The folly of central banks tightening to keep governments on the leash
Lorenzo Bini Smaghi
July 10, 2014
The Bundesbank is right to remind us that the unprecedented monetary accommodation in the eurozone has produced undesirable side effects. In particular, the policy has reduced the pressure on politicians to pursue speedy budgetary consolidation and to implement structural reforms. In the summer of 2011, for instance, as soon as the European Central Bank intervened to purchase Italian and Spanish government bonds through the Securities Market Programme and the spread on interest rates decreased, the commitments made earlier by those two governments began to be diluted. The same thing happened two years later, after the announcement of the Outright Monetary Transaction by the ECB contributed to sharply reduced market tensions, but also structural reforms.
It is not clear, however, whether or how central banks should incorporate these effects into its own policy framework. In other words, should central banks try to calibrate monetary policy – in particular, by being tighter than would otherwise be the case – with a view to keeping a tight leash on governments and inducing them to play their own part? There may be some good reasons for doing so but on balance it would be a serious mistake. Here are several reasons why.
The first is that the central bank would jeopardise its own objective, which in the case of the ECB is primarily the achievement of price stability. If a central bank maintains a more restrictive monetary policy, just to put pressure on politicians, it risks missing its own target, which is an inflation rate below – but close to – 2 per cent. In the current environment, with an inflation rate below 1 per cent, the risk of missing the target is already very high.
Second, by using its policy instruments to achieve not only price stability but also to try to influence governments’ actions, the central bank undermines the basis of its own independence. Such independence is predicated on the fact that, by pursuing only one objective, the central bank does not have to address trade-offs. Only elected politicians can make choices between mutually exclusive objectives. The central bank does not have the legitimacy to influence governments’ choices in one direction or another.
Third, it is not at all clear that keeping interest rates higher than would otherwise be the case strengthens policy makers’ incentives to implement the right policies. The reaction largely depends on the room for manoeuvre and the environment. The eurozone experience during the crisis shows that, when monetary and credit conditions are too tight, the fiscal contraction produces extreme recessionary effects, which are counter-productive and may even increase the public debt instead of reducing it. This in turn can ultimately lead to a rejection of such policies by public opinion. Theory and practice show that fiscal contractions are successful when they benefit from easy monetary conditions, in particular when the nominal rate of interest is lower than the nominal rate of growth of the economy.
Fourth, structural reforms take time to produce their effects, as shown by the German experience in 2002-04. If monetary conditions are too restrictive and the fiscal contraction is not gradual enough, the short-term costs of implementing structural reforms become too high and policy makers are discouraged.
Finally, the attempt to use monetary policy to create incentives for governments to implement fiscal consolidation and structural reforms does not seem to have been particularly beneficial to the eurozone. While the euro member states implemented a much sharper fiscal contraction and much broader reforms than the other major economic areas – the US, Japan and the UK – they have not been rewarded by a relatively more accommodating monetary policy, as reflected by the strong euro exchange rate. It is no surprise that the overall results are much more disappointing. Eurozone growth remains fragile and lagging behind the other major economies, while deflationary fears are mounting.
To sum up, the argument that the central bank risks crossing the line of fiscal policy should be turned upside down. The truth is exactly the opposite. It is by trying to influence fiscal policy through a tighter monetary policy than would be justified by the primary objective of price stability – and by not using all the instruments available to monetary policy, including the intervention in the largest segment of the financial market, government bonds – that the central bank is most at risk of interfering with other policies and becomes vulnerable. It is by not achieving price stability, and consequently making it harder for other policy makers to do their own part of the adjustment, that the central bank puts at risk its most valuable asset: its independence.
The writer is a former member of the executive board of the European Central Bank and is visiting scholar at Harvard’s Weatherhead Center for International Affairs and at the Istituto Affari Internazionali in Rome
It is not clear, however, whether or how central banks should incorporate these effects into its own policy framework. In other words, should central banks try to calibrate monetary policy – in particular, by being tighter than would otherwise be the case – with a view to keeping a tight leash on governments and inducing them to play their own part? There may be some good reasons for doing so but on balance it would be a serious mistake. Here are several reasons why.
The first is that the central bank would jeopardise its own objective, which in the case of the ECB is primarily the achievement of price stability. If a central bank maintains a more restrictive monetary policy, just to put pressure on politicians, it risks missing its own target, which is an inflation rate below – but close to – 2 per cent. In the current environment, with an inflation rate below 1 per cent, the risk of missing the target is already very high.
Second, by using its policy instruments to achieve not only price stability but also to try to influence governments’ actions, the central bank undermines the basis of its own independence. Such independence is predicated on the fact that, by pursuing only one objective, the central bank does not have to address trade-offs. Only elected politicians can make choices between mutually exclusive objectives. The central bank does not have the legitimacy to influence governments’ choices in one direction or another.
Third, it is not at all clear that keeping interest rates higher than would otherwise be the case strengthens policy makers’ incentives to implement the right policies. The reaction largely depends on the room for manoeuvre and the environment. The eurozone experience during the crisis shows that, when monetary and credit conditions are too tight, the fiscal contraction produces extreme recessionary effects, which are counter-productive and may even increase the public debt instead of reducing it. This in turn can ultimately lead to a rejection of such policies by public opinion. Theory and practice show that fiscal contractions are successful when they benefit from easy monetary conditions, in particular when the nominal rate of interest is lower than the nominal rate of growth of the economy.
Fourth, structural reforms take time to produce their effects, as shown by the German experience in 2002-04. If monetary conditions are too restrictive and the fiscal contraction is not gradual enough, the short-term costs of implementing structural reforms become too high and policy makers are discouraged.
Finally, the attempt to use monetary policy to create incentives for governments to implement fiscal consolidation and structural reforms does not seem to have been particularly beneficial to the eurozone. While the euro member states implemented a much sharper fiscal contraction and much broader reforms than the other major economic areas – the US, Japan and the UK – they have not been rewarded by a relatively more accommodating monetary policy, as reflected by the strong euro exchange rate. It is no surprise that the overall results are much more disappointing. Eurozone growth remains fragile and lagging behind the other major economies, while deflationary fears are mounting.
To sum up, the argument that the central bank risks crossing the line of fiscal policy should be turned upside down. The truth is exactly the opposite. It is by trying to influence fiscal policy through a tighter monetary policy than would be justified by the primary objective of price stability – and by not using all the instruments available to monetary policy, including the intervention in the largest segment of the financial market, government bonds – that the central bank is most at risk of interfering with other policies and becomes vulnerable. It is by not achieving price stability, and consequently making it harder for other policy makers to do their own part of the adjustment, that the central bank puts at risk its most valuable asset: its independence.
The writer is a former member of the executive board of the European Central Bank and is visiting scholar at Harvard’s Weatherhead Center for International Affairs and at the Istituto Affari Internazionali in Rome
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