The interplay between monetary policy and fiscal policy in EMU
Yves Mersch:
Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, at the ALGAFI General
Assembly, Luxembourg, 12 March 2003.
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Introduction
It is a pleasure for me to take part in this ALGAFI General Assembly in Luxembourg. I am all the more
satisfied because ALGAFI gave me the opportunity to discuss an extremely interesting issue, namely
the interplay between monetary and fiscal policy in EMU. For obvious reasons, I will not refer to the
specific case of Luxembourg but will instead primarily talk about the European Monetary Union (EMU)
as a whole. However, I will privilege the Luxembourg dimension when the need emerges to illustrate
some of my contentions.
The advent of EMU has prompted a renewal of the debate on the interplay between fiscal and
monetary policy. Although this debate is multifaceted, I will narrow it down to three basic questions. In
my opinion, these questions address the most relevant issues at stake.
The first question is whether the co-ordination of fiscal and monetary policy should be enhanced in the
euro area, in order to secure a more efficient policy mix. There would exist strong arguments for an
enhanced coordination at first sight, because of the existence of many interaction channels between
monetary policy and fiscal policy. On the one hand, monetary policy affects the interest rate
conditions, which have a significant impact on interest rate expenditure. Let me remember you that
interest charges represent 4% of GDP in the euro area considered as a whole, and close to 6,5% in
Belgium, Italy and Greece. On the other hand, fiscal policy has an influence on aggregate demand
and long-term interest rates, which are of course taken on board in the elaboration of monetary policy.
Furthermore, aggregate demand and interest rates have a direct impact on the balance sheet of
financial intermediaries and, hence, on the transmission channels of monetary policy.
The second question is conceptually linked to the first one, as will become clear in my answer. This
question is whether fiscal policy should play a more prominent role in EMU, in order to palliate the
so-called asymmetric shocks in a context where monetary policy is no longer defined at the national
level. By definition, these shocks affect a subset of countries and do not embrace the euro area as a
whole. For this reason, they do not play a central role in the conduct of the area-wide monetary policy.
On the other hand, however, asymmetric shocks could inflict macroeconomic instability on the
Member States concerned. On a priori grounds, this would justify an enhanced role for an active fiscal
policy at the national level.
The third and last question is related to whether the fiscal policy rules encapsulated in the European
Union Treaty and in the Stability and Growth Pact have a constraining or a favorable impact on the
way monetary policy is conducted and implemented, and whether they do not unduly restrict the room
for maneuver of national government in a context where monetary policy is no longer designed at the
national level.
My conclusion is centered on the mutual reinforcement between stability-oriented monetary and fiscal
policies.
First question
Let me now provide my answers to these three questions. As regards the first one, I would simply say
that an enhanced coordination of fiscal and monetary policy is in no way a necessary condition for a
smooth functioning of monetary policy in the euro area. From a purely theoretical viewpoint, an
improved coordination could help achieve a more appropriate combination between monetary policy
and fiscal policy. The resulting policy mix would be more efficient, in the sense that the authorities
would be able to fine tune their policy action in response to the type of economic shock they face.
However, the conceptual validity of this contention is not so guaranteed as widely held, because
several necessary conditions for the design of an adequate policy mix are not fulfilled.
First, it is usually extremely difficult to differentiate the type of economic shock involved - whether the
shock is permanent or transitory, or whether it is a demand or a supply shock - except maybe several
years after the occurrence of the problem. A fortiori, it is therefore impossible to pick up the policy mix
that is best suited to the economic circumstances. This undoubtedly casts a shadow on the feasibility
of an active and explicit coordination of monetary and fiscal policy.
The second "practical" argument is in my opinion even more powerful. The cornerstone of the
"coordination paradigm" is the contention that fiscal policy is able to impact on aggregate demand in a
timely and significant way. For this reason, it can be combined with monetary policy in an effective
way, depending on the state of the economy and the nature of the underlying shocks. However, the
"ideal policy mix" would turn into a lame duck in circumstances where fiscal policy cannot be activated
in a timely fashion and with the expected impact on the macroeconomic situation. In other words, the
co-ordination between monetary policy and fiscal policy can be compared to a walking man, who has
to stand firm on both legs. Should one of the legs fail to respond in a timely and coordinated way for
whatever reason, many adverse consequences would inevitably follow.
Although fiscal policy is of course extremely useful in many respects, I am quite skeptical as regards
this specific feature that is so important for the elaboration of an appropriate policy mix, namely the
stabilisation properties of an active fiscal policy geared towards macroeconomic fine-tuning. This "leg"
seems quite unreliable to me, for several reasons. First of all, experience shows that fiscal impulses
are frequently implemented too late, after the occurrence of the shock. These delays simply reflect a
time-consuming decision-making process. Let me draw your attention on the various steps involved:
the identification of the problem, the elaboration of the required measures, the discussion of these
measures and their political adoption, their implementation and the time it takes before they exert an
impact on aggregate demand.
There are many examples of allegedly contra-cyclical policies that turn out to exert a procyclical
impact on the economy because of the time lags involved. In these circumstances, fiscal impulses
could contribute to magnify economic cycles. In addition, long and variable delays increase the
uncertainty about the impact of discretionary measures on the economy. This "impact uncertainty" will
increase the uncertainty for economic agents and monetary policy-makers.
Furthermore, any stabilisation policy has to be conducted in a symmetrical way in order to avoid a
systematic drift in the level of public expenditure. This condition is unfortunately difficult to fulfill,
because many expenditure items are not flexible downwards. They could be increased in an easy way
when the policy mix requires an expansionary fiscal policy, but a decline of the same magnitude will in
all probability not be implemented when a restrictive stance becomes more appropriate. Let me give
the example of Luxembourg to illustrate the validity of this point. The compensation of employees and
social transfers - two expenditure categories characterised by a weak downward flexibility for evident
reasons - jointly account for about 70% of total general government expenditure. On a priori grounds,
only the intermediate consumption of general government could be used in a symmetric way and in a
timely manner, but this expenditure item does not account for more than 3% of GDP. In addition, it is
split between the central government and local governments, which would also require a close
co-ordination between these two entities.
The weak magnitude of fiscal multipliers in Europe cast some additional doubts on the validity of the
fine-tuning approach. All the available empirical evidence indeed shows that the so-called leakage
effects are very significant in the euro area countries, due to the high import content of expenditure
and, as far as revenue are concerned, a high propensity to save. Multipliers are of course also very
small in Luxembourg, especially on the government revenue side, because Luxembourg is really the
epitome of a small, open economy.
A final reason to be skeptical about the ability of fiscal policy to fine-tune the economy at discretion is
the existence of the so-called "non-Keynesian" effects. Although the concept may seem complicated at
first sight, it merely refers to the impact of expected budgetary developments on private consumption.
These non-Keynesian effects could further dampen the impact of an active budget policy. For
instance, private consumers might be inclined to save more when government expenditure tend to
increase, because they expect that more taxes will be levied in the future in order to finance the
budgetary imbalance associated with the fiscal impulse.
According to the specialised economic literature, these effects would be higher the higher the level of
public debt and the tax burden. Given the very low public debt in Luxembourg, this factor does not
play a prominent role in this country at first sight. However, I am convinced that non-Keynesian effects
could emerge also in the Luxembourg context, in case the long-term sustainability of public finances is
no longer guaranteed. Thus the need to monitor for instance the budgetary consequences of
population ageing and the inflow of cross-border and foreign workers.
These various practical problems make it extremely difficult to design an appropriate combination
between monetary policy and fiscal policy, and this is further complicated by the fact that monetary
policy has to be conducted in a proactive way, on the basis of some projections about future
inflationary developments. My answer to the question "is the co-ordination of fiscal and monetary
policy a necessary condition for a smooth monetary policy" is therefore clearly negative. In many
circumstances, such coordination could even turn out to be counterproductive. It would blur the clear
delineation of responsibilities between policy makers and would undermine the commitment of national
governments to fiscal discipline.
Second question
My answer to the second question - whether fiscal policy should play a more prominent role due to the
fact that monetary policy is no longer conducted at the national level - is also extremely clear. At first
sight, fiscal policy could be used in a more active way in the Member States in order to palliate the
disappearance of a specifically national monetary policy. This more active use of fiscal policy would
dampen asymmetric shocks, which would contribute to reinforce the homogeneity of the euro area
economy.
This argument is conceptually appealing, but in practice its foundations are rather shaky, to say the
least. More specifically, I think that it would be extremely difficult to iron out the impact of asymmetric
shocks via an active fiscal policy. This is simply a particular case of my general contention that a
fine-tuning, demand management strategy would be extremely difficult to carry out at the national
level. This contention has just been made in relation with the first question on co-ordination.
My answer to the second question is therefore that an increased role of fiscal policy is not justified on
practical grounds, at least as far as an active fiscal policy is concerned. However, the absence of a
national monetary policy conducted at the national level also magnifies the importance of what I would
call a "passive" form of fiscal policy, based on the free play of automatic fiscal stabilisers. The reliance
on automatic stabilisers - basically unemployment expenditure and taxes - would in general be
preferable to a more active fiscal policy, because they have a more immediate impact on aggregate
demand. In addition, unlike most discretionary policies, they do not have a persistent effect on fiscal
variables, since they are reversed as soon as economic conditions change. In Luxembourg, automatic
stabilisers tend to exert a more stabilising impact than public investments, because investment
programmes typically have to go through heavy legal procedures, which results in long and variable
implementation lags.
Of course, the free play of automatic stabilisers presupposes the attainment of a sound budgetary
position, as will be demonstrated in my answer to the third question.
Third question
But before I address the third question, let me briefly recall the salient point of the fiscal rules
encapsulated in the Treaty establishing the European Community and in the Stability and Growth
Pact. The Treaty (and some protocols annexed to it) contains three crucial rules related to fiscal
discipline. Since they are widely known, I will describe them in a concise way. A first rule basically
states that the general government deficit should not exceed a reference value of 3% of GDP. A
second, stock-oriented rule requires that general government debt should not be higher than 60% of
GDP, unless the ratio "is sufficiently diminishing and approaching the reference value at a satisfactory
pace". A third rule prohibits the monetary financing of the different subcomponents of the public sector
and of Community institutions or bodies.
The Treaty is supplemented by the Stability and Growth Pact. The cornerstones of the Pact are two
council regulations adopted in 1997. Under the Pact, Member States are expected to adhere to the
medium-term objective of general government balances close to balance or in surplus. In order to
establish this adherence, Member States are required to present stability and convergence
programmes each year. These programmes present inter alia the medium-term objectives for the
budgetary balance and the adjustment path towards the "close to surplus or in balance" position. The
ECOFIN Council is required to deliver an opinion on each national programme, which gives way to
"peer pressure". In case of a failure to adhere to the Treaty reference values, an "Excessive deficit
procedure" is in principle implemented. Sanctions could be applied in case an excessive deficit is
established.
In my opinion, this framework is in no way an impediment to the smooth conduct and implementation
of the single monetary policy. I would indeed argue that the aforementioned fiscal rules are clearly
supportive of a stable monetary policy, for at least three reasons.
- First, the prohibition of any monetary financing coupled with the high degree of
independence of the ECB and the National Central Banks ensures that a potentially
destabilising link between fiscal and monetary policy will no longer exists. A regime in which
monetary financing is allowed is indeed characterised by a "soft" intertemporal budget
constraint. In such a situation, the government may be tempted to resort to the inflation tax in
order to finance budgetary deficits. The resulting situation could be "mutually destructive" for
monetary and fiscal policy. In such a context, fiscal discipline could indeed degenerate into a
loose fiscal policy, and the latter would in turn contaminate monetary policy. Monetary policy
would therefore become unpredictable and would increase the volatility of the monetary base
and of the inflation rate. In the extreme case, this situation could lead to hyperinflation, as
illustrated for instance by the situation of Germany under the Weimar Republic. EMU is
congenitally immune from such episodes, owing to the prohibition of monetary financing and
the independence of central banks in the euro area.
- Second, I am convinced that the fiscal rules embedded in the Treaty and in the Stability and
Growth Pact are not incompatible with the free play of automatic stabilisers. As I told you
earlier, automatic stabilisers are especially important, because they help counteract
asymmetric shocks at the national level in a situation where monetary policy is conducted at
the euro area level.
Provided that Member States are able to reach a close to balance or in surplus position, they could
indeed let automatic stabilisers operate in full, without incurring the risk of breaching the 3% reference
value. A close to balance or in surplus position indeed means that the cyclically adjusted fiscal balance
should be in equilibrium. In such a situation, it would require a very negative output gap, equal to
about 6% of GDP, to reach a nominal deficit in excess of 3% because of the free play of automatic
stabilisers.
This underlines the overriding importance of the attainment of a close to balance or in surplus position.
Let me also highlight that such a position would requires a nominal surplus under favorable economic
circumstances. In other words, it is essential to apply a strict fiscal discipline also during economic
upturns.
- Third, the attainment of a sound fiscal position compatible with the Treaty and the Stability
and Growth Pact would facilitate to a considerable extent the conduct of monetary policy.
The absence of clear and binding fiscal rules could have resulted in a non-cooperative
equilibrium, characterised by higher long-term interest rates. This can be illustrated by the
example of an individual Member State willing to tolerate higher deficits and to issue more
debt securities in order to finance the resulting gap. This additional debt issuance would in all
likelihood give way to a crowding out effect - namely to an upward pressure on interest rates
due to the drain on private savings. The key point is that in EMU - where there exists a single
currency and a high degree of integration between national financial markets - this additional
burden would be borne by the euro area as a whole, and not just by the individual
Member State responsible for the additional debt issuance. This kind of spillover effects
could encourage each Member State to issue excessive amounts of debts. As a result, the
euro area-wide interest rates would tend to be higher than required by economic
fundamentals. Such a situation could complicate to a considerable extent the conduct of
monetary policy, which underlines the need to resort to commonly shared rules of fiscal
restraints.
Conclusion
Let me conclude with the statement that the relationship between monetary and fiscal policy runs both
ways. First, I would like to point out that the more predictable fiscal policy fostered by the
aforementioned fiscal rules would produce a more stable environment as regards, for instance, the
inflation rate, aggregate demand or the tax burden. Such an environment would be conducive to
economic and financial stability, which would enhance the efficiency of monetary policy.
It also goes without saying that a more predictable monetary policy is supportive of fiscal discipline.
More predictable short-term interest changes are indeed liable to impact on the budgetary equilibrium
in several Member States. In addition, a stable monetary policy able to anchor the inflation
expectations of economic agents will generate lower and less volatile long-term interest rates, which
will further dampen the risk of budgetary slippages induces by unforeseen interest rate developments.
More predictable interest rates are also extremely important for the Luxembourg general government,
in spite of the extremely low public debt level observed in Luxembourg. First, the assets of the
Luxembourg general government - including the accumulated reserves of the investments and special
fund and the assets held by the general pension regime - are quite substantial, and the associated
income is primarily dependent on short and long-term interest rate developments. Second, the
soundness and profitability of the financial sector, which accounts for more than one third of all taxes
collected by the Luxembourg central government, is very sensitive to the level of short-term interest
rates, to the slope of the yield curve and also to stock exchange prices, namely three variables that
are either directly fixed or strongly influenced by monetary policy. The importance of a predictable
monetary policy for the Luxembourg government is particularly apparent in such a context.