Some Incomplete Monetarist Arithmetic

My latest post at Pieria looks at modern-day fiscal dominance and its consequences:

In 1981, Sargent & Wallace published their now-famous research paper Some Unpleasant Monetarist Arithmetic. It demonstrated the difficulty that central banks have in controlling inflation when governments are hell-bent on fiscal profligacy. Coming after the fiscal and monetary policy disasters of the 1970s, it seemed like a breath of fresh air. Its recommendation of "monetary dominance" - that fiscal policy-setting should be constrained by the inflation target of the monetary authority - became the standard for "good practice" in macroeconomic management for the next thirty years.
Even today, its shadow lies long. Gavyn Davies recently suggested that the Bank of India needed to establish monetary dominance in order to get inflation under control. And Pozsar and McCulley incorporated its findings into their paper on helicopter money, although they only applied it to the circumstance where inflation was out of control due to fiscal and monetary profligacy. Indeed Sargent & Wallace themselves only apply their analysis to that situation. In effect, they assume that fiscal authorities will always be profligate unless disciplined by a monetary inflation target, and that unconstrained deficit spending will always result in higher inflation.
But the situation in developed countries today is the polar opposite...."

Read on here.

Comments

  1. I think you are wrong to treat the using and not using of credit as equal and opposite . I’m thinking that Fiscal policies and that don’t involve credit don’t come under the inflation target, that the inflation target was envisioned as something associated with purchases where credit is involved. Moving towards a balanced budget is an issue between the government and the current tax payer. The Bank is not involved.
    We have seen Mirvin King explaininng going over the inflation target on the cost of commodities and other things out of control of sterling credit levels. And so fiscal policy would also come under that set of things.

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    1. I really don't accept that you can separate out the component parts of the economy like that. Government finances affect the finances of the rest of the economy, and the relationship between government spending and inflation is well documented. Therefore government finance IS a concern of the monetary authority.

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  2. I was thinking of the deflation case. If the average price level falls due to the Government or any other economic actor not using credit even at a zero interest rate - then their actions and there effect on price level moves away from the purview of the Bank of England role as credit facilitator.

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    1. Ah, I see what you mean. Yes, that's what I meant when I said that central banks lack the means to discipline fiscal authorities pursuing unnecessarily contractionary policies.

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  3. Frances, you are at last seeing that this is the fault of central banker?- what took you so long.

    They do not have to play the game of politicians by printing money willy nilly. They could stand up for themselves and their fellow citizens.

    The effects are more perverse and destructive than being purely deflationary in current goods and services and they are also wholly unaccountable.

    eg more money has to be spent on every asset prices (eg.houses, leaving less for current expenditure)
    eg. savings income dissipates
    eg. redistribution to wealthy and away from those with greater propensity to spend..

    Richard

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    1. I'm afraid you have misunderstood. "Fiscal dominance" means that the main responsibility for the mess lies with politicians, not central banks. I don't blame central banks for trying to do what their political lords and masters expect them to do. I blame the political lords and masters for dropping them in it.

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    1. This comment has been removed by the author.

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  5. central banks and " discipline fiscal authorities " do you really mean that. It is putting the cart before the horse is it not. If the government has made a decision to lower borrowing then that is the prime prerogative of the governmental administration , not what the central bank thinks would help its inflation mandate. If the desire was to increase borrowing and make use of what the BOE makes possible then that would be a different matter.

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    1. You are missing the entire point, Dinero. I suggest you actually read Sargent & Wallace's paper. Their research shows that if fiscal policy dominates, the central bank is unable to control inflation. Monetary policy must therefore constrain fiscal authorities - they call that "discipline". I am not disputing their findings, just arguing that they have not considered the full implications. You are disputing their findings and arguing that fiscal policy should dominate. I can't go along with that, I'm afraid.

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  6. In the paper the word discipline is used to mean reduce borrowing . To use it as you do in the opposite to mean promote borrowing by a government that has a clear aim to not do so seams confusing or at least making a political point.
    As I said in my first comment increasing and decreasing borrowing are politically very different things.

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    1. No, "discipline" does not mean "reduce borrowing". That's a misreading of the paper. The monetary framework limits the amount the fiscal authority can borrow. It does so in order to prevent excessive borrowing and forced monetization of debt causing high inflation. But the whole point of this post is that Sargent & Wallace only did half the job. They did not consider the possibility that a fiscally dominant government pursuing aggressive fiscal contraction could also cause the central bank to lose control of inflation. That is what I am talking about.

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  7. Very nice analysis. I would just comment that the situation may be very difficult to unwind given that it's not just "wealthy" voters who are over-concerned about inflation. In a zero bound situation, all savers look at pitiful returns on savings and conclude that almost any non-zero level of inflation, no matter how low, is a disaster.

    This isn't helped by the number of commentators out there who are bravely fighting the last war, and predicting excessive or even hyper-inflation just around the corner.

    Add to that the popular view that sovereign debt is debt owed some shadowy "someones" rather than mostly to our collective selves, and it's not surprising that Osborne's policies get far more support from the public than they do from professional economists.

    In fact, you could throw in a couple of other phrases; "political dominance" and "folk memory dominance".

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    1. > John

      The transfer of money in debt spending transactions is not from the borrower to the lender it is from the borrower to the recipient of the spending.

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  8. There is a mechanism that fits the possibility in question . In the economy of mass production decreasing demand can lead to increasing prices as the unit cost of production goes up which could lead to further decreases in demand. . But I don't think that is in the purview of the central bank when it does not involve credit.

    decreasing demand and deflation is a corollary of the Sargent and wallace paper . If it were not true that government decreasing spending causes some deflation then on the face of it Sargant's findings could not be true either.

    Prices - In the UK almost half the purchases are made by a single economic actor , the government . Thats a lot more than the environment of USA 1981. Its not uprising the actions of everyone else including the CB is muted.

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    1. Dinero,

      You are still missing the point! Yes, of course deflation is the flip side of the Sargent & Wallace paper. That is EXACTLY the point. Central banks are supposed to control inflation on the downside as well. Allowing uncontrolled deflation is not consistent with their mandate. If fiscal authorities pursue policies that create deflation that the central bank cannot control, the central bank's mandate becomes impossible - just as it does if fiscal authorities pursue policies that create uncontrolled inflation.

      The central bank's job is NOT just to control credit creation. The central bank is responsible for overall monetary management of the economy. Decreasing demand leading to increasing prices is definitely within the central bank's remit.

      You are surely not saying that half the purchases in the entire economy are made by the government? What is your evidence for that statement?

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  9. That Government activity is 48% of GDP. Its not surprising if it is that prices are affected by government's decisions. As That is 48% of money controlled by the decisions of one elected cabinet Vs the accumulated transactions from the decisions of millions of individuals.

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    1. That's not the same as "half the purchases". It's the total VALUE of Government spending in relation to value of total domestic production. However, I take your point. Where Government spending is a much higher proportion of national income, we would indeed expect Government activity to have much greater impact on the price level.

      However

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