World War II period.
With the emergence of increasing inflationary
pressures during the 1970s, the monetary policy
began to assume prominence in the advanced
economies. The limitations of fiscal policy to undertake macroeconomic stabilisation in the short-run
through discretionary measures also came to
the fore, as inherent inertia in legislative processes
did not provide for the discretionary component of
fiscal policy to adjust in line with monetary policy
actions strategically at business cycle frequencies.
De facto counter-cyclicality was, therefore, noted to
be ‘accidental Keynesianism’, such as tax cuts in the
US in 1982. With greater likelihood of interaction of
automatic stabilisers with macroeconomic shocks
at business cycle frequencies, the co-ordination
of monetary policy with this component of fiscal
policy was considered critical. Accordingly, fiscal-monetary
co-ordination called for strategic setting of
legislations in respect of tax rates, unemployment
benefits and other entitlements in tune with monetary
policy. For the US, the case for aggressive monetary
policy got arguably strengthened as automatic
stabilisers were found to be weak.
United States
2.17 Economic policymaking in the US since
the Great Depression of the 1930s has involved a
continuing effort by the government and the Fed to
find a mix of fiscal and monetary policies that would
sustain economic growth and stabilise prices. During
the early post-war period, the emphasis was on
growth and employment, which continued up to the
1970s. However, the US government began paying
more attention to inflation, with monetary policy
assuming the responsibility for inflation control from
the late 1970s.
Greater Monetary Independence during 1979-87
(Volcker Period)
2.18 The Fed reasserted its independence in
1979 amidst stagflation against the backdrop of
greater willingness to accept higher unemployment
and the use of aggressive monetary policy measures
to reduce inflation. With the Fed’s successful
disinflation policy during this period, a view emerged
that well-timed tightening by an independent central bank can enhance its credibility for reducing inflation
permanently without supportive fiscal policy at a far
lower cost in terms of loss in output and employment.
Accordingly, the monetary policy became more
strongly disinflationary in the US than elsewhere,
with the federal funds rate rising to 19 per cent by
1980. Notwithstanding some initial fiscal restraints,
fiscal policy shifted to a stimulus mode under the
Economic Recovery Tax Act, 1981.
2.19 During the 1980s, the Fed also announced
a switchover from the system of having the federal
funds rate as the operating target to a monetary
targeting framework. The Fed’s limited flexibility in
determining policy rates often led these rates to rule
at levels lower than those warranted for anchoring
inflationary expectations, with money supply growth
turning out to be higher than required. Under the
monetary targeting framework, borrowed reserves
were targeted directly so as to ensure better anchoring
of money growth, and to make monetary policy
more effective.1 During the 1980s, monetary policy
decisions were increasingly guided by a broader set
of information on economic activity, inflation, foreign
exchange developments and financial market
conditions, although the monetary policy continued
to be anti-inflationary and countercyclical in nature.
Monetary and Fiscal Policy since 1987
2.20 During the Greenspan period (1987-2006),
the Fed sought to re-enforce its standalone role for
low inflation, as it was held that monetary policy
could sustain both low inflation and unemployment
along with infrequent/mild recessions. With an
expansionary fiscal policy and rising debt servicing
costs amidst high interest rates, fiscal deficits
surged by the mid-1980s. As a result, it was
decided to impose fiscal rules under the Balanced
Budget and Emergency Deficit Control Act of 1985
and the Balanced Budget and Emergency Deficit
Reaffirmation Act of 1987, which led to a positive
primary structural balance in 1988. The enactment
of the Omnibus Budget Reconciliation Act of 1993 strengthened the fiscal consolidation process and
enabled the overall budgetary balance to turn
positive in 1994.
2.21 The Fed continued with its tight monetary
policy stance till the onset of a brief recessionary
phase during 1991-92. Accordingly, the monetary
policy was relaxed by reducing the intended federal
funds rate to 3 per cent by the end of 1992, and
with inflation running at the same level, the implied
real federal funds rate neared zero. However, the
real policy rate turned positive when the federal
funds rate was steadily raised to 6 per cent in early
1995, while inflation ranged between 2 and 2.5 per
cent. This stance of monetary policy was largely
maintained till 2000, albeit with modest adjustments.
As budget deficits switched to a surplus mode, the
government announced income tax concessions
to stimulate aggregate demand in the wake of the
slowdown in information technology sector and a
brief recession in the US economy in 2001. The
expansionary fiscal initiative was also supported by
a significant reduction in the federal funds rate. An
important change in the monetary policy operating
procedure occurred during this phase. With financial
innovations, as the link between non-borrowed
reserves and monetary policy objective weakened,
the Fed switched to targeting the federal funds rate
indirectly through borrowed reserves. Further, as
the relationship between borrowed reserves and the
federal funds rate became unstable, the Fed moved
towards targeting the federal funds rate directly.
2.22 During the first half of the 2000s,
both monetary and fiscal policies remained
expansionary. Despite concerns about fiscal
unsustainability, macroeconomic conditions
remained conducive without necessitating any
reversals of accommodative policy stance until the
inception of the crisis in August 2007. The onset of
recession from December 2007, with contraction
becoming pronounced after the Lehman Brothers
collapse in September 2008, necessitated the use
of both conventional (the federal funds target rate
was brought down to zero per cent by late-2008)
and non-conventional (significant purchases of
longer-term Treasury securities during 2009 and early 2010, followed by a second quantitative easing
and modification of the Fed’s reinvestment policy to
avoid shrinking of its balance sheet as mortgage-backed
securities matured/redeemed) monetary
easing measures in the wake of unemployment rate
doubling to 10 per cent before settling to around 9
per cent (much above the non-accelerating inflation
rate of unemployment i.e., NAIRU of 5.75 per cent)
and falling inflation rates. Complementing the actual
monetary measures, the Fed’s communication
policy was designed to shape investor perceptions
appropriately. Such asset purchases were directed
to expand aggregate demand by lowering the cost
of credit, to raise household wealth with the rising
prices of securities and to increase export demand
through depreciation of the dollar (Yellen, 2011).
In consonance with the monetary easing, the US
activated fiscal stimulus measures from early 2008.
To an extent, quicker and more sustained fiscal
activism was facilitated by relaxing budget rules
that made countercyclical fiscal interventions easier
(Auerbach et al., 2010).
2.23 As alluded to earlier, the US government
undertook an expansionary fiscal policy in the first
half of the 2000s. By the time the global financial
crisis struck, fiscal deficit had already reached
elevated levels on account of large tax cuts, a new
entitlement programme for healthcare and heavy
spending on security-related areas. Therefore, the
deterioration in the fiscal deficit position reflected
not only the policy response to a financial sector-driven
deep recession but also the cumulative
impact of expansionary fiscal measures undertaken
in the pre-crisis period. The fiscal policy stimulus
provided by the US government during the crisis
is considered to be the largest across the major
economies and was aimed at boosting aggregate
demand through infrastructure investment, tax
concessions and unemployment benefits. Fiscal
measures contributed about 2 percentage points to
GDP growth in 2009, and one percentage point in
2010 (Lipsky, 2011). In addition, with the failure of
Lehman Brothers, it was realised that the liquidity
provision by the Fed would not be sufficient
to support the financial system and, therefore, support from the US Treasury would be required. In
particular, the lack of liquid funding, concerns about
the value of the underlying loans, and the integrity of
the securitisation process hampered the functioning
of securitisation markets. To revive these markets,
the Fed worked with the Treasury to establish the
Term Asset-Backed Securities Loan Facility. Under
the facility, the Fed supplied the liquid funding,
while the US Treasury assumed the credit risk.
Therefore, the global financial and economic crisis
saw fiscal and monetary policies working in tandem
to address liquidity and financial stability concerns,
with the Fed assuming risks of loss on its balance
sheet by lending to stabilise systemically important
firms and the Treasury providing explicit support
and acknowledgement of those risks. The US
government has continued to maintain a supportive
fiscal policy stance since 2010 recognising the
limitations of near-zero policy interest rates and
uncertainty about the effectiveness of monetary
policy. The fiscal programme sought to ‘combine’
pro-growth policies in the near term with firm steps
undertaken to reduce budget deficits over the long-term,
which was regarded as ‘a valuable complement’
to monetary policy (Yellen, 2011). In September
2012, the Fed announced its plan to purchase
mortgage-backed securities amounting to US$40
billion per month guaranteed by the government-sponsored
enterprises. Along with purchases under
previous programs involving Treasury securities,
the Fed announced to purchase US$ 85 billion of
longer-term securities per month. The objective has
been to put further downward pressure on longer-term
interest rates, including mortgage rates so
as to foster economic recovery. Even though the
Fed recognises the fiscal challenges that the US
economy is facing, according to Bernanke (2012),
achieving these fiscal goals would be even more
difficult if monetary policy were not helping support
the economic recovery.
2.24 The sharp deterioration in US fiscal position
in recent years attributed partially to the the bailouts
under the Troubled Asset Relief Programme (TARP),
and partially to the fiscal stimulus packages of 2009
and 2010, as also to the US recession, led to the situation referred to as the US fiscal cliff. The fiscal
cliff refers to a large predicted reduction in the budget
deficit and consequent slowdown of the US economy
if specific laws are allowed to automatically expire or
go into effect at the beginning of 2013. These laws
include tax increases due to the expiration of the Tax
Relief, Unemployment Insurance Reauthorization,
and Job Creation Act of 2010 and the spending
reductions (“sequestrations”) under the Budget
Control Act of 2011. The US fiscal cliff was averted
by signing of a deal on tax hikes on January 1,
2013, though significant policy uncertainty remains
on spending cuts, known as the sequester, which
have been postponed for two months. The adoption
of a credible medium-term fiscal consolidation plan
remains a priority in the US.
United Kingdom
2.25 The Bank of England (BoE), originally
incorporated as a limited liability entity, was founded
as the government’s banker and debt manager. The
government’s recourse to monetary financing of its
borrowings dated back to the pre-nationalisation
phase of the BoE. With the nationalisation of the
BoE in 1946, the government became its owner
and assumed the power to issue directions to the
Bank. Nonetheless, in practice, there was no major
difference in terms of its functions and the Bank
continued to remain as the Treasury’s banker,
advisor, agent and debt manager.
Active Fiscal Policy during the post-War Period
2.26 During the post-World War II period,
an abiding objective of the government was to
maintain a high level of aggregate demand with a
countercyclical role played by fiscal policy through
discretionary stimulus or the operation of automatic
stabilisers. With the use of an active fiscal strategy
to prevent large negative output gaps, demand
pressures started emerging, eventually leading
to positive output gaps and sharp rise in inflation
in the late 1960s and early 1970s (MacFarlane
and Mortimer-Lee, 1994). Notwithstanding the
emergence of strong inflationary pressures, monetary policy was assigned only a marginal role
in aggregate demand management in the UK till the
collapse of Bretton Woods in the early 1970s. It was
incomes policy rather than monetary policy that was
the preferred tool to manage demand pressures
spilling over to high inflation and deteriorating
balance of payments. Since the incomes policy
could not address inflationary pressures in 1974,
monetary policy was accorded greater importance in
managing aggregate demand. Against the backdrop
of high inflation in the 1970s and early 1980s,
monetary targeting was introduced which became
an integral part of macroeconomic strategy in 1979.
Nonetheless, direct controls (prices, wages and
credit) and fiscal policy continued to be major policy
tools to contain inflationary pressures.
Emphasis on reduction in borrowing requirement to
contain money growth under MTFS (1980)
2.27 The practice of announcing annual targets
for M3 growth and public sector borrowings under its
Medium-Term Financial Strategy (MTFS) plan was
started in 1980 with a view to restore policy credibility.
A gradual reduction in borrowing requirements was
perceived as a major factor in containing money
growth. The monetary targeting framework helped
restrain government spending plans, as it implied a
limit on public sector money creation. Thus, monetary
targeting became a means of co-ordinating fiscal and
monetary policies. The tightening of monetary policy
in 1980-81 helped reduce the inflation rate from 22
per cent in early 1980 to below 4 per cent in mid-
1983, even though M3 targets could not be achieved
(Bernanke et al., 2001). The target for M3 was
gradually de-emphasised, while growth in narrower
monetary aggregate (M0) began to be considered
as an appropriate indicator of the monetary policy
stance, which was announced in the UK Budget for
1986.
2.28 Notwithstanding the decline in public sector
imbalances during the first half of the 1980s, the
fiscal policy remained by and large expansionary
till the mid-1980s. During the second half of the
1980s, the government was able to tighten fiscal policy significantly. In spite of aggressive tightening
of monetary policy from 1988-Q3 to 1990-Q3, the
inflation rate reached a peak level of 10.9 per cent by
September 1990, while the UK economy faced a deep
recession. Monetary targets, found to be inadequate
for preventing the bubble-bust cycle, were then
abandoned. In fact, monetary policy targets were
de-emphasised in 1987, when the UK government
attempted to keep the pound sterling in a narrow
band at 3.0 Deutsche Mark (DM) per pound. After
the formal suspension of the M3 target, the monetary
policy in the UK was increasingly conducted towards
stabilising exchange rate movements. The UK joined
the European exchange rate mechanism (ERM)
in 1990, which was supposed to provide greater
stability and predictability to monetary policy.
Inflation Targeting and Reforms in the
Macroeconomic Framework during the 1990s
2.29 With the increasing pressure for the
unification of Germany, interest rates in Europe
moved up in the early 1990s. Since the pound
sterling was pegged to the DM under the ERM
arrangement, it had become difficult for the UK
to pursue a tight monetary policy due to domestic
growth concerns. Therefore, the UK government left
ERM membership in September 1992 and decided to
adopt inflation targeting (IT). While the IT framework
implied increasing accountability of monetary policy,
it did not withdraw its flexibility, even in principle, to
deal with uncertain macroeconomic events. Until
1997, both the monetary and fiscal policies were
determined by the Chancellor of the Exchequer
in consultation with HM Treasury and the Bank of
England. Under the IT regime, the UK economy
was able to broadly achieve stable inflation between
1992 and 1997, but inflation expectations remained
high as the possibility of fiscal policy operations
conflicting with the objective of price stability
continued to exist.
2.30 Under the new macroeconomic framework
announced in 1998, the Chancellor was assigned
the ultimate responsibility for both monetary
and fiscal policies, while operational control was divided between an independent Monetary Policy
Committee (MPC), with the sole responsibility for
monetary policy, and the Treasury, which retained
responsibility for fiscal policy. The enactment of
Bank of England Act aimed at transferring full
operational responsibility for monetary policy to the
BoE, while the government retained operational
control of monetary policy only in ‘extreme
economic circumstances’ under the reserve powers
of the Treasury (Section 19, BoE Act, 1998). The
operational objective of monetary policy, i.e., the
inflation target, however, continued to remain under
the purview of the government, and not the BoE. The
policy rate decisions began to be determined by the
BoE rather than the Chancellor of the Exchequer, as
had been the practice before May 1997.
2.31 Subject to the primary objective of price
stability, the BoE was also required to support the
government’s other economic policy objectives of
growth and employment. This implied that price
stability was not considered to be an end in itself,
but was instead regarded as necessary to meet
the government’s other economic objectives. In
1998, the government also announced fiscal rules
to facilitate high and stable levels of growth and
employment. These fiscal rules were to be followed
under the guidelines of the ‘Code for Fiscal Stability’.
Debt management on behalf of the government was
transferred to HM Treasury, while the regulatory
functions were entrusted to the Financial Services
Authority. Recognising the limitations of fiscal policy
as a short-term instrument, the focus shifted to the
medium and long-term objectives. A clear distinction
was also made between the roles of the government
and the MPC. The essence of such an arrangement
was to ensure that monetary policy decisions were
not affected by short-term political considerations
and were, therefore, perceived to be more credible.
2.32 One potential concern about the new
framework was its efficacy in ensuring effective
co-ordination between fiscal and monetary policies
(Buiter and Sibert, 2001). The potential co-ordination
problems were, however, addressed in three main
ways. First, co-ordination was achieved because the government was to set the objectives for both
the monetary and fiscal policies. The MPC based
its decisions on the government’s fiscal projections,
while the Chancellor could determine the policy mix,
as long as the MPC’s reaction function was known
(Bank of England, 2010). Second, the objectives of
both arms of policy were made more explicit and
subject to more transparent procedures. Third, co-ordination
between monetary and fiscal policies was
also to be aided by the presence of a representative
from HM Treasury at MPC meetings, who provided
information on fiscal policy (including the Budget).
One consequence of assigning the responsibility for
price stability to an independent MPC was effectively
to rule out the use of activist fiscal policy.
Bursting of the Dot-Com Bubble in 2000:
Expansionary Monetary and Fiscal Policies
2.33 With the adoption of IT, the inflation rate
broadly remained under control during the 1990s
and growth remained above trend, averaging
around 3 per cent during the IT phase of the 1990s.
In general, inflationary expectations remained much
more stable in the UK, reflecting public confidence
in monetary policy. Under the IT framework, fiscal
policy is not supposed, in principle, to be used for
short-term objectives. While there was no major
shift in the stance of monetary policy (except
expansionary in the late 1990s), fiscal policy was
significantly tightened. However, in 2001, both
monetary and fiscal policies had to be relaxed to
address growth concerns that emanated when the
dot-com bubble bursted. Until the mid-2000s, both
fiscal and monetary policies remained expansionary
and there has been no evidence on monetary policy
attempting to offset the impact of the expansionary
fiscal stance (Committee on Economic Affairs,
House of Lords, 2004). The expansionary fiscal
policy pursued during this period reflected not
only cyclical factors but also planned increases in
spending to improve public infrastructure and other
services.
Fiscal tightening from 2005-06 to 2007-08, but reversal during crisis
2.34 To underpin the credibility of the IT regime,
the government reiterated its commitment in 2003 to
maintain net public debt below 40 per cent of GDP,
while the sustainable investment rule appropriately
constrained fiscal discretion within the limits set by
long-term considerations, such as demographics
and debt sustainability. Recognising the inflationary
impact of rising commodity prices, the government
budgets presented during 2005-06 to 2007-08
reflected firm commitment to fiscal tightening.
However, during the recent global crisis, the overall
fiscal stance has been to support monetary policy in
the short-run and to allow the automatic stabilisers
to help smooth the path of the economy.
2.35 The BoE, on its part, provided unprecedented
monetary stimulus to counter disinflationary
pressures and boost economic recovery. The policy
rate was kept near zero, while its asset purchase
of £200 billion (mostly of longer-term government
bonds) also helped to reduce bond yields and
boost asset prices, thereby supporting market
confidence, household net wealth, and corporate
credit supply. Most of the operations of the BoE,
viz., credit lines to financial institutions, purchase of
asset-backed securities and commercial paper, and
asset swaps were undertaken with treasury support
(IMF, 2009a). Further, complementing the asset
purchase programme, the Bank of England and HM
Treasury launched the Funding for Lending Scheme
(FLS) in July 2012. While the impact of quantitative
easing (QE) was mainly indirect through demand
and incomes, the FLS aimed to reduce borrowing
costs by going directly through the banking sector,
and boosting lending to households and corporate
sector.
2.36 To sum up, the macroeconomic policy
framework in the UK has changed significantly
over the years. While fiscal policy was the principal
instrument of economic policy during the 1960s
and 1970s with its focus almost exclusively on
demand management, monetary policy (subject to
a lower bound) and the provision of public services
were essentially accommodating factors as the financing of persistent current account deficits
continued to operate as a constraining factor.
In the 1980s, the emphasis shifted to reducing
the size of the government spending to contain
inflationary pressures. The role of fiscal policy in
demand management was phased out, while that
of monetary policy was enhanced in inflation control
and monetary management, albeit with limited
success in the earlier phases of monetary and
exchange rate targeting. The role of monetary policy
was formalised with the adoption of the IT regime
with an independent BoE and MPC. Since then,
monetary policy actively pursued low inflation and
stable growth.
2.37 During the 1990s, fiscal policy was designed
strictly in combination with an active monetary
policy based on IT. With the new macroeconomic
framework put in place in 1998, fiscal policy
became more oriented towards the medium-term
objectives while monetary policy remained as an
instrument of choice to respond to cyclical price
pressures. However, during the global financial
crisis, the UK government had to temporarily
provide fiscal stimulus in 2008-09, which was also
supported by the use of automatic stabilisers, and
unprecedented monetary easing. Importantly,
while the monetary policy stance has remained
accommodative to support private and external
sector-led growth, the government started phasing
out fiscal accommodation in 2010, recognising the
need to create fiscal space for countercyclical fiscal
policies and to moderate inflationary expectations.
Notwithstanding the fact that a prudent approach has
been adopted to achieve a more sustainable fiscal
position under the self-imposed fiscal mandates, the
FLS programme undertaken by the Treasury and
the BoE has continued to provide monetary stimulus
with a view to help counteract the sluggish economy.
Euro Area
Co-ordination framework in a Monetary Union
2.38 Fiscal-monetary co-ordination in the euro
area represents a special case of centralised
monetary making by a unified monetary authority, viz., the European Central Bank (ECB), and
decentralisation of fiscal policies with individual
member states of the European Monetary Union
(EMU). The ECB’s Governing Council decides
monetary policy actions, which are implemented by
the national central banks of the euro area. The ECB
pursues price stability as its primary objective, while
support for the economic policies of the member
states of the euro area serves as a secondary
objective, as enunciated in the Maastricht Treaty.
Being committed to the price stability objective,
monetary policy controls aggregate output at
the euro area level, while national fiscal policies
determine the distribution of aggregate demand
across member countries.
2.39 While individual country developments matter
for the monetary policy of the EMU as they have a
bearing on price stability in the euro area, individual
fiscal authorities may not be commensurately
sensitive to the impact of their own policies on other
countries. Since the beginning of EMU, there has
been apprehension that if such externalities, in
terms of inflation and interest rates, turn out to be
negative, the consolidated euro area’s fiscal deficit
may tend to be higher than the optimal level required
to achieve consistency with the objective of price
stability. Therefore, such a framework necessitates
fiscal co-ordination at the monetary union level
(Dixit and Lambertini, 2000). Studies point out that
under such an institutional arrangement, national
governments may engage in a purely distributional
game that may result in inefficient outcomes unless
policies are co-ordinated (Hagen and Mundeschenk,
2002). It is, therefore, held that the benefits of such
a policy framework can be derived only if economic
policies (including fiscal policy) and the economic
structures of member economies are sufficiently
flexible and adaptable to the unified monetary policy
(Weber, 2011).
2.40 With an independent central bank and its
price stability-oriented strategy, the euro area has
a highly predictable monetary policy (Issing, 2005). This sets aside any ambiguity in monetary response
towards economic, including fiscal, developments
having a bearing on price stability. While the monetary
authority reacts to aggregate economic fluctuations
in the euro area as a whole, fiscal authorities
focus on country-specific needs. Nonetheless,
studies indicate that if national fiscal authorities
are able to accurately perceive the behaviour of
the single monetary policy, they will take actions
that would lead to implicitly ‘co-ordinated’ policy
outcomes ex post (Issing, 2005). Notwithstanding
its inherent national character, the conduct of fiscal
policy for euro area members has been subject to
several constraints linked to procedural guidelines
stipulated under the Excessive Deficit Procedure,
the Mutual Surveillance Procedures and the Stability
and Growth Pact (SGP). The Maastricht Treaty and
the subsequent Stability and Growth Pact (SGP)
stipulated that each country’s fiscal deficit in a year
should not exceed 3 per cent of its GDP, unless the
country is in a recession. SGP filled the void of an
EU-wide fiscal authority and provided a framework
for fiscal policy discipline that supported stability,
growth and cohesion in the euro area.
2.41 In the absence of an exchange rate
instrument in the EMU, the role of automatic
stabilisers at the national level assumed significance
for enabling adjustments to asymmetric shocks,
thereby ensuring support from the national fiscal
policies towards stability-oriented monetary
policy. Notwithstanding the emphasis of various
procedures on the importance of fiscal discipline for
the conduct of monetary policy, they were termed
‘soft enforcement’, i.e., persuade member countries
to follow proper behaviour through monitoring,
dialogue, information exchange, peer pressure and
warnings. Although through the ‘dissuasive element’
in SGP sanctions could be imposed on member states
that breached the fiscal deficit limit of 3 per cent of
GDP, experience showed that no penalisation took
place when this limit was breached by major EMU
states (Germany and France) in the early 2000s due
to lack of the required qualified majority in the voting
process undertaken in November 2003.
2.42 These developments indicated lack of an
adequate institutional framework for fiscal policy
co-ordination in the EMU because it ignored the
aggregate fiscal policy stance for the euro area as a
whole (Blanchard and Giavazzi, 2004 and Wyplosz,
1999). Although the desired level of fiscal balances
may be consistent with long-run macroeconomic
stability, short-run stability imperatives may warrant
different constellations of monetary and fiscal
policies at different stages of business cycles (Hagen
and Mundschenk, 2002). Further, in the absence
of credible enforcement mechanisms, ex ante co-ordination
between monetary and fiscal policies may
not necessarily be a successful ex post outcome.
It was argued that ex ante co-ordination tended to
blur fundamental responsibilities for the respective
economic actors, thereby increasing uncertainty
about the general policy framework.
2.43 In the euro area, the channels for the
exchange of information between the fiscal and
monetary authorities are well developed. The
Governing Council undertakes a constructive and
open exchange of information on the economic
situation and structural reforms with other bodies
and institutions. Further, the outlook for fiscal policy
plays a key role in the ECB’s assessment of risks to
price stability. However, even with these elements of
co-ordination between monetary and fiscal policies,
there is no pre-commitment to a particular course of
monetary policy action as this may undermine the
ECB’s independence.
Monetary and fiscal policies since inception of the
ECB
2.44 In the euro area, the ECB aims at inflation
rates of below, but close to, 2 per cent over the
medium-term and conducts monetary policy through
the setting up of short-term interest rates, thereby
seeking to influence the economy and work towards
attaining the price stability objective. Although
no rigid rules are set out in the monetary policy
operating procedure, ECB has kept flexible checks
over monetary aggregates with a clear priority
accorded to price stability over full employment
without exclusively focusing on the former goal.
2.45 Since its inception, the ECB has followed
a two-pillar approach to determine the nature and
the extent of risks to price stability in the euro area.
Under this approach, while economic analysis is
undertaken to assess the short to medium-term
determinants of price developments, the monetary
analysis focuses on a longer-term horizon. The
economic analysis focuses on real activity and
financial conditions in the economy, while assessing
the interplay of supply and demand in the goods,
services and factor markets in determination of
price developments over the short to medium-term.
The monetary analysis examines the long-run link
between money and prices and serves as a cross-check
over the longer-term of the short- to medium-term
indications emerging from the economic
analysis. An analysis of the ECB’s monetary
policy decisions since its inception does show that
notwithstanding price stability remaining a major
objective, the growth implications of decisions were
also not overlooked.
2.46 In the early years of its inception, the ECB
explicitly emphasised that the fiscal consolidation
process should continue in member countries in
line with the SGP and the commitment made in the
context of the stability programme albeit the growth
outlook had weakened due to geopolitical concerns
in 2001. The avoidance of inflationary concerns on a
permanent basis required that national governments
necessarily implement structural measures in a
more decisive manner. This reflected fiscal concerns
emanating from some member economies, viz.,
Germany, Italy, the Netherlands, Greece and
Portugal, which undertook expansionary fiscal
policy in the initial years of the ECB’s inception and
continued the stance till 2003. The ECB’s monetary
policy remained expansionary until the second
quarter of 2003 due to growth concerns arising from
external developments and euro appreciation. The
policy rates were, however, kept unchanged from
July 2003 to December 2005 as the medium-term
outlook for price stability remained favourable. Most
member countries, however, continued to adopt
an expansionary fiscal policy, because growth
remained less than anticipated. While announcing the monetary policy stance, the ECB persistently
emphasised the need to maintain the credibility of
fiscal policy in member countries. In contrast, as the
budget deficit breached the SGP target of 3 per cent
in major member economies, the SGP was revised
in March 2005, allowing for flexibility in rules across
a range of areas. It was decided that no excessive
deficit procedure would be launched against a
member state experiencing negative growth or
a prolonged period of low growth. Previously,
the exception was made only for countries in a
recession (negative growth of 2 per cent), which
was rather unusual among EU member countries.
The policy move by the government authorities was
somewhat preposterous in the context of the single
monetary framework of the ECB.
2.47 The ECB tightened monetary policy from
December 2005 as risks to price stability began to
emerge due to uncertainties arising from oil market
developments, the pass-through of previous oil price
increases to consumers via domestic production
chains, the possibility of second-round effects in
wage and price-setting behaviour, as well as further
increases in administered prices and indirect taxes.
Further, fiscal policies remained expansionary
in most countries in the wake of some downside
risks to growth, concerns about global imbalances
and weak consumer confidence. Monetary policy
tightening continued till the end of the third quarter
of 2008. The government deficits in some of the
member economies, viz., Greece, Ireland and
Spain, expanded sharply by the end of 2008, which
were frequently highlighted by the ECB in its post-policy
introductory Statements.
Fiscal-Monetary Co-ordination during Crisis
2.48 During the global financial crisis, a number
of co-ordinated monetary and fiscal policy measures
were implemented in the euro area to provide
stimulus to the economy. The ECB’s response to the
crisis was through standard and non-standard policy
measures. With the intensification and broadening
of the financial market turmoil and taking into
account the slack in global and euro area demand for a protracted period of time, the ECB undertook
a policy rate cut on October 8, 2008. By this period,
the strong fall in commodity prices had moderated
the likely pressures on prices, cost and wages.
Keeping in view the deteriorating macroeconomic
outlook, the ECB continued to reduce policy rates
until May 2009. On a cumulative basis, the interest
rate on the main refinancing operations of the Euro
system was reduced by 325 basis points between
October 8, 2008 and May 13, 2009.
2.49 Perceiving the gravity of the crisis, the
ECB undertook various unconventional measures
to facilitate declining money market term rates,
to encourage banks to maintain and expand their
lending to clients, to improve market liquidity in
important segments of the private debt security
market, and to ease funding conditions for banks
and enterprises. Notwithstanding the use of various
monetary easing measures to improve financial
market conditions, including outright purchases
of covered bonds, the ECB deliberately refrained
from buying government bonds to safeguard its
independence from the political authorities of
different countries (Stark, 2009). For the same
reason, the ECB implemented its measures without
any form of government guarantees.
2.50 Fiscal policies of member countries also
played an important role in containing the adverse
impact of the financial and economic crisis in the
euro area. The support of national governments
for the banking sector was aimed at stabilising
the entire financial system and preventing a
further detrimental impact on the real economy.
The national governments provided various types
of financial assistance, including government
guarantees for interbank lending, recapitalisation
of financial institutions, increased coverage of
retail deposit insurance and asset relief schemes.
The fiscal impact was, thus, evident in terms of
higher government deficit and debt-to-GDP ratios.
The ECB, however, continued to emphasise the
need for fiscal discipline. It was also recognised
that the fiscal policies of national governments in
the euro area needed to be transparent enough to provide a clear and credible medium-term timetable
for exit strategies to help maintain a predictable
environment, both for economic agents and for the
conduct of monetary policy (Stark, 2009).
2.51 In the post-crisis period, the ECB showed
commitment to its mandate by reiterating that the
level of key interest rates would be adjusted in
response to changes in the outlook for price stability.
Although the ECB initially refrained from monetary
financing of debt during the global financial crisis
unlike the central banks in the US and the UK, it
had to participate in government debt-buying
programmes, as many fiscally-stressed member
countries subsequently faced the risk of insolvency
and were unable to sell their bonds in the market.
Under the programme, the purchase of government
bonds was to be offset – or sterilised – by removing
equal amounts of cash from the banking system,
thereby avoiding the risks to price stability. Further,
considering the economic and financial adjustment
programme of the Greek government (negotiated
with the European Commission in conjunction with
the ECB and the International Monetary Fund) to
be appropriate, it repeatedly adjusted its collateral
requirements to ensure that Greek public debt
remained eligible.
2.52 The ECB’s bond-buying programme, albeit
perceived to be temporary, continues as the debt
crisis is yet to be fully resolved. In addition, as part
of the new Treaty on Stability, Coordination and
Governance in the EMU, Fiscal Compact was signed
by most EU members in March 2012. Fostering the
economic policy co-ordination, the Fiscal Compact
was expected to strengthen EU fiscal governance
framework required for effective implementation
of price stability-oriented monetary policy of the
ECB. The Fiscal Compact inter alia constitutes the
mandatory introduction of a balanced budget rule
at the national level as well as a strengthening of
the automaticity of the excessive deficit procedure
in case of breaches. According to the ECB (2012),
successful implementation of reforms towards fiscal
discipline would relieve the monetary policy from
having to address negative externalities from other policy areas when striving to maintain price stability.
As a necessary adjunct to monetary policy and
support sovereign bond market in the euro area, the
ECB announced the Outright Monetary Transactions
programme in September 2012 under which it was
prepared to buy unlimited government bonds with a
maturity of one to three years in the secondary market
to lower borrowing costs for national governments,
provided the respective country follows a euro-zone-approved
bailout plan. The program helped reduced
the bond yields in Italy and Spain having hefty public
and private debt.
2.53 As stated above, the ECB’s monetary policy
is independently determined under the mandate
of price stability. Even though there is no formal
mechanism of fiscal and monetary co-ordination
in the euro area, the emphasis on fiscal discipline
for overall macroeconomic stability was explicitly
spelt out in the SGP pact. While the ECB frequently
cautioned about expansionary fiscal policy in
its member countries, deficit levels continued to
rise in some EMU countries, which subsequently
surfaced in terms of financial crisis in countries,
such as, Greece. With the worsening of confidence
in the bond markets of fiscally-stressed member
countries, the ECB had to co-ordinate with national
governments by subscribing to their debt. The coordinated
monetary and fiscal policy measures
undertaken during the financial crisis might have
been effective in alleviating the funding concerns of
banks and providing stimulus to the economy, but
sustaining such policy measures may lead to risks
in the long-run.
2.54 To sum up, several issues have been
raised regarding fiscal-monetary co-ordination in
the euro area. First, there is a need for vertical co-ordination
between the common monetary authority
and the national fiscal authorities (the governments
of different countries) taken as a group. Typically,
concerns in the conduct of the European monetary
policy can emanate from instability in the external
value of the Euro or could reflect asymmetric effects of
a common monetary policy across member countries
due to different transmission mechanisms or lack of a common business cycle. The implicit co-ordination
of fiscal policies of members, which eventuates as
an optimal fiscal policy stance across the euro area
and is consistent with common monetary policy, has
remained an important challenge since the inception
of the Euro. Since 1999, one of the most problematic
issues in the EMU has been the growing interactions
between sovereign countries’ fiscal policy and the
ECB’s monetary policy. The implementation of the
SGP in 1997, one of the mainstays of the European
fiscal framework, introduced additional conflicts.
2.55 Second, a common monetary policy, strictly
speaking, is considered to be sub-optimal as it aims
to reduce the deviation of the average EU inflation
rate from the target and not the average of the
individual deviations. It, therefore, does not take into
account the variability or distribution of the deviations
across countries. In an inflationary period, those with
below-average inflation are penalised and forced
to tighten as much as those with above-average
inflation. Similarly, in a recession, countries with
above-average inflation must loosen just as much
as those below-average. This raises the question
whether policy objectives would be better served if
the differences in national circumstances (country
circumstances) were also to enter into the policy
calculations. A possible solution could be to allow
fiscal policymakers to adjust their fiscal stance to
compensate for national differences, allowing them
to pursue expansionary fiscal policy when inflation
is below average and vice versa. Nevertheless, this
again requires close co-ordination between fiscal
and monetary policies.
2.56 Third, the conduct of fiscal-monetary co-ordination
in the euro area has remained different
from the US, reflecting contrasting economic and
financial structures in these two economies. Unlike
in the US, small and medium-sized enterprises play
a dominant role in the European economy, and are
major players in the ownership structure of certain
banks. Overall, the economy in the euro area is less
flexible than in the US. Wages and prices are slower
to adjust. While limited flexibility in the euro area
might hamper the reaping of benefits from positive supply-side shocks like technical innovations, during
a crisis this sluggishness offers some protection
against an overshooting of negative expectations
leading to a deflationary spiral. In shaping its policy
response to address the crisis, the ECB had taken
into account the structural characteristics of the euro
area economy. As part of non-standard measures,
the ECB provided liquidity to banks at the longer term
and funded the same through the standing deposit
facility offered to banks. This led to absorption of
liquidity mismatches of the banking system onto the
balance sheet of the central bank.
2.57 Further, the Eurosystem of central banks
accepted illiquid collaterals, increased the number
of counterparties eligible for bidding for central
bank liquidity and protected the anonymity of its
counterparties. The crisis-driven extraordinary
measures led the Eurosystem of central banks
to supply liquidity requirements on a gross basis
instead of fulfilling the net liquidity requirements
of the banking system during the normal period.
Consequently, the central bank balance sheets in
the Eurosystem expanded substantially, off-setting
the fall in money multiplier due to the freezing of
money markets, and supporting the money supply
and financial intermediation process. In the process,
the traditional ‘lender-of-last resort’ function of the
central bank evolved into ‘intermediation-of-last
resort’ during the crisis, which prevented banks from
undertaking the “fire-sale of marketable assets and
premature liquidation of loans” (Giannone, et al.
2010). In the US, by contrast, the Fed bought assets
outright on capital markets, given the reliance of US
companies on capital markets rather than on bank
loans.
Fiscal-Monetary Co-ordination in Emerging
Market and Developing Economies
2.58 Fiscal-monetary policy co-ordination is
essential for any economy irrespective of its level
of development. However, the form and nature of
co-ordination varies across countries depending on
country-specific characteristics, depth of financial
markets, exchange rate regimes and the prevailing institutional framework. Despite their rising economic
importance, many EMDEs still have relatively
underdeveloped financial markets and weak
institutional framework, their per capita incomes
lag far behind those of the advanced economies,
and a significant fraction of their population still
lives in poverty. This puts a number of constraints
on the effective formulation and implementation
of macroeconomic policies. For instance, the
developmental needs in EMDEs may necessitate the
adoption of expansionary fiscal policy, which could
pose a challenge for monetary policy. Therefore,
the need for fiscal-monetary co-ordination assumes
significance in the EMDEs in the context of ensuring
appropriate policy responses to absorb shocks
emanating from within or outside these economies.
In fact, there have been instances in the past
when growing public sector liabilities affected both
monetary policy conduct and outcomes in EMDEs
(e.g., Brazil in 2002).
Constraints on monetary policy in EMDEs
2.59 Central banks in EMDEs face a unique set of
challenges. These are both institutional and technical,
and act as severe constraints on monetary policy
implementation. The key institutional constraint is
the lack of central bank independence when the
central bank is statutorily under the purview of the
finance ministry. In countries where the central
bank is ‘in principle’ independent, there is still the
reality that it can be buffeted by various political
forces (Dragutinovic, 2009). Hence, central banks
have to maintain a balance between their credibility
and independence, particularly during a period of
macroeconomic disruptions. Further, irrespective of
the degree of statutory independence, operational
independence may be constrained due to the
exchange rate objective thrust upon most central
banks in EMDEs. Goodfriend (2004) argued that
maintaining the exchange rate at a particular level
or within a specific range can often limit the central
bank’s flexibility in terms of using policy instruments
such as the interest rate to pursue an independent
domestic monetary policy aimed at managing
domestic activity and inflation. A number of studies have attempted to identify such differences across
advanced countries and EMDEs.
2.60 Fiscal dominance is another key problem
facing central banks in EMDEs. The literature
suggests that many EMDEs lack long-term fiscal
discipline and their monetary policy is often
subservient to fiscal policy, particularly since the
latter is seen as having important redistributive
functions. An unsustainable fiscal policy, reflected
in high levels of government budget deficits and
public debt, poses an additional constraint on
monetary policy operations. In such situations, the
responsibility to facilitate the government borrowing
programme often comes in conflict with the price
stability objective, as managing inflation expectations
becomes difficult when borrowing requirements are
substantially large.
2.61 Of late, there has been an evolving
consensus about the relative roles of monetary and
fiscal policies. While fiscal policy is expected to focus
on longer-term sustainability (and be constrained by
some form of fiscal rule or confined to automatic
stabilisers), there is a broad agreement that
monetary policy should focus on price stability, but it
could play a stabilisation role within that constraint.
Cecchetti (2002) argues that “the proper role for
fiscal policy is to focus on building solid foundations
for long term growth…Stabilization policies should
be left to the central bankers.” Against this backdrop,
the following discussion highlights the diverse
experiences of select EMDEs in the area of fiscal-monetary
co-ordination.
Brazil
2.62 Unlike other economies, the history of
fiscal-monetary co-ordination in Brazil has been
different. With the establishment of its central
bank, the currency issuing function was shifted
from the Treasury, but the central bank had to act
according to the needs of the Bank of Brazil, which
was a banker to the government and controlled
foreign trade operations on behalf of public sector
enterprises. Besides, the responsibility for managing
public debt was also assigned to the central bank.
This institutional arrangement continued until 1988
when the functions of the monetary authority were
progressively transferred from the Bank of Brazil to
the central bank and the administration of the federal
public debt was transferred to the National Treasury.
As highlighted by Ornellas and Portugal (2011), the
conflict persisted due to the distinct obligations of
each of these organisations, which had implications
for the overall interest rate environment. The central
bank of Brazil has the objective of price control in the
economy, for which it uses the short-term interest
rate as an instrument. In contrast, the National
Treasury, by managing domestic and foreign debt,
has to ensure that government deficit is financed
through best debt deals of longer maturity.
2.63 The Brazilian economy faced hyperinflation
during the mid-1980s to early 1990s. The high bouts
of inflation during the second half of the 1990s were
accompanied by high budgets deficits. The ‘Real
Plan’ was implemented in 1994 as a programme
for economic stabilisation, which successfully
contained inflation to a single digit in less than
three years, while the size of the public sector was
substantially reduced through privatisation of state
companies. However, the stabilisation policies
were largely based on some form of exchange rate
anchor when external liberalisation also took place.
Although the stabilisation plan was successful
in controlling inflation, currency appreciation
was witnessed, leading to balance of payments
problems. The stabilisation process proved to be
gradual and, therefore, many structural issues
pertaining to fiscal policy remained unresolved,
increasing the vulnerability of the Brazilian economy
to a confidence crisis. This, in fact, became a reality
when the international financial turmoil culminated in
the Russian moratorium on external debt in August
1998.
2.64 Brazilian policymakers responded to the
1998 crisis by introducing a new macroeconomic
framework based on a flexible exchange rate,
inflation targeting and fiscal responsibility. While
the central bank raised short-term interest rates,
the government announced a strong tightening of the fiscal regime. Recognising the implications
of fiscal policy from the point of view of inflation
expectations and investment decisions in future,
IT was formally integrated with the monetary policy
framework in July 1999, under which the inflation
targets as well as the tolerance intervals were set by
the National Monetary Council based on a proposal
by the Finance Minister. By this time, Brazil had also
adopted a floating exchange rate policy and the
central bank was of the view that sustained fiscal
austerity together with a compatible monetary policy
would support price stability. In fact, fiscal austerity
was envisaged by enacting the Fiscal Responsibility
Law in 2000, which provided an encompassing
framework, applicable to the federal, state and
local governments. It, inter alia, introduced sharp
constraints on the financing of the public sector,
including state-controlled financial institutions.
2.65 Importantly, fiscal dominance was sought
to be reduced to relieve the pressure on monetary
policy and strengthen its ability to deliver the inflation
targets. However, Blanchard (2004) found evidence
that fiscal dominance continued during the crisis
period of 2002-03 and the monetary policy remained
counter-productive to tackle inflation. The Brazilian
economy also had high levels of indebtedness,
with a large share of the public debt denominated
in foreign currency. Therefore, the perceived risk of
interest rate hikes increased the likelihood of default,
thereby causing depreciation of the domestic
currency and leading to new inflationary pressures
that restrained the use of monetary policy. In fact, it
was the fiscal policy that could have controlled high
inflation.
2.66 During the recent global crisis, a co-ordinated
response by the central bank and the
government helped faster recovery in business
sentiments. Unlike in the past, the central bank
was better positioned to respond to circumstances
without wavering in its commitment to the floating
exchange rate, while the government had fiscal
room to initiate expansionary fiscal policy without
adversely impacting the markets. The central bank
also reinforced its vast international reserves with contingent lines with the US Fed (US$ 30 billion)
and the IMF, which, however, were never used.
Levy (2010) categorised policy response to the
global slowdown into measures undertaken for (i)
protection of financial markets and support to credit;
(ii) full use of automatic stabilisers; and (iii) outright
fiscal stimulus. The central bank in Brazil had
implemented measures in the first category, while
policies in category (ii) were already in place. In
addition, discretionary stimulus measures including
a combination of tax breaks and public-sector wage
increases, and a pro-active stance by public sector
banks were also initiated to counter the impact of
the global financial crisis.
2.67 The central bank also facilitated liquidity
injection by reducing cash reserve requirements
by 40 per cent, which helped small banks to meet
the credit requirements of their mid-sized corporate
borrowers and to support personal credit. Even
though the central bank did not play a direct role in
supporting aggregate demand, its policy measures
towards this end were evident when interest rates
fell to a 15-year low level. In addition, a better
social transfer system boosted the operation and
effectiveness of the automatic stabiliser mechanism
and had a countercyclical impact on growth. The co-ordinated
policy response by both the government
and central bank helped the Brazilian economy
recover faster from the crisis.
South Africa
2.68 Prior to South Africa’s transition to a
democratic rule in 1994, its macroeconomic policy
was dominated by the fiscal policy. The South
African Reserve Bank (SARB) primarily acted
as an agency responsible for market-making of
government bonds. However, with the adoption of
the Growth, Employment and Redistribution (GEAR)
policy in 1996, fiscal discipline was introduced in
South Africa. Emphasising fiscal-monetary co-ordination,
the GEAR policy envisaged that fiscal
policy would be conducted and financed in a non-inflationary way, while monetary policy would focus
on achieving and maintaining low levels of inflation.
The government aimed to reduce the conventional
budget deficit-GDP ratio to below 3 per cent per
year. A medium-term expenditure framework was
also introduced in terms of which a Medium Term
Budget Policy Statement is published in the second
half of every fiscal year.
2.69 Under the new Constitution of South Africa,
operational independence was guaranteed to the
SARB. The objectives and framework of monetary
policy also changed significantly during the 1990s. It
started with monetary targeting, while IT was put in
place later.
2.70 Fiscal consolidation measures initiated
during the 1990s also ensured increasing monetary
policy independence. The National Treasury was set
up in 1999 to manage the debt of the government.
As debt management became more active, the
government started maintaining a transparent
relationship with the market. The structural, legal
and infrastructure constraints were also addressed
to develop a government bond market in close co-ordination
with the SARB and other agencies.
2.71 The adoption of an IT framework in
February 2000 necessitated further co-ordination
between the fiscal and monetary authorities. Under
this framework, monetary policy operations are
conducted by the legally independent SARB to
achieve the inflation target set by the government in
consultation with it.
2.72 Since 1994, the focus of fiscal policy has
been on consolidation and, therefore, has generally
been countercyclical in intent. The government’s
fiscal discipline during the period of cyclical upturn
helped it achieve marginal surpluses in 2006 and
2007. With a better fiscal-monetary policy mix,
output and price level variability also declined. Even
though there has been no ex ante co-ordination of
policies, it has been observed that the monetary
policy reacts to fiscal policy, but rarely has fiscal
policy been a problem for monetary policy. There
is some arrangement for co-ordination in the form
of a memorandum of understanding between the
Treasury and the central bank, under which there is
a provision for three standing committees. Regular bilateral meetings are held between the Governor
and the Minister of Finance, where the focus of
discussion is generally on overall strategic and
technical issues rather than explicit fiscal-monetary
policy mix.
2.73 During the post-global financial crisis,
the fiscal authorities responded with a strong
countercyclical policy. This entailed a large fiscal
stimulus complemented by appropriate monetary
policy in line with the reduced inflationary pressures.
The SARB reduced policy rates sharply between
December 2008 and November 2010. Subsequently
in July 2012, the SARB again reduced policy rate
as growth concerns emerged due to external
factors viz., fiscal austerity measures and bank
deleveraging in the euro area. The objective has
been to deal with domestic growth concerns and
ensure well contained inflation expectations.
Similarly, fiscal policy in recent years has aimed
at striking a good balance between the needs of
growth and maintaining fiscal sustainability. To sum
up, the SARB has been conducting monetary policy
within a flexible IT framework, which, in addition
to inflation, considers the implications of monetary
policy actions on growth, employment and financial
stability.
Russia
2.74 The framework for fiscal-monetary policy co-ordination
changed significantly in Russia with the
disintegration of the Union Soviet Socialist Republic
(USSR). In 1991, the State Bank of the USSR was
disbanded and renamed the Bank of Russia (BoR).
With the setting up of a single centralised federal
treasury system in 1992, the Bank of Russia was
no longer required to provide cash services for the
federal budget. In July 1993, the problems of the
ruble area led Russia to introduce the Russian ruble
and demonetise the pre-1993 ruble. The Law “On
the Central Bank of the Russian Federation (Bank
of Russia)” (Article 22) provided for independent
functioning of the BoR from the federal, regional
and local government structures. However, the BoR
is accountable to the State Duma of the Federal Assembly of the Russian Federation. While the
principal function of the BoR is to protect the Russian
ruble and ensure its stability, the single-state
monetary policy is formulated and implemented in
collaboration with the federal government.
2.75 As an agent of the Ministry of Finance, the
BoR developed the government securities market.
During the initial period, the size and volatility of the
government’s fiscal deficit undermined monetary
control. Measures to deal with major structural
constraints at times were found to be in conflict
with the requirement of tight demand management
policies. Higher expenditures and lower tax
revenues in the second half of 1993 increased the
deficit, leading to higher central bank credit to the
government. The larger deficit in 1994 also required
central bank financing equivalent to about two times
the stock of base money as at the end of 1993.
The central bank tried to control directed credits,
but its net domestic assets more than quadrupled
during 1994. Recognising fiscal concerns, investors
began to shift from ruble-denominated assets and,
consequently, a foreign exchange crisis took place
in October 1994.
2.76 The crisis led to tighter fiscal and credit
policies, and central bank purchases of foreign
exchange became the main source of monetary
growth in 1995. In 1995, the BoR stopped extending
loans to finance the federal budget deficit, and
discontinued centralised loans to individual sectors
of the economy. These policies facilitated the
adoption of an exchange rate-based monetary
policy. By this time, the government securities
market was reasonably well developed. With
reduced monetary financing of the fiscal deficit and
discontinuance of the practice of directed credits,
the BoR shifted to the use of indirect instruments
and, in particular, those which were market-based,
in its monetary policy operations. Although direct
monetisation was discontinued in 1995, the impact
on base money growth of rising capital outflows and
financing of government deficit was largely offset by
the sale of foreign exchange reserves by the BoR.
The exchange rate policy was used to minimise the inflationary impact of persistent fiscal deficit until
mid-1998. Referring to policy choices during the
period, Gaider (1999) pointed out:
Between the autumn of 1997 and August
1998, the Russian government faced a
choice between two possible strategies.
The first was to demonstrate that it had the
political will to tighten the budget by reforming
its relationship with large enterprises, such
as those in the oil and gas sectors, through
the imposition of hard budget constraints.
The second was to give up, abandoning the
attempt to promote anti-inflation policies.
Unfortunately, the attempt to tighten
budgetary policy received insufficient
political support. The result was inevitable:
the continuation of soft budget constraints,
soft budget policy, and soft monetary policy.
2.77 Notwithstanding the use of policy measures
towards monetary stabilisation during 1995-97,
inflation had eroded cash balances and made the
financing of budget deficits more difficult in 1998. In
addition to negative market sentiments prevailing
towards EMDEs, the government’s ability to borrow
in the domestic Russian market to finance its deficit
was significantly constrained due to lack of cash
balances in the economy. The government had
to unilaterally undertake restructuring of ruble-denominated
debt, while the imposition of a 90-
day moratorium on external debt payments further
eroded market confidence. During the crisis, the
BoR intervened heavily in the foreign exchange
market but could not limit the depreciation of the
ruble. Since the large-scale support by the BoR to
both banks and the government intensified pressure
on the ruble, the BoR abolished the exchange rate
band and adopted a floating exchange rate system
in 1999.
2.78 Significant depreciation of the ruble during
the crisis was followed by export-led recovery; the
rise in international oil prices also contributed to
higher exports. Monetary policy was significantly
tightened through a reduction in ruble credit to the government and banks, and servicing of external
debt payments through drawdown of foreign
exchange reserves of BoR. In 2000 and 2001, there
was some evidence of fiscal consolidation supported
by robust tax collections, the contribution of oil sector
and expenditure restraint exercised by the Russian
government. The fiscal consolidation not only eased
the pressure on the monetary policy, but also led
to a lower inflation rate. Recognising the implication
of surplus balance of payments on the value of the
ruble, the BoR made large-scale purchases in the
foreign exchange market, which were only partially
sterilised to avoid excessive monetary tightening.
In 2002, the fiscal situation again deteriorated, as
expenditures increased sharply, particularly at the
regional level. The BoR’s intervention policy, which
aimed at gradual depreciation in the ruble against
the dollar, helped to avoid a large deviation from
the 2002 inflation target, albeit with money growth
remaining above the target.
2.79 In subsequent years, the BoR continued
to pursue the dual target policy of seeking to
reduce inflation and containing ruble appreciation,
while the fiscal policy was becoming a challenge
as the government decided to finance various
pending reforms by partly using oil revenues. The
contradictions in the fiscal-monetary policy mix
were thus clearly evident. Monetary policy remained
broadly accommodative in 2004 and 2005, while
fiscal policy was relaxed in 2004. Recognising the
impact of an increase in base money growth as the
government began to spend more of its oil revenues
and with inflation remaining higher than the target
range, the BoR modified its intervention policy and
began to allow some limited ruble appreciation. The
expansionary fiscal stance continued in 2007-2008,
though it was recognised that pro-cyclical fiscal
relaxation at a time when demand pressures were
already strong could increase pressures on prices
and the ruble.
2.80 The fiscal situation deteriorated further
during the global financial crisis, following the
relaxation in fiscal policy and contraction in oil
revenues. The sharp drop in oil prices and the pressure on the ruble led to a massive drive to hedge
exposures in expectations of ruble depreciation.
The BoR initially facilitated this outflow by providing
sizeable liquidity injections at low interest rates,
while large international reserves were also drawn
down to prevent the sharp depreciation of the ruble
and avoid abrupt loss in confidence in the Russian
banking system. However, as the policy of drawdown
of reserves became increasingly unsustainable, the
BoR was forced to tighten monetary policy in January
2009 through hikes in policy rates, alongside steep
ruble devaluation. In the post-crisis period, the
Russian government planned fiscal consolidation by
undertaking a modest retrenchment as announced
in the Budget 2011-13. While the BoR also started
a tightening cycle, excess liquidity available with
banks continued to render key BoR policy rates non-binding.
However, as highlighted by the IMF (2011),
the BoR still lacks decisive monetary tightening to
rein in inflation. In short, the dominance of fiscal
policy is observed in Russia, which poses significant
challenges for achieving the dual objective of the
central bank to contain inflation and to ensure a
stable exchange rate. Going forward, Russia has
targeted to achieve a balanced budget by 2015
which will facilitate effective implementation of
monetary policy.
China
2.81 The fiscal-monetary co-ordination
framework in China is more inter-twined than in most
other EMDEs. The People’s Bank of China (PBC)
started functioning as a central bank in 1983, but
the State Council confirmed its legal status in 1995.
The PBC is entrusted with the implementation of
monetary policy; it carries out business operations
independently according to law and is free from
intervention by local governments, government
departments at various levels, public organisations
or any individuals. However, the PBC has to seek
the concurrence of the State Council in respect of
its decisions concerning the annual money supply,
interest rates, exchange rates and other important
issues assigned to it. As part of the monetary policy
function, the PBC is required to maintain the stability of the value of the currency and thereby promote
economic growth.
2.82 The PBC has frequently adjusted interest
rates in response to inflation since 1985, but these
adjustments were insufficient as other functions of
PBC, especially borrowing by financially constrained
State-owned enterprises (SOEs) acted as
constraints to monetary policy. Interest rates were
largely administered by the PBC in consonance with
the State Council. Before the new law was enacted,
a major portion of the PBC’s loans to state banks
was influenced by local governments. However,
with the passage of the Central Bank Law in 1995,
the role of local governments in influencing the
process of monetary policy and credit allocation
declined. At the same time, hard budget constraints
were prescribed for SOEs to make them fiscally
responsible and commercial viable, without State
support.
2.83 The PBC also acts as a fiscal agent of the
government and has been a major source of the
government’s financing requirements. Therefore,
monetary and fiscal policy co-ordination becomes
important, as the government bond market is one
of the most important channels for the central bank
to adjust the money supply. While the traditional
approach of the PBC has been to use monetary
base as the operational target and money supply
as the intermediate target, more recently the growth
rates of both money and bank lending have been
used as explicit intermediate targets (Goodfriend
and Prasad, 2005).
2.84 Assessing the implications of government
debt on money growth, World Bank (1990)
highlighted that the planning process involving
the PBC, Ministry of Finance and State Planning
Commission had not resulted in the past in a credit
control programme capable of keeping monetary
growth within the economy’s potential for real
growth. Therefore, the credit plan, based on the
demands of the enterprises and regions, imparted
an expansionary bias to monetary policy. Whenever
financing outside the banking system fell short of the
requirement to cover growing budget deficits, the resultant unplanned recourse of the MoF to central
bank credit led to excessive monetary expansion
and inflation. The overly expansionary monetary
policy often reflected the failure to control and offset
the rising financing needs of the government. For
instance, following the rapid expansion of credit in
1984-85 and the peaking of broad money growth
at an annual rate of 50 per cent in the first quarter
of 1985, the PBC adopted a restrictive monetary
policy stance in response to emerging inflationary
and balance of payments pressures. However,
the restrictive monetary policy stance had to be
reversed due to concerns pertaining to slowdown
in economic growth raised by the government in
mid-1986. Consequently, the higher growth rate
was accompanied by inflationary pressures and the
economy began to overheat. Subsequently, both
authorities co-ordinated to address the overheating
tendencies. While the government adopted fiscal
austerity measures, the PBC was allowed to follow
a tight monetary policy. As a result, both growth
and inflation were stabilised by 1990. Nonetheless,
monetary policy subordination continued even after
the enactment of the Central Bank Law in 1995.
2.85 In 2002, the new government adopted a much
stronger pro-growth strategy than pursued earlier
and focused on promoting job growth through local
infrastructure projects to be financed through banks.
Despite the reservations of the PBC, monetary policy
became substantially more expansionary in the
first quarter of 2003. Further, concerns with regard
to the output impact of Severe Acute Respiratory
Syndrome (SARS) led the PBC to raise targets for
broad money growth and credit expansion to 18 per
cent and RMB 2.0 trillion, respectively. During this
period, the PBC was prepared to take the risk of
higher inflation, which was approved by the National
People’s Congress, China’s legislative body. In
mid-2003, the PBC and the newly created China
Bank Regulatory Commission shared concerns
of expansionary monetary policy. Accordingly,
the PBC proposed policy guidelines in June 2003
to contain lending to the property sector, which
had shown signs of overheating. However, more
specific regulations announced by the State Council in August 2003 were less restrictive than those
proposed by the PBC.
2.86 In recent years, the PBC has tried to balance
low inflation with continued strong growth through
its monetary policy, using monetary aggregates as
intermediate targets, but administrative controls
and exchange rate policy have continued to impact
the efficacy of monetary policy. Fiscal policy has
been more proactive since the Asian crisis as
special bonds were issued for on-lending to local
governments to be spent on capital projects. In the
2005 budget, however, the fiscal policy stance was
shifted from “proactive” to “neutral.” Fiscal policy was
largely guided by the government’s medium-term
focus on fiscal consolidation aimed at making room
for likely future expenditures on contingent liabilities,
such as the banking sector’s large non-performing
loans and a need for higher social spending as the
population ages.
2.87 Even though there has been emphasis
on fiscal prudence in China, an issue that has
implications for the independent conduct of
monetary policy pertains to financing of state-owned
enterprises (SOEs) through the banking system in
China, which impedes the development of banking,
fiscal, and monetary policies. Therefore, operational
independence is often emphasised for the PBC so
that it has the authority to move its policy instruments
aggressively on short notice without permission
from other government agencies. In this context,
Goodfriend and Prasad (2006) suggested two key
prerequisites for effective instrument independence.
First, the PBC must be given full control of aggregate
bank reserves, and second, the Chinese banking
system must be made financially robust against
interest rate fluctuations, which can be achieved by
the separation of fiscal policy support for SOEs from
the banking sector.
2.88 Although these structural issues with regard
to fiscal-monetary co-ordination continue to exist,
expansionary fiscal and monetary policies were
undertaken during the crisis to minimise the impact
of global factors on export demand and falling private
investment. IMF (2009b) highlighted that a long track record of fiscal discipline drove down public debt,
affording China the space needed to significantly
expand fiscal support. The PBC’s moderately
relaxed monetary policy during this period also
served to support growth and mobilise the resources
needed to finance a surge in investment. Further,
allowing exchange rate to move with greater band
since April 2012 is also likely to increase the central
bank’s flexibility to alter monetary conditions in
the economy. In short, the fiscal policy in China
continues to play a more direct and active role in
promoting and stimulating the domestic economy,
while monetary policy is assigned the role of timely
and effective actions to face the situation of cyclical
swings in the economy and maintain financial
stability.
IV. Global Financial Crisis and Fiscal-Monetary
Co-ordination
The Great Moderation, Global Imbalances and
Loss of Governance feed into the genesis of the
Global Financial Crisis
2.89 It is widely believed that the genesis of the
global financial crisis lay in the build-up of global
imbalances, which, in turn, resulted from excessively
loose monetary policy in the advanced economies
since the early 2000s. Monetary policy in the US
was eased after the dot-com bubble burst, with
policy rates reduced to one per cent in June 2003
and kept at that level up to June 2004, with only a
gradual withdrawal from monetary accommodation
thereafter. The low interest rates not only boosted
demand in excess of domestic output in the US
directly, but also did so indirectly through the wealth
effect in the wake of rising asset prices. The excess
domestic demand spilt over into the growing current
account deficits of the US. This was appropriately
matched by substantial current account surpluses
in Asia, particularly China, and the oil-exporting
countries in the Middle East and Russia, which
catered to the demand in the US by supplying goods
and services at cheaper rates.
2.90 The conducive macroeconomic environment
in terms of stable economic growth and low inflation encouraged the search for better yields, relaxation of
lending standards and under-pricing of risks (Mohan,
2009). Bereft of any formal mandate for maintaining
financial stability, public policy tended to ignore the
expanding global imbalances and undue financial
leveraging as long as economic growth remained
steady and inflation low, as characterised by the
Great Moderation which lasted over almost a decade
and a half. Central banks focused excessively on
inflation at the expense of financial vulnerability.
By accommodating lax credit conditions and rising
debt, monetary policymakers in a way increased the
risks of a bust. Besides, many central banks were
persuaded to be very transparent and provided
forward guidance to the financial markets on their
policy stance, especially on the future course of
monetary policy. Such forward guidance provided
excessive comfort to the financial markets and aided
the under-pricing of risks.
2.91 Empirical evidence found US monetary policy
to be much looser during 2002-2006 than warranted
by the conventional Taylor rule, supported in many
cases by government programmes during the period
leading up to the housing boom (Taylor, 2009).
Taylor also argues that the softening of policy rates
by the ECB reflected, to an extent, the influence of
US monetary policy decisions, though the monetary
easing in the euro area did not venture that far while
the current account position remained generally
in surplus. Corroborative evidence of monetary
excesses was also found in other countries in a study
by the OECD, which showed that the greater the
degree of monetary excess in a country, the larger
was the housing boom. Sharp booms and busts in the
housing markets were shown to impact the financial
markets, as falling house prices led to delinquencies
and foreclosures. These effects were amplified by
several complicating factors including the use of
sub-prime mortgages, especially adjustable rate
housing loans, which led to excessive risk-taking.
2.92 In the US, this was encouraged by
government programmes designed to promote
home ownership. Government-sponsored
agencies, viz., Fannie Mae and Freddie Mac, were encouraged to expand and buy mortgage-backed
securities, including those formed with risky sub-prime
mortgages. While legislation viz., Federal
Housing Enterprise Regulatory Reform Act of 2005
was proposed to control these excesses, it was not
passed into law. The crisis worsened when the US
government (more specifically the Treasury and
the Federal Reserve) decided not to intervene to
prevent the bankruptcy of Lehman Brothers around
mid-September 2008. According to one stream of
thought, the recent financial crisis reflects a collapse
of the market as well as the State, since governance
in both the private and public sectors failed (Reddy,
2009).
Policy response entailed higher degree of co-ordination
across countries
2.93 As the effects of the crisis extended from the
financial to the real sector, a wide range of monetary
and fiscal policy measures were undertaken in a
manner that marked a distinct departure from the
pre-crisis macroeconomic orthodoxy and reflected
valuable lessons gained from the Great Depression.
Initially, as confidence in the financial system
plummeted to historic lows and liquidity in the
overnight money market dried up, the central banks
acted first, and some co-ordinated measures at the
international level were also undertaken particularly
under the Group of Twenty (G 20) to restore market
confidence.
Orthodox monetary policy, constrained by near-zero
interest rates, gave way to unconventional
monetary policy measures
2.94 Contrary to previous experience, central
banks in the US, euro area, Japan and other
economies continued to run expansionary monetary
policy even after cutting their nominal policy rates
to very low levels to counteract downside risks to
price stability and, in some cases, to avoid outright
deflation. The need for sustaining the efficacy of
monetary policy even when policy rates neared the
liquidity trap or zero lower bound (ZLB) levels in
major advanced economies prompted central banks to activate non-standard or unconventional monetary
policy response options by using communication
policies to shape public expectations about the future
course of interest rates, expanding their balance
sheets (quantitative easing) and changing the
composition of their balance sheets through targeted
purchases of long-term bonds. By deciding to buy
long-term debt, the dividing line between fiscal and
monetary policy gets blurred. Thus, unlike the Great
Depression phase of the 1930s, the global financial
crisis of 2007-09 entailed a close co-ordination of
fiscal policies with, particularly, non-conventional
instruments of monetary policy. The balance sheet
effect of unconventional monetary policy measures
is discussed in detail in Chapter 4.
2.95 Several solutions to the ZLB have been
explored in the literature, focusing on alternative ways
of conducting monetary policies, such as price-level
targeting instead of inflation targeting (Svensson,
2003) or exchange rate targeting (McCallum, 2000).
Other strands in the literature address the ZLB with
a focus on the financial environment. Examples
include analysis of the balance sheet of the central
bank (Auerbach and Obstfeld, 2005), fighting the
ZLB through purchasing illiquid assets (Goodfriend,
2000) and countering negative short-term market
interest rates by imposing a tax on cash holdings
and deposits [Buiter and Panigirtzoglou (1999) and
Goodfriend (2000)]. In respect of fiscal policy also,
several studies examined the use of instruments as
a way to overcome a ZLB situation, such as analysis
of fiscal multipliers (Christiano, Eichenbaum and
Rebelo, 2009; Cogan, Cwik, Taylor, and Wieland,
2009; Romer and Bernstein, 2009).
Huge fiscal stimulus programme tantamounts to
Keynesian resurrection with a difference
2.96 Notwithstanding monetary policy becoming
the first line of defence and central banks turning
lenders of first resort, the credit markets were slow
to respond. Accordingly, fiscal measures were
deployed to avoid any erosion of the gains from the
actions taken by central banks. With monetary policy
rates nearing zero in most advanced economies in the post-crisis period, and considering the scale
and sweep of the global financial crisis, there was a
resurrection of the Keynesian strategy of activating
fiscal stimulus measures. Governments intervened
with huge fiscal packages to stimulate domestic
demand and to recapitalise banks. The onset of the
‘great recession’ from December 2007 saw fiscal
policy activism in the US (temporary tax rebates in
February 2008, first homebuyers tax credit in July
2008, American Recovery and Reinvestment Tax
Act, which combined tax cuts, transfers to individuals
and states, government purchases in February 2009
and temporary ‘cash for clunkers’ programme in the
summer of 20092 ), the UK (temporary consumption
tax rebates) and China (large public works projects).
Notably, the fiscal activist responses across
countries were co-ordinated in an unprecedented
fashion, delivering a joint fiscal stimulus of 1.7 per
cent of global GDP in 2009 (Khatiwada, 2009). This
reflected not only the severity of the recession but
also some optimism about the potential effectiveness
of activist fiscal policy.
2.97 This contrasted with modern economic views
prevailing during the decades prior to the crisis that
doubted the efficacy of discretionary fiscal policy in
stimulating the economy from a downturn, reflecting
a belief in the Ricardian equivalence perspective,
recognition of fiscal policy implementation lags and
apprehensions about political influences. The non-discretionary
fiscal policy in terms of automatic
stabilisers was considered to be more effective than
discretionary stimulus in responding to changes
in business cycles. It was held that the impact of
automatic stabilisers rose with an increase in the
size of the government. Further, a need was felt
to reduce and stabilise high debt levels, which had
paved the way for the introduction of fiscal rules and
independent councils in economic policy-making. As
a result, by early 2009, 80 countries had put in place
national or supranational fiscal rules (Cottarelli,
2009).
2.98 Huge fiscal stimulus programmes, operated
in tandem in the US, the UK, and many other countries,
gave rise to a debate about their effectiveness, with
studies indicating their effectiveness to ‘stimulate’
if and only if they do not generate expectations of
future taxes to pay off the increased debt (Cochrane,
2011). Apprehensions also emerged about the
feasibility of undertaking large fiscal expenditures
rapidly. As fiscal deficits became massive, credit
guarantees surged and central banks purchased
risky private assets, the traditional fiscal dominance
issue has re-emerged during the post-crisis phase.
Thus, fiscal constraints have begun to take hold
over monetary policy-making. Nonetheless, fiscal
activism during the great recession phase drew
empirical validity from several studies that found
fiscal policy stimulus measures to be effective in
reducing the duration of a ZLB episode. They also
showed that fiscal multipliers were enhanced during
the ZLB period, due to the inability of monetary
policy to react.
2.99 Not only were the two kinds of policies coordinated
across the globe in pursuit of common
objectives, but also the scale of monetary and
fiscal expansions remained unprecedented, which
paradoxically rekindled familiar conflicts (Subbarao,
2009). Huge fiscal stimulus packages and climbing
fiscal deficits entailed high government borrowing
programmes with concomitant implications for
monetary transmission and liquidity management
by the central banks. The central bank’s liquidity
management, and especially its unconventional
measures, had both fiscal and distributional
consequences. For example, the United Kingdom’s
quantitative easing has had massive fiscal
consequences. It was felt that the central bank’s
choice of market for its operations should not be
based so much on its fiscal implications, but rather
on the extent to which such intervention might distort
relative prices and have a distributional effect,
benefitting one set of borrowers rather than another
(Goodhart, 2010).
Fiscal-financial linkages show up in Sovereign
debt crisis in peripheral Europe
2.100 The global financial crisis – in its fifth year
in 2011 – manifested itself in an altogether different
phase, moving from private debt into the sovereign
space. The dynamics of the crisis and the policy
options available changed markedly during 2009.
As discussed earlier, in view of the prevailing low
interest rates, central banks did not have much
freedom to reduce the interest rates and had to
resort to unorthodox balance sheet policies. Public
expenditures to provide stability and stimulus
featured prominently in the policy response by
different countries. This has left very little policy
space for any future crisis management. In the
transformation of the global financial crisis into the
sovereign debt crisis, the rescue of Bear Stearns
in March 2008 clearly marked the turning point. It
generally raised expectations about policymakers
providing sufficient financial support to banks to
enable the bailout of the banks’ creditors. As the
constraints on fiscal commitments became clearer
with the nationalisation of the Anglo Irish Bank in
January 2009, the separation between the sovereign
and the financial sector got blurred.
2.101 The fiscal-financial linkages are exemplified
by the fact that during 2008-09, in the euro region,
each sovereign’s spreads evolved largely in
response to the stress experienced by its domestic
financial sector. Fiscal problems, in turn, began
to exert adverse feedback effects on the financial
sector and growth. Higher sovereign spreads
increased the borrowing costs of domestic banks
and generated capital losses on the holdings of
public debt, contributing to lower growth.
Interplay of Sovereign Risk with the Banking
Sector manifested particularly in the deepening
of the European Crisis
2.102 The interplay of sovereign risk with the
banking sector progressively worsened in the euro
area since the second half of 2011, and financial
stability concerns increased considerably. The
movements in credit default swap (CDS) spreads on the sovereigns and banks showed high correlation
in some of the euro area countries (Spain, Italy
and France), reflecting a close connection between
sovereign credit risk and banking sector weakness.
Links between sovereign debt problems and the
banking sector became evident through an increase
in credit risks vis-à-vis governments, liquidity
squeeze and reduced creditability of government
guarantees. As highlighted in the Committee on the
Global Financial System (CGFS) ‘Panetta’ Report
(2011), a deterioration in sovereign creditworthiness
can hurt the financial sector through one of three
channels: (i) increased counterparty risks, increased
cost of funding via new bond issues and reduced
access to credit from repo and derivatives market
due to the reduced value of government collateral;
(ii) loss of value of implicit or explicit government
guarantee of banks and their borrowers; and (iii) the
induced fiscal consolidation might undermine credit
demand and weigh on the quality of private sector
debt in the short-term. Further, when the sovereign
debt moves from being a ‘risk free’ to a ‘credit risk’
instrument, it might have adverse macroeconomic
and financial ramifications (Caruana, 2011). In
view of this, it is critical for sovereigns to gain back
credibility of the instruments issued by them, i.e.,
their gilt-edged or risk-free status as sovereign
solvency is a pre-requisite for the success of central
bank operations dealing with threats to monetary
and financial stability.
2.103 Another issue is the availability of sufficient
fiscal capacity to provide sizeable financial support
to their banks. In view of the heightened risks and
uncertainties, some banks, especially those heavily
reliant on wholesale funding and exposed to riskier
public debt, may also need more capital. For the
sovereign to act as the backstop for the financial
system, it is important that fiscal buffers be built
during good times. Traditionally, central banks are
held responsible for addressing liquidity problems of
banks, while solvency problems or bank failures have
to be addressed by the government. If liquidation of
a failing bank cannot be allowed and the market is
not prepared to provide more capital, then the only
recourse is taxpayer funding.
2.104 In the case of taxpayer funding, or (partial)
nationalisation of failing banks, the relevant political
representative of the government would have to be
entrusted with the responsibility of the resolution
exercise. While leaders of the G20 discussed a
range of options available on this issue, they could
not reach a consensus. While some countries have
adopted banking levies, others are considering how
to make the financial sector responsible for sharing
fairly and substantially any burden associated with
government interventions to repair the banking
system. The European Commission (EC) put
forward a proposal for financial transaction tax (FTT)
for 27 EU members on September 28, 2011. For the
11 member states3 which agreed to adopt the FTT,
the EC on February 14, 2013 adopted a proposal
setting out the details of the tax which is expected to
generate revenues worth € 30-35 billion a year.
2.105 To break the link between banks and
sovereigns, Herman Van Rompuy, President of
the European Council suggested three actions
as necessary: (i) completion and thorough
implementation of a stronger framework for fiscal
governance; (ii) establishment of an effective single
supervisory mechanism (SSM) for the banking
sector and the entry into force of the Capital
Requirements Regulation and Directive; and (iii)
setting up of the operational framework for direct
bank recapitalisation through the European Stability
Mechanism (ESM). Substantial progress has been
made in this direction.
Risks of fiscal-monetary co-ordination ending
up in fiscal dominance of monetary policy
2.106 While the 1990s saw an increasing trend
towards central bank autonomy, a view was also
emerging that central bank independence and a
lack of co-ordination of monetary and fiscal policies
could pose a problem in addressing the conditions
of a liquidity trap (Krugman, 1998). This view has
gathered support in the light of the fiscal-monetary co-ordination
undertaken to address the global financial crisis, thereby further rekindling debate between
the need for monetary policy to act in tandem with
the fiscal policy as well as the issue of central bank
autonomy. Notwithstanding the imperatives of fiscal-monetary
co-ordination, care has to be taken that
interactions with the government do not undermine
the effectiveness of policymaking to the detriment
of the public. In that context, the arrangements to
ensure effective dialogue and consultation between
the central bank and the executive and legislative
branches, and setting limits on central bank advice
to the government, in private and in public, on issues
outside its mandate, become important. Further, the
institutional arrangements that are being evolved
after the crisis for overseeing financial stability have
an inherent tendency to infringe on the mandate of
the central banks.
2.107 A related issue that has been highlighted in
the post-crisis period is that of the fiscal dominance of
monetary policy. Before the crisis, fiscal dominance
had continued to wane as fiscal discipline was
taking centre-stage in most countries. However,
the extraordinary fiscal expansion by the advanced
economies to combat the crisis, which has been
actually mutating into structural fiscal deficits, has
given rise to the apprehension that monetary policy
will have no choice but to accommodate continued
elevated government borrowing into the medium-term.
For example, the ECB has had to show
unusual accommodation in resolving the sovereign
debt crisis in some European countries.
2.108 Such concerns are not confined to the
euro area. It is widely perceived that this is just the
beginning of a trend whereby fiscal policies will once
again start dictating monetary stances, particularly
in advanced economies. Fiscal deficits ballooned to
levels never seen in peacetime in the US, the UK
and the euro area. Though the fiscal cliff deal of
January 2, 2013 could avert the immediate risks of
a sharp fiscal contraction in the US, concerns about
long-term debt sustainability remain. Going by the
current fiscal developments in various economies, former US President Nixon’s view of the return of
Keynesian orthodoxy appears to be applicable,
which could lead the conduct of monetary policy to
be progressively driven by fiscal compulsions in the
years ahead (Box II.1).
2.109 At present, the situation is under control,
as financing these fiscal deficits has not been a
problem so far. The extreme risk aversion in the
wake of the crisis triggered a ‘flight to safety’ and a
‘flight to liquidity’, which, in turn, ensured that there
was enough appetite for treasuries. Even so, yields
on treasuries have started firming up in the recent period, suggesting the return of some risk appetite.
As central banks are showing extraordinary
monetary accommodation by pumping in huge
amounts of liquidity to support banks and financial
institutions, the surplus liquidity conditions have
helped governments to raise borrowings.
2.110 In fiscal-monetary co-ordination, ‘arm’s
length’ co-ordination has become the main
co-ordination mechanism in recent times,
overshadowing face-to-face discussion. If fiscal
authorities have a sufficient understanding of the
monetary policy reaction function, and the monetary authorities of fiscal policy rules, then there is a
scope for tacit negotiations without face-to-face
engagements. Under extreme circumstances (as
might be characterised by Sargent’s “unpleasant
monetarist arithmetic”), a switch to joint decision-making
could prove necessary. The co-ordination
of fiscal and monetary policies during the global
financial crisis across the advanced economies
reflected the criticality of joint actions for both
these policies to stimulate aggregate demand. The
consensus emerging from a long line of research
is that separating monetary policy and fiscal policy
overlooks policy interactions that are important for
determining equilibrium (Davig and Leeper, 2009).
Box II.1
Fiscal Concerns and Challenges for Monetary Policy
The recent global financial crisis had significant fiscal
implications across advanced as well as emerging market
economies. Although fiscal deterioration was a common
feature in some of the advanced economies even before
the crisis due to unfavourable demographic profiles and
other domestic obligations, it was exacerbated during the
crisis. The build-up of fiscal imbalances and debt during the
crisis were largely due to automatic tax and spending policy
responses to slow growth and countercyclical discretionary
fiscal measures. As a result, fiscal imbalances and debt
levels have surged sharply since 2008, particularly in
advanced economies. For instance, in the US, the general
government deficit as a ratio to potential GDP rose from 2.2
per cent in 2007 to 7.0 per cent in 2010, while government
debt as a ratio to GDP increased from 43.9 per cent in
2007 to 94.4 per cent in 2010. According to the IMF, the
government debt-GDP ratio is likely to remain higher than
100 per cent for the US in the medium-term. The case is
similar for most other advanced economies. Based on a
study of 18 OECD countries, Cecchetti et al. (2011) found
that government debt beyond the threshold of around 85
per cent of GDP is not sustainable and may act as a drag on
growth. Accordingly, the current level of fiscal imbalances
and debt appear to be highly unsustainable compared to the
pre-crisis situation. During the pre-crisis period, fiscal and
debt sustainability was not much of an issue, as prevailing
interest rates were lower than growth rates. However, this
is unlikely to be the case in the period ahead as interest
rates might rise while growth prospects remain subdued,
particularly in advanced economies. Further, negative
feedback of lower growth on fiscal consolidation is likely to
aggravate fiscal imbalances.
In a highly unsustainable fiscal scenario in the post-crisis
period, central banks face two types of challenges that can
have implications for the conduct of their monetary policy.
First, the balance sheets of central banks with government
debt, particularly in the advanced economies, raises not
only the issue of the credibility of monetary policy but
also shows that they are exposed to market risks, viz.,
interest rate risk and credit risk. These aspects can come
into conflict with monetary policy going forward. Second,
the fiscal and debt sustainability issues, particularly in
the advanced economies, have critical implications for
monetary policy, and the credibility of central banks is likely
to be largely determined by nature of their co-ordination
with fiscal authorities.
Although the expansion of central bank balance sheets
proved more effective than conventional measures during
the crisis, it should not be encouraged for a long time due
to concerns relating to market risks, the moral hazard of
further future support and possible crowding out of funding
markets. In fact, balance sheet expansion to support
a particular asset class is considered a fiscal measure
undertaken by central banks. According to Plosser (2011),
“once a central bank ventures into conducting fiscal policy,
it may find itself under increasing pressure from the private
sector, financial markets, or the government to use its
balance sheet to substitute for other fiscal decisions. This
pressure can threaten the central bank’s independence
in conducting monetary policy and thereby undermine
monetary policy’s effectiveness in achieving price stability”.
BIS (2011) also highlighted the risk that operations
undertaken during a crisis could be perceived as intended to fund fiscal policy initiatives, thereby undermining
central bank independence. Mohanty and Turner (2011),
Gagnon and Hinterschweiger (2011) and Plosser (2011)
highlight the possibility of monetisation of government
debt as a policy of creating higher inflation to solve fiscal
failures. In the post-crisis period, it would be appropriate
that central banks should calibrate exit by withdrawing
unconventional measures. In fact, the US Federal Reserve
and the European Central Bank had indicated their intent
to undertake exit strategies in late 2009 and early 2010.
However, due to the deepening debt crisis in the euro area
and the slowdown in economic conditions in the US, such
strategies were put on hold. Given the current economic
and financial conditions, the phasing out of central banks’
balance sheet measures seems to be difficult. Further,
central bank balance sheet policies by their nature are
targeted at specific markets and there is a risk of distortion.
Consequently, central banks can face difficult trade-offs
between the costs of these distortions against attainment of
their policy objectives. Holding of government bonds may
not augur well for central banks in advanced economies as
it can complicate their future relations with fiscal authorities
and debt managers (Mohanty and Turner, 2011).
In addition to the expanded balance sheets posing a
challenge for central banks through various risks, the lack
of a credible long-term fiscal consolidation plan may put
further pressure on the conduct of monetary policy. In the
absence of credible fiscal plans, public debt may continue
to rise due to ageing problems in advanced economies. As
a result, there is a risk of increase in the interest rate. At
the same time, ageing may reduce future growth, further
undermining fiscal and debt sustainability. It calls for major
policy changes in terms of spending and revenue levels
in many advanced economies, in case they have to avoid
an increase in their debt to unsustainable levels. While
there may not be much scope for reduction in spending
and tax increases due to subdued economic conditions,
a credible plan for fiscal consolidation in the medium-term
is necessary. Monetary policy can remain accommodative
so long as inflation expectations are contained. Once the
process of inflation expectation builds up, the central bank’s
policy focus may shift to tightening the monetary policy and,
there could be a conflict of interest between the central
bank and government.
Quantitative easing undertaken in recent years and
expected high levels of market borrowing in advanced
countries pose upside risks to inflation, which may call for
higher policy rates. This, in turn, may lead to a high interest
rate environment that may not bode well for advanced
economies, which are already facing high debts and
subdued growth conditions. Thus, fiscal policy and debt
management decisions will play an increasingly important role in formulating and implementing monetary policy. In this
context, Cecchetti (2011) argues “central bank operating
procedures of the future will be more complicated, with
more tools and more options. In addition, the interaction
of monetary policy and sovereign debt management will
be a major challenge for those operating procedures in
the coming years. Central banks in economies with high
debt burdens and those affected by the actions taken in
economies with high debt burdens will therefore need to
keep abreast of the activities of debt managers when
implementing monetary policy.” To address the challenges
posed by debt overhangs and fiscal concerns, particularly
of the public sector, for the credibility of central banks, the
Committee on International Economic Policy and Reform
(2011) has emphasised that a communication strategy
needs to evolve that deals with concerns about the central
bank’s independence from the fiscal authorities.
Going forward, advanced economies should work out
credible medium-term fiscal consolidation plans that ensure
a balance between short-run growth fragility with fiscal
sustainability, while monetary policy can support fiscal
adjustment and remain accommodative till medium-term
inflation expectations are well anchored. Central banks’
interaction with fiscal authorities is likely to be critical not
only from the perspective of smooth conduct of monetary
policy to anchor inflation expectations but also from the
perspective of financial stability. In the process of co-ordination
with fiscal authorities, central bank autonomy
should not be compromised and, therefore, it may require
a well-specified framework. In short, the future credibility
of monetary policy in advanced countries is contingent
upon (i) how concerns with regard to already purchased
government debt during a crisis are addressed and (ii) how
future fiscal plans in advanced countries are chalked out,
which should specify timeframes to reduce gross debt-to-
GDP ratios to sustainable levels and fiscal policy measures
adding to the medium-term growth potentials. For both
these aspects, central banks, fiscal and debt authorities
would need to follow a close co-ordination approach.
Select References
Cecchetti, Stephen G., M. S. Mohanty and Fabrizio Zampolli
(2011), “The real effects of debt”, BIS Working Paper No.
352.
Plosser, Charles I. (2011), “Some Observations on Fiscal
Imbalances and Monetary Policy”, The Philadelphia Fed
Policy Forum on “Budgets on the Brink: Perspectives
on Debt and Monetary Policy”, Federal Reserve Bank of
Philadelphia, December 2.
[For other references, see the complete list for Chapter 2 at
the end of the report]
Financial stability emerging as an important
objective of public policy
2.111 In the post-crisis period, financial stability
has come to occupy centre stage in the hierarchy
of economic policy objectives, particularly since a
major lesson from the crisis is that financial stability
can be jeopardised even in an environment of
price stability and macroeconomic stability. The
genesis of the global financial and economic crisis
showed that extended periods of price stability and
macroeconomic stability could blind policymakers
to financial instability brewing in the underbelly. It
has become evident that apart from co-ordinating on
monetary and fiscal policies, the government and the
central bank need to co-ordinate on financial sector
issues as well. On the contrary, in the pre-crisis
period, policymakers – the monetary authority and
the government – did not always respond effectively
in a co-ordinated manner to events unfolding in
the financial sector, because financial stability was
taken more or less as a subject in the domain of the
central banks.
2.112 The lessons from the crisis have triggered
a vigorous debate on whether financial stability
should be made an explicit mandate of central
banks. Prior to August 2007, most central banks
had formally or informally included financial stability
in their mandate along with the explicit mandate of
setting the monetary policy. In the post-World War II period, there was a debate about whether the
central bank would be in charge of systemic financial
stability, and, if not, how its relationship with the
systemic regulator can be defined. An argument
in favour of central banks being entrusted with this
responsibility was that they were best suited to
handle the financial stability objective since in many
economies they were the banking sector regulators
and played the role of lender-of-the-last-resort
(LOLR). The crisis exposed some clear deficiencies
and inconsistencies in regulatory systems across
countries and clear conflicts of interests in financial
regulation and supervision.
2.113 It is now increasingly recognised that
regardless of the regulatory architecture,
preserving financial stability requires coordination
among regulators, and between regulators and
governments. Across most jurisdictions, the post-crisis
focus has been on shifting responsibilities
and mandates among regulators. The Financial
Stability Oversight Council that has been created
in the US brings together various elements of the
regulatory and supervisory framework of the Fed,
the Banking Insurance Oversight, the Securities and
Exchange Commissions, etc. Such a Systemic Risk
Board has also been created in the euro area. In
India, a Financial Stability and Development Council
(FSDC) was set up in December 2010 with a view
to establishing a body that would institutionalise
and strengthen the mechanism for maintaining
financial stability, financial sector development and
inter-regulatory co-ordination. Such councils could
handle the unique combination of responsibilities
for macroprudential regulation and microprudential
supervision, and make recommendations for
heightened prudential standards for the safety of the
financial system (Box II.2).
2.114 The creation of systemic risk boards also
amounts to creating institutional arrangements for
the task of macroprudential surveillance, so that
central banks can focus on monetary policy-making.
EMDEs, including India, have experimented with the
deployment of macroprudential tools to supplement
the interest rate policy and to preserve financial stability over the business cycle. In the pre-crisis
phase, the exercise of macroprudential regulation
was vested with the central bank. Considerable
efforts are underway following the crisis on
developing a macroprudential policy framework
– its objective and scope, its sets of power and
instruments, and their governance.
Box II.2
Financial Stability Arrangements in the Post-Crisis Period
A growing trend post-crisis across various countries has
been towards carrying out major reforms in the governance
arrangements for financial stability. In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act
was implemented in July 2010. In the European Union (EU),
the European Parliament adopted legislation in September
2010 with respect to new governance arrangements in
both the micro- and macro-prudential spheres. France and
Ireland also re-engineered their supervision arrangements
in March and October 2010, respectively, and Mexico
introduced a new inter-agency framework in July 2010.
In the US, the Dodd-Frank Act created the Financial
Stability Oversight Council (FSOC) to be headed by the
Treasury Secretary and comprises the heads of the central
bank and all the regulatory agencies. The FSOC does not
have rule-writing or enforcement authority, but has the
powers to recommend, and in some cases require, action
by member agencies. The Act entrusts the Fed with powers
of supervision of not only all banks but also non-banks if
they pose a threat to financial stability and to oversee the
payment, clearing and settlement system.
In the EU, the new legislation seeks to strengthen the co-ordination
for microprudential supervision, while retaining
its national base. It also creates a centralised structure for
macroprudential policy. With respect to microprudential
policy, three new European Supervisory Authorities (ESAs)
replaced the existing advisory committees, and a joint
committee was created to promote co-operation among
them. With respect to macroprudential supervision, the
European Systemic Risk Board (ESRB) was created in May
2012 to contribute to the prevention or mitigation of systemic
risks to stability that may arise from developments within
the financial system and the macroeconomic framework
more generally. The ESRB does not have direct authority
over any policy instruments, but instead has the power
to issue recommendations and risk warnings concerning
systemic risks to the authorities that wield the relevant
instruments. Such recommendations, which carry an “act
or explain” obligation, could be made public under certain
circumstances. The ESRB is chaired by the President of
the ECB, membership comprises of central bank governors
of the 27 member states, chairpersons of the three ESAs,
and a representative from the European Commission (EC).
The chairperson of the Economic and Financial Committee
(EFC) representing the finance ministry participates as an
observer.
With a view to safeguard EU financial stability, the Europeon
Financial Stability Facility (EFSF) was created on June 7,
2010 for providing financial assistance to member states.
The European stability mechanism (ESM) was launched on
October 8, 2012 as permanent firewall for the euro zone with a maximum lending capacity of € 500 billion.
Europe took its first big step towards banking union on
December 13, 2012, with the EU finance ministers agreeing
to make the ECB their common bank supervisor. The ECB
is expected to begin direct supervision of up to 200 euro
area lenders from early 2014.
In the UK, a paradigm shift is underway in terms of the
institutional arrangements for microprudential as well as
macroprudential regulations. The government announced
plans, which should be in place in 2012, to: (i) shift the
responsibility for prudential oversight from the Financial
Services Authority (FSA) to a new Prudential Regulation
Authority (PRA) under the Bank of England; and (ii) set
up a Financial Policy Committee (FPC) within the Bank
of England to “monitor macro issues that may threaten
economic and financial stability”. The Committee would
comprise a representative of the Treasury, other regulators
and external members appointed by the Treasury. The
Treasury would, however, lead the co-ordination of actions
in a crisis.
Among countries like France and Australia, the co-ordination
of financial supervision has been entrusted with
the Governor of the central bank. In India, the new Financial
Stability and Development Council (FSDC) is headed by
the Finance Minister.
At this stage, there is no clear vote for any particular model,
but different institutional structures are being evolved for
system-level supervision depending on country-specific
circumstances. Nonetheless, a common stance emerging
is that while financial sector regulators and the sovereign
have a joint role in maintaining financial stability, from
an effectiveness and accountability perspective and
for preventing and managing a crisis, the executive
responsibility for financial stability would have to fall upon
a single entity. The central bank is best positioned to be
that single entity with responsibilities for both systemic
oversight and prudential regulation. Further, there would be
institutionalisation of collegial arrangements involving the
central bank, other regulators and the government, which
would jointly have the primary responsibility for identifying
threats to financial stability.
The possibility of institutionalising a global equivalent of
systemic risk boards is being examined at international
forum, but uncertainty remains about how to organise it.
Quite clearly, this would require careful consideration of
issues, that may exert conflicting pulls. In particular, there
is the issue of balancing the interests of global stability and
national sovereignty, particularly on practical considerations
that require flexibility in the context of country-specific
adaptations.
Difficult policy trade-offs in meeting the short- to
medium-run challenges of fiscal consolidation,
financial restructuring and reviving growth
2.115 The recent financial crisis has revived the
debate on the relative effectiveness of monetary and
fiscal policies. With interest rates approaching zero
and constraining traditional monetary policy, fiscal
policy was found to be potentially more effective
in boosting economic activity than it usually would
be. While the crisis saw the application of non-conventional
instruments of monetary policy, the
unprecedented ways of easing financial conditions
have transformed central bank balance sheets,
whereby risks on the financial system have been
absorbed by central banks with potentially greater-than-
usual fiscal ramifications.
2.116 Monetary policy faced a challenge even
before the crisis, with interest rates ruling at low
levels, but now when sovereign spreads are high,
the ability of monetary policy to lower the rates
paid by businesses and households is getting
further limited. To the extent that high public debt
increases uncertainty about future interest rates,
fiscal-monetary feedbacks are likely to be stronger
when public debt/GDP ratios rise. In such a
situation, unconventional monetary policies appear
to be a more feasible option. The success of such
a strategy, nevertheless, would depend on how well
the monetary policy and debt management policy
are co-ordinated in practice (Mohanty and Turner,
2011).
2.117 The interaction between fiscal and monetary
policies became evident during the sovereign debt
crisis in Europe, marked by developments in Ireland,
Portugal and Greece. Despite the considerable policy efforts undertaken at the national and EU
level, the crisis threatens not only global recovery,
but also the very existence of the euro. Major policy
packages have been announced through a series of
rounds (May 2010, February 2011, July 21, 2011,
October 26, 2011, December 9, 2011 and June 28-
29, 2012). The crisis highlighted the importance
of institutional arrangements for the conduct of
monetary and fiscal policies. In monetary unions
like the euro system, member countries pursue
independent fiscal policies but do not have recourse
to exchange rate or monetary policy levers to make
the necessary adjustments. This underscores the
importance of sound and credible fiscal policies by
member countries to ensure the independence and
credibility of their collective monetary policy.
2.118 In the absence of fiscal discipline across
member countries, there is the threat of monetary
policy becoming hostage to the fiscal excesses of
individual members. The European Council meeting
of December 9, 2011 paved the way for a fiscal
stability union with a new fiscal rule at its heart. The
Treaty on Stability, Coordination and Governance
in the Economic and Monetary Union – better
known as the “fiscal compact” – that was signed
on March 2, 2012 by the leaders of 25 EU member
states, entered into force on January 1, 2013.
Government budgets shall in future be balanced or
in surplus, and they must also be in line with the
country-specific medium-term budgetary objective,
as defined in the EU’s SGP and this requirement
will also be transposed into national legislation by
January 1, 2014. In the event of deviation from
the balanced budget rule, an automatic correction
mechanism will be triggered. Further, in future all
major economic policy reforms planned by euro area
members will be jointly discussed and co-ordinated
for convergence and competitive issues so as to
establish benchmarks for best practice in the new
euro area summits, that are planned twice a year
prolonging European Council meetings. It is also
proposed that surveillance should be strengthened
over countries that receive financial assistance via
the EFSF and ESM and of those at serious risk of financial instability. The role of EFSF/ESM, along with
ongoing work on a single supervisory mechanism,
progress with the ratification of the Fiscal Compact,
and further structural reforms in euro area member
states, holds the key to the future of the euro area.
V. Concluding Observations
2.119 The evolution of macroeconomic theory
and progress of fiscal-monetary co-ordination
across countries as analysed above suggests
that the former, to a great extent, influenced the
latter in practice. The evolution of macroeconomic
theory underscored the need for co-ordination
between both arms of economic policy to achieve
macroeconomic objectives. However, the nature of
the fiscal-monetary interface has evolved since the
Great Depression through various phases, switching
between extremes of fiscal dominance and monetary
dominance. Regardless of the policy dominance
regime, the literature points towards the need for
co-ordination between the fiscal and monetary
authorities. Illustratively, under fiscal dominance,
monetary policy loses instrument independence
to tackle inflationary pressures that may emerge
from fiscal profligacy. On the other hand, even
when central banks are not bound to monetise
government deficits, the theoretical possibility of
conflict of interest between the central bank and the
government cannot be ruled out if deficit levels are
set autonomously. The literature provides ample
evidence that macroeconomic outcomes turned out
to be better when both fiscal and monetary policies
are co-ordinated.
2.120 The theoretical evolution of fiscal-monetary
co-ordination provided valuable guidance for both
advanced and emerging market economies to
develop institutional arrangements between their
central banks and governments in consonance with
historical imperatives and country circumstances.
The policy co-ordination mechanism improved during
the 1990s amid an emphasis on price stability either
explicitly in the UK, Japan and some other advanced
countries or implicitly like in the US. However, the
policy framework remained flexible to address short-term output loss considerations. The formation
of the EMU in 1999 brought forth new challenges
in the form of co-ordinating a common monetary
policy with decentralised fiscal policies pursued by
national authorities. Even though fiscal-monetary
co-ordination was emphasised statutorily under the
SGP, experience shows that procedural mandates
provided flexibility to member countries to pursue
fiscal policies without strictly adhering to prescribed
limits. The repercussions of fiscal profligacy during
the pre-crisis period got magnified during the global
financial crisis and led to unsustainable debt levels
in some member countries of the euro area.
2.121 The experience of EMDEs shows that
fiscal policies tend to be dominant, reflecting
development concerns, while central banks lack
autonomy compared with advanced economies.
Country experiences have been divergent across
EMDEs. The overall experience shows that the
trend since the mid-1990s has been for a growing
number of countries to adopt fiscal rules that place
limits on deficits and/or debt and also prohibit
primary financing of debt by the central banks.
One of the broad outcomes of this effort has been
that central banks found themselves relatively free
to conduct independent monetary policy, not only
free of fiscal compulsions but also in a predictable
fiscal framework. The environment of price stability
coupled with steady growth that characterised the
Great Moderation came to be seen as a vindication
of the merits of freeing monetary policy from fiscal
dominance.
2.122 In the aftermath of the crisis, apprehensions
about the fiscal dominance of monetary policy
resurfaced. There are widely shared concerns about
the extraordinary fiscal expansion necessitated by
the crisis, and when and how long it will take to
reverse that. But, by far the larger concern is not
about the crisis-related cyclical deficits but about
the structural fiscal deficits looming large in most
advanced economies. Present estimates show
that rich countries will see a rapid increase in their
social security payment obligations because of
ageing populations and shrinking workforces, and that they will need to raise a significant amount of
debt year-on-year to finance these commitments.
In such a case, monetary independence would
remain circumscribed by fiscal compulsions into the
medium-term. There is wide consensus that public
debt levels would have to be reduced to sustainable
limits to facilitate the smooth conduct of monetary
policy, particularly in advanced economies, albeit
EMDEs also need to further enhance the resilience
of their public debt portfolios in the wake of increasing
global uncertainties.
2.123 In major advanced economies, monetary
policy is constrained by the zero interest rate bound.
The room for fiscal policy action has been largely
exhausted. In view of the high output gap, high
unemployment levels, weak sovereign balance
sheets and still-moribund real estate markets in
advanced economies, especially in certain euro area economies, fiscal positions need to be placed
on sustainable medium-term paths by adopting
fiscal consolidation plans and entitlement reforms
supported by stronger fiscal rules and institutions.
The sovereign debt crisis and growth also feed on
each other adversely raising the growth versus
austerity debate. Policy action must involve both
short-term as well as medium-term reforms to secure
growth and debt sustainability. On the one hand, the
worsening outlook for the economy is making the
debt situation worse. Annual GDP in 2012 is forecast
to contract by 0.4 per cent in the euro area, and
continue to contract in 2013 by 0.2 per cent, while
growth differences continue to persist. On the other
hand, fiscal consolidation pressures are expected to
lower short-term growth prospects. With pressure to
consolidate, new sources of growth will need to be
identified with a focus on structural reforms.
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