High levels of public and private debt and policy rates close to their lower bound make economies vulnerable to macroeconomic and financial instability and disruptive crises such as the COVID-19 pandemic. Even worse, smaller disturbances can activate perverse loops that, without a convincing and sufficient policy response, can undermine activity in advanced and developing economies. This causes a persistent state of uncertainty and anxiety that feeds high precautionary saving by households while discouraging investment by firms, slowing down growth and pushing equilibrium interest rates further down to zero or even negative territory.
The return of the policy mix
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. Monetary and fiscal policies must forcefully act together, which can blur the distinction between the two. The policy mix, long forgotten in the public debate as well as in economics textbooks, 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.
Read It’s All In the Mix: How Monetary and Fiscal Policies Can Work or Fail Together, the 23rd Geneva Report on the World Economy, here
How should we rethink the policy mix in the 21st century? To address this question, in the 23rd Geneva Report on the World Economy we distil the main lessons from three key sources: the seminal literature on the policy mix, the empirical evidence over the mix in advanced economies during the last three decades, and past episodes of large crises (Bartsch et al. 2020). We then bring these lessons together to look into the reasons behind the current vulnerability to tail events.
Early and modern views on the policy mix converge more than you think
Looking back at classic literature on the policy mix, Tinbergen taught us that many policy objectives require many independent policy instruments. All instruments affect all objectives and interact with each other; hence, the policy problem cannot be solved piecewise, but the mix must consider how policies interact. Mundell taught us that an efficient mix should recognise that policies should be assigned to the objectives that they can control more efficiently (the assignment problem). Tobin taught us that fiscal and monetary policies together determine aggregate demand (nominal spending) – a given aggregate demand can be achieved with loose money and a tight budget, or tight money and a loose budget. Yet the two combinations have different long-run implications for growth, the external balance, and fiscal sustainability.
The neo-classical revolution taught us that a policy mix cannot be effective if its policy elements are not credible; it needs to be embedded in an institutional framework that ensures credibility. Okun taught us that a good policy mix must keep an eye on the future policies. Hence, today instruments must keep as much as possible to the ‘middle of the road’ – not only because we may be less confident of the effects of instruments when they are stretched, but also for a precautionary motive. We do not want to erode policy effectiveness by pushing instruments to a corner – i.e. the budget should tend to be in surplus in booms to create a fiscal buffer for rainy days. Putting all these considerations together, we conclude that while a policy mix need not have all instruments deployed countercyclically at all times, countercyclical monetary and fiscal policies should occur much more often than not.
It is also striking to realise that across all schools of thoughts on the policy mix, the leading figures emphasise the need to preserve the effectiveness and independence of multiple instruments, a goal that is hard to achieve if policy decisions are made by policymakers without a clear mandate and legally defined institutional independence.
The policy mix at work
In the Geneva Report, we dissect the evidence on the policy mix for a sample of advanced countries over the years 1986 to 2019. At odds with the prescriptions of the classics, we find that a ‘congruent’ policy mix of simultaneously countercyclical policies is rare; most often, monetary and fiscal policies pull in different directions. In some cases, this may be the case for good reasons – such as supply or financial shocks that require one of the two instruments to be used procyclically. But the frequency of divergent or even destabilising mixes (where the two policies run against output stabilisation) is too high to be explained by such shocks alone. One plausible conclusion is that, especially for fiscal policy, political factors and, in some cases, debt constraints have prevented governments from following good principles.
Tail events like the COVID-19 crisis are not business as usual, and important lessons can be drawn from crisis episodes that catch policymakers in situations in which monetary and fiscal instruments are already stretched – situations the classics reviewed above had warned against. Nonetheless, interpreting the current state of the mix, a first observation is that, with policy rates at their lower bound, monetary policy is far from being ineffective – unconventional instruments drive a wedge between the lower bound constraint and a liquidity trap. In crisis years, despite the constraint on policy rates and the high debt, the policy mix has been congruent. However, and this is the second observation, unconventional monetary policy blurs the distinction between monetary and fiscal policies, and low borrowing costs complicate the assessment of debt sustainability. Preserving the independence of instruments is the second key warning of the classics.
Complementarities and coordination in large downturn
Macroeconomic theory and experience teach us that, in a crisis situation, a good policy mix can be effective only to the extent that fiscal and monetary authorities correctly internalise and manage the effects of their actions on each other’s policy space. To be clear, monetary policy creates fiscal space in two crucial ways. First, by keeping borrowing costs low – as a by-product of its forward guidance and measures to influence risk-free rates further into the term structure – it relaxes the financing constraint on the treasury. Second, by effectively providing a monetary backstop to government debt, it shields the debt market from potentially disruptive self-fulfilling crises, addressing an argument often used in support of precautionary austerity to rule out these crises by reducing debt procyclically, irrespective of its macroeconomic costs in the short run.
For its part, the treasury can protect the central bank from having to run with thin or negative capital if it incurs large portfolio losses from its monetary policy operations. Such insurance is key to preserve the central bank’s independence and credibility by enabling the significant risk-taking inherent to unconventional monetary operations. In short, when the treasury creates monetary space by ‘backstopping’ monetary authorities, these can deploy unconventional measures up to their efficient scale, without being inefficiently constrained by the prospect of small-probability losses (the residual value at risk inherent in balance sheet policies).
Figure 1 Two-way policy space creation in large downturn
Without creating policy space for each other, monetary and fiscal policy cannot pursue the level of stimulus required to address tail events. While pursuing complementarities between monetary and fiscal policies may be irrelevant or even counterproductive in normal times, these should be fully exploited to deliver the required support to the post-COVID-19 economy. Their success, however, crucially depends on preserving credible commitments to long-term goals (i.e. public debt sustainability and price stability).
Preserving credibility and independence of instruments is the key challenge
To deliver its benefits, the policy mode of strict complementarity of monetary and fiscal policy cannot be made and/or expected to be permanent. Mutually supportive monetary and fiscal policies require a solid institutional framework that preserves policy credibility over time. A ‘monetary backstop’ to government debt cannot be successful if inflation expectations are unanchored; a ‘fiscal backstop’ to the central banks’ unconventional policy cannot work if public debt sustainability is in jeopardy.
To put it another way, in response to a large tail shocks, the required stimulus requires both authorities to the edge of their ability to create money and run fiscal deficits. But this edge can stand high enough only if both policies support it with effective instruments. What the two authorities cannot do is fall into a regime where optimal temporary actions turn into a permanent mode of engagement – a situation that would be unsustainable by its very nature, and would backlash into an immediate crisis. The cost would be a loss of instrument effectiveness as soon as this change in regime is anticipated by firms, workers, and markets.
The exit from a temporary regime of close coordination between monetary and fiscal policymakers may be a long and winding road. To gain historical insight on the way this road is travelled, we review the experience of central banks with yield curve control (YCC) in the US, the UK, Japan, and Australia. The main lesson is straightforward. Even though YCC was embraced for good reasons during an emergency, it ultimately ignites a clear conflict of interest between the treasury (enjoying the easy ride of cheap borrowing costs) and the central bank (concerned with possible inflationary consequences once the emergency has subsided). History teaches us that this conflict of interest may work in subtle ways. The moment markets start to doubt the ability of policymakers to return to rhyme and reason, bad things can happen. Once again, a good mix only works if independent instruments are controlled by independent policymakers. This was already well understood in the classic literature.
The post-pandemic mix: R* as a shared objective for a Great Normalisation
Looking into the current vulnerability of our economies to disruptive tail risk, the negative trend in the equilibrium interest rate, R*, is a key source of concern (Figure 2). If R* is very low, with a reasonable target inflation in most countries, central banks are systematically at risk of hitting the lower bound of policy rates. Hence it keeps the economy at risk of continuously falling into the need to activate unconventional instruments that blurs the respective role of fiscal and monetary policy.
More fundamentally a low R* is a clear indicator of a destabilising global inefficiency – too much savings chases too little investment – and hence a sign of economic malaise and imbalances, beyond the issues it raises in conducting stabilisation policy. Accepting a low R* is tantamount to giving up on correcting the frictions and inefficiencies that have plagued growth and stability for more than a decade. As long as the negative trend in R* is not reversed, there is little hope to restore economic resilience and build effective policy strategies, away from repeated falls into the emergency patterns we are experiencing now.
R* is largely determined by global, structural factors, hence its control lies outside the reach of individual national policymakers. Globally, however, it also reflects frictions and distortions that either are produced by policies – or can be attacked with appropriate policies, combining demand management with reforms. These considerations motivate our proposal below.
Figure 2 Equilibrium real rate of interest estimates (R*) in the United States and the euro area (%)
Sources: National Bank of Belgium Annual Report 2019; calculations based on Holston et al. (2017).
We propose that a rise in R* should be considered a global public good. Much like containing the rise in global temperatures, policymakers should understand that raising R* is a matter of common interest requiring bold action. Leaders of large nations cannot but recognise that in this context, self-interested, aggressive and beggar-thy-neighbour actions are bound to be self-defeating – not just ultimately, but already today. Specifically, trade wars and vaccine nationalism must be left in the graveyard of bad ideas as they feed uncertainties that have been heavily weighing on R*. Just like lower temperatures are needed to normalise the climate, a higher R* is the condition for a ‘Great Normalisation’ of the policy mix and a much-wanted resilience to tail risk.
Although the difficulties of coordinating international policy initiatives are notorious, the current COVID-19 crisis creates a unique opportunity for countries to see the mutual benefits from acting in the same direction – overcoming the problems created by their debt levels and constrained monetary instruments. The prospect of bringing the policy mix back to the middle of the road would considerably increase the stabilisation potential in all countries, and thus their ability to handle potentially large and global shocks. Reduced uncertainty about the effects of bad shocks would, on its own, contribute to a sustained rise in R* by lowering savings and encouraging investment. It thus creates favourable conditions for implementing structural reforms contributing to reduce or eliminate frictions and impediments to growth, the rebalancing of inequalities within and across countries, and much needed action addressing global challenges arising from climate change and health.
Leading proposals that may go in the direction of raising R* include a temporary regime of fiscal deficits not offset by future primary surpluses (and backed by temporary monetisation); high-quality public spending to take advantage of the low borrowing costs; and expanding the supply of safe assets. There are strong links among them: all work only if the central bank can offer a convincing monetary backstop to fiscal policy; and they are effective only if public spending enhances overall investment (possibly exploiting complementarities between private and public capital) and reduces precautionary saving (providing income insurance and addressing unsustainable trends in income inequality). Although many aspects of these proposals are in uncharted territory, they can only work if the main lessons from theory and experience are not forgotten, which implies resisting adventurous walks into the confusing intellectual woods of ‘new’ or ‘modern’ theories.
With COVID-19 having caused a deep contraction in economic activity, the lessons learned so far from history and economics should convince us that the time to act – forcefully and together – is now.
Bartsch, E, A Bénassy-Quéré, G Corsetti, and X Debrun (2020), It’s all in the mix: how can monetary and fiscal policies work or fail together?, Geneva Report on the World Economy, No 23, ICMB and CEPR.
Holston, K, T Laubach and J C Williams (2017), "Measuring the natural rate of interest: International trends and determinants", Journal of International Economics 108: S59-S75.