Geneva Report 23 | It's All in the Mix: How Monetary and Fiscal policies Can Work or Fail Together

Monday, December 14, 2020



IT'S All IN THE MIX: How Monetary and Fiscal policies Can Work or Fail Together 

Since the Global Financial Crisis, central banks in advanced economies have expanded their set of tools, without being able to meet official inflation targets. The massive economic crisis associated with the Covid-19 pandemic has exacerbated this problem and highlighted the need for better coordination between monetary and fiscal policy. The need for a coordinated and effective policy mix has rarely been more pressing.

Authored by leading European Economists, Elga Bartsch, Agnès Bénassy-Quéré, Giancarlo Corsetti and Xavier Debrun, the new CEPR and ICMB Geneva Report on the World Economy calls for a more effective and coordinated fiscal and monetary policy mix to deal with the extraordinary challenges currently facing European economies, and discusses the institutional and economic preconditions necessary for that policy mix to deliver. 


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The Covid-19 pandemic has left most countries with substantially higher public and private debt, adding to the already high legacy debt from the Global Financial Crisis, making economies vulnerable to macroeconomic and financial instability. At the same time, consensus estimates of the ‘equilibrium’ real interest rate (R*) have been on a downward trend for the last few decades, bringing it close to or even below zero. In this context, neither monetary nor fiscal policy by itself can shield the economy from the ‘tail risk’ of extreme output contractions, job losses and financial turmoil. The need for a coordinated and effective policy mix has rarely been more pressing.

“The policy mix, long forgotten in the public debate, is back with a vengeance, and with it the impression that the conventional wisdom about the respective roles of monetary and fiscal authorities is seriously outmoded.”

As this report shows, while ‘mixing’ monetary and fiscal policy is sometimes necessary, past experiences have shown that, without a strong and credible institutional framework, monetary-fiscal coordination can fail. Credibility is key. Sustainable fiscal policy amplifies the credibility of the central bank by ruling out fiscal dominance and a credible central bank contributes to debt sustainability by reducing the likelihood of disruptive self-fulfilling crises. 

The legacy of past excesses reduces economies’ policy space and exposes countries to disruptive tail events. While coordination is important, the report illustrates that it is not easy and presents several examples of open conflicts between central banks and treasuries. Fiscal and monetary authorities should not only be aware that they need to act together to provide sufficient economic stimulus, they should also understand that they depend on each other for policy space – in the short as well in the long run. 

“A good policy mix can be effective only to the extent that fiscal and monetary authorities internalise the effects of their actions on each other’s policy space… without creating fiscal space for each other, monetary and fiscal policy cannot pursue the level of stimulus required to address tail events.”

The report draws lessons from the origins of the policy mix, and discusses what can be learned from Tinbergen, Mundell, Tobin and Okun. Two key concepts highlighted in the report are Tobin’s funnel in which monetary and fiscal policies jointly determine output; and Okun’s view that policies should ideally be ‘in the middle of the road’.

The report concludes with a discussion of the benefits of increasing the currently low equilibrium real interest rate (R*). A higher R* could play a key role in moving the policy mix closer to the middle of the road and thus increase countries’ ability to prevent tail events. However, in a financially globalised world, individual countries have a limited impact on R*. The report highlights the benefits of global coordination and points to the need for international policy initiatives aimed at increasing R*. The authors conclude that the ongoing strategic reviews of monetary and fiscal frameworks in a number of countries provide a unique opportunity to rethink the issues discussed in this report.
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This report was produced following the Geneva Conference on the World Economy held online in October 2020. CEPR and ICMB are very grateful to the authors and several discussants for their efforts in preparing material for this report, as well as to the conference attendees for their insightful comments.

To contact the authors or for further information, email [email protected]

See the full list of Geneva Reports here.