SPEECH
SVERIGES RIKSBANK
DATE:
08/12/2021
SE-103 37 Stockholm
SPEAKER: (Brunkebergstorg 11)
Deputy Governor Per Jansson
VENUE:
Sveriges Riksbank
Tel +46 8 787 00 00
Fax +46 8 21 05 31
registratorn@riksbank.se
www.riksbank.se
Is it time to review the division of roles
in macroeconomic policy?*
Sometimes, developments can make you start pondering somewhat larger and
more fundamental issues than you might usually do. This is how it has been for
me recently. The question I would like to address today is whether it might be
time for us to modify our view of the appropriate division of roles in
macroeconomic policy, by which I mean our overall fiscal and monetary policy. I am not
entirely sure of the answer myself, although I am inclined to believe that it is
something we should probably do. In this talk, I will try to explain my preliminary and
probably rather unfinished thoughts.
What I am quite sure of, however, is that we have reached a point where it is time
for us to start discussing what an appropriate division of macroeconomic roles
would be. I am glad to say that the number of articles touching upon the subject
has increased recently, and I hope that this speech will contribute further to this
discussion.
But let me take a step back and start from scratch.
The devaluation policy reached the end of the road in
the early 1990s
Thirty years ago, the Swedish economy was in a dire situation. The problems were
the result of a development that had been going on for a long time, and even
though it had been a cause for concern for almost as long, we had not been able
to get to grips with it. Perhaps the main concern was the strong domestic inflation
trend with price and wage spirals that collided with attempts to maintain a fixed
exchange rate, and therefore led to recurring cost crises and devaluations.
Another reason, which was partly connected to this, was that fiscal policy was often
too expansionary, with rapidly rising public spending and tendencies towards
structural deficits as a result. In addition, there was a deregulation of the credit
market in the mid-1980s, which would turn out to lead to greater problems than
were anticipated when the reform was implemented.1
In the early 1990s, these and other ingredients contributed to another domestic
cost crisis, which also coincided with a financial crisis largely caused by excessive
lending to households and companies. Unemployment rose sharply and public
finances deteriorated dramatically. The krona was put under strong pressure by
investors who expected Sweden to devalue again soon and, in November 1992, the
Riksbank was forced to give up its defence of the fixed exchange rate.
New policy with emphasis on long-term anchors
The consequences of the crisis emphasised, with all desired clarity, that the type
of policy Sweden had pursued for a number of decades had reached the end of
the road and needed to be fundamentally reshaped. Instead of defending a fixed
exchange rate, the task of monetary policy from now on would be to keep
inflation low and stable. For its part, fiscal policy would focus considerably more than
previously on keeping public finances in good condition so as to maintain market
confidence.
Gradually, the new order was confirmed through changes in the fiscal and
monetary policy frameworks. The price stability target, which, in practice, had been
introduced in 1993 in the form of an inflation target, was written into law in 1999,
at the same time as monetary policy decisions were delegated to an independent
Executive Board. In fiscal policy, the budget process was changed so that it would
be easier to gain control over expenditure developments, while public net lending
would, on average, show a surplus. The purpose of the latter was, of course,
largely to bring the rampant government debt under control and to restore
confidence in public finances. But other reasons were also given when the surplus
target was introduced, namely that good public finances create room for stabilisation
policy and that an ageing population entails challenges that need to be
addressed.2 The surplus target was thus seen not only as an end in itself, but also as
a means of increasing the fiscal room for manoeuvre over time.
This was, of course, a wise way of dealing with the problems that the Swedish
economy had been struggling with for so long. In order for monetary policy and
fiscal policy - and thus macroeconomic policy in general - to be conducted in an
efficient manner, some basic conditions must be met. One of these is that they
are anchored over the long term, and this, above all, was what Sweden wanted to
achieve.
Long-term sustainable finances are the anchor for fiscal
policy...
For fiscal policy, it is crucial that economic actors have confidence in public
finances and see them as sustainable in the long term, or, in other words, that
public debt is stable in the long term, expressed as a share of GDP. If confidence in
public finances begins to loosen, many who would normally be willing to lend to
the government, that is, buy government securities, will be reluctant to do so due
to concerns about not getting their money back. When fewer people are willing to
lend and those who do demand a higher return for the risk they take, interest
rates rise. In turn, this means that government expenditure increases, the
situation worsens and there is a risk of entering a negative spiral with increasing
expenditure and rising deficits and interest rates. In a worst case scenario, fiscal
tightening may be required in an already poor economic situation in order to
restore confidence. To succeed with this is, of course, very difficult, as the austerity
measures mean that the economy will shrink further in the short term. This, in
turn, reduces the tax base and simultaneously increases the need for support for
vulnerable groups.
Given that there is confidence in the sustainability of public finances, there is also
room to use fiscal policy to counter recessions and address structural problems in
the economy. To a large extent, fiscal policy stabilisation of economic activity
takes place via so-called automatic stabilisers, without any political decisions
having to be made.3 However, if there is confidence in public finances, it is also
possible to make decisions about expenditure increases or tax cuts, so-called
discretionary fiscal policy, without this giving rise to doubts about the sustainability of
the finances. Good long-term anchoring is thus a prerequisite for fiscal policy to
be used for economic stabilisation or to address structural problems in the
economy.
The fact that anchoring creates such room actually seems to have been a bit
overshadowed in recent decades. As I have just noted, the fiscal framework launched
after the crisis of the 1990s was motivated not only by lower public debt creating
confidence that public finances are under control, but also by creating greater
opportunities to use fiscal policy for other purposes. I will come back to that.
...and the inflation target is the anchor for monetary
policy
The mechanisms for monetary policy are similar. What anchors monetary policy in
the long term is confidence that the central bank can keep inflation low and
stable. For most central banks, this means inflation of 2 per cent. These now also
include the European Central Bank (ECB), which, in July this year, moved to a
symmetrical target of 2 per cent, instead of the previous wording, where inflation
should be below, but close to, 2 per cent.
In the same way that confidence in public finances provides flexibility for fiscal
policy, monetary policy will have room for manoeuvre to counteract economic
downturns if there is confidence in the central bank's ability to keep inflation low
and stable. If monetary policy can be made expansionary without this causing
economic actors to fear that inflation will rise sharply, their expectations of what
inflation will be in the longer term will not be affected either. However, if fears of
sharply rising inflation arise as a result of the expansionary policy, long-term
inflation expectations may also begin to creep upwards. If the anchor comes loose
completely, the long-term consequence may be that inflation continues to rise in
a price and wage spiral. And, just as it may take a great deal of effort to restore
confidence in public finances that have begun to erode, it may be difficult and
costly to bring inflation back under control. As I mentioned at the start, in Sweden
we have some experience of price and wage spirals of this type, even though this
was some decades ago.
Too low inflation is also a problem...
However, it is not only an anchor that is drifting 'upwards' that is a cause for
concern. Monetary policy can also have major problems if it drifts 'downwards' and
inflation becomes persistently very low. In this case, monetary policy becomes
less effective because the main instrument, the policy rate, becomes more
difficult to use. I have talked about why this is the case many times in recent years
and I therefore do not intend to go into it in more detail here today.4 Briefly,
however, what is at issue is this: since nominal interest rates include compensation for
inflation, these interest rates will be lower, on average, in a low-inflation
economy. Moreover, there is an effective lower bound for the policy rate, where the
positive effects of further reductions cease and the negative ones begin to
dominate.5
This means that there is less scope for lowering the interest rate to stimulate
demand in economic downturns. In addition, since expected inflation is lower, it is
also more difficult to achieve as low a short-term real interest rate as would be
needed to have a sufficient effect.
One consequence of this that is worth noting is that, with inflation more
persistently below 2 per cent, negative policy rates would become more common.
Those who are critical of a policy rate below zero should therefore be strong
advocates for maintaining confidence in the inflation target and thus also for a
monetary policy that strives to achieve the target.
...which is reflected in the strategy reviews of the
Federal Reserve and the ECB
The problems of persistently too low inflation play a central role in both the ECB's
strategy review from July this year and the US Federal Reserve's review from
August last year. The changes that were made clearly show a wish to avoid these
problems. In the justification for its new strategy, the Federal Reserve notes that
the level of the policy rate that is compatible with maximum employment and
long-term price stability has fallen relative to its historical average. The policy rate
will therefore be limited by its lower bound more often than has been the case in
previous periods. In order to anchor long-term inflation expectations at 2 per cent
and prevent them from falling below this level - which would make the lower
limit binding even more often - it has chosen to specify the target as an average
of 2 per cent. This makes it clear that 'bygones' are not 'bygones': if inflation has
been below the target for a period, this must be compensated for by inflation
then being above target for a period.6
In turn, as I have just mentioned, the ECB has moved on to a symmetrical target of
2 per cent in the medium term. In practice, this means that the target has been
raised slightly, as previously inflation should have been "below, but close to, 2 per
cent". This symmetry means that both negative and positive deviations from the
target are equally undesirable. The ECB too points out that the marked decline in
the equilibrium real interest rate has meant that the effective lower bound for
nominal interest rates is likely to limit monetary policy more often. It also
emphasises that one consequence of this is that strong or sustained monetary policy
measures are needed when the interest rate is close to the lower bound to avoid
negative deviations from the inflation target becoming permanent. It also notes
that the new strategy may mean that inflation periodically will be above the
target, but, unlike the Federal Reserve, it has chosen not to introduce an average
target.7
Mutual dependence
We have thus seen that a prerequisite for fiscal policy and monetary policy to be
effective is that they have a stable long-term foundation. For fiscal policy, there
must be confidence that public debt is stable over the long term and, for
monetary policy, there must be confidence that the central bank can keep inflation low
and stable. In order for monetary policy to be able to use the policy rate to
counteract economic downturns and increased unemployment, it is also necessary for
average inflation not to be too low. It is therefore natural for fiscal policy
frameworks to focus on maintaining long-term stable public finances and for monetary
policy frameworks to keep inflation at 2 per cent.8
Although it is practical, and probably necessary, to have separate frameworks for
fiscal and monetary policy, it is important to recognise that there is an
interdependence between the two policies. Confidence in one depends on there
simultaneously being confidence in the other. For example, if public finances are
perceived as unsustainable, the expectation may easily arise that monetary policy will
eventually allow inflation to rise in order to reduce the real value of public debt,
that is, inflate it away. This may also cause the anchor of monetary policy to
loosen. Similarly, if inflation rises because confidence in the inflation target has
been eroded, it may lead to significantly higher interest rates, which, in turn, will
lead to an increase in the government's interest expenditure and will challenge
the sustainability of public finances.
A common view is that monetary policy is in the
driver's seat
The practical application of macroeconomic policy under this policy regime is
often described as a situation in which monetary policy is sitting in the driver's seat
and is expected to play the active part in stabilisation policy. It is monetary policy
that is expected to keep the economy in balance and inflation stable. Fiscal policy
is perceived to have a more passive role, which in principle is restricted to
adjusting taxes and expenditure when this is necessary to keep public debt stable over
the long term.9 It is not considered to have any explicit stabilisation policy task,
other than that which follows from the automatic stabilisers, except possibly in
the event of deep recessions or crises.
This view has had a major impact throughout the world, both in academic
research and in policy departments at finance ministries and central banks.
Conducting macroeconomic policy with this division of roles has also worked relatively
well in most places, not least in Sweden. It has thus been an arrangement with
which most people have been pretty content.
The division of roles may no longer be so obvious
But perhaps it is time for us to begin to ask ourselves whether this division into an
active monetary policy and a more passive fiscal policy really is the best way to
achieve a favourable macroeconomic development in all situations. Perhaps the
division has been taken a step too far after all, given that certain circumstances
have changed.
I think this is something we may now need to reconsider for at least a couple of
reasons. Monetary policy and fiscal policy are probably more dependent on each
other than we usually think, and this dependence has become even clearer as the
macroeconomic environment has changed quite a lot in recent decades.
For quite long periods, it may indeed work well if monetary policy is focused on
maintaining the inflation target and fiscal policy on keeping track of public
finances - that they manage their own business, so to speak. Indirectly, the two
policy areas nevertheless provide valuable support to each other.
Assume, for example, that inflation begins to rise rapidly and risks becoming
persistently too high, and that the central bank therefore raises interest rates in
order to dampen demand in the economy. The higher interest rate increases
government interest expenditure and weakens public finances. Of course, how much
depends, among other things, on how large the debt is from the start and by how
much the central bank raises the interest rate. If the economic agents trust that
fiscal policy will stabilise public debt, they will expect taxes to be raised or
expenditure to be reduced, or both. They will adjust their behaviour accordingly and
hold back on their consumption and investments in preparation for the expected
tightening. In this way, fiscal policy's stabilisation of public debt supports the
tightening of monetary policy - fiscal policy and monetary policy are pulling in the
same direction.
Greater dependence than we usually think...
But if the budget process works poorly and higher public expenditure is routinely
financed by the government raising even more loans, then the economic agents
will not expect a tighter fiscal policy, at least not until the government, at some
point in the future, will perhaps find itself absolutely forced to pursue such a
policy. This, in turn, helps to keep demand up and it becomes more difficult for the
central bank to use rate increases to counteract the rise in inflation, as fiscal
policy and monetary policy are pulling in different directions.10
Framed in this way, the relationship between monetary policy and fiscal policy is
straightforward and intuitive. However, the mechanisms actually also work in
about the same way when policies move in the opposite direction, and that is
something that I believe we may need to pay more attention to and discuss more.
If inflation is low for a period, the central bank's policy rate will also be low. In the
same way as before, therefore, government interest expenditure will be affected.
But in this case, it will decrease, which means that public finances will improve. If
the task of fiscal policy is to keep public debt stable, there is thus room to pursue
a more expansionary fiscal policy than would otherwise be the case.
As in the previous example, it will be more difficult for monetary policy to fulfil its
task - in this case to raise inflation to the target - without the support of a more
expansionary fiscal policy. If the task of fiscal policy is to stabilise public debt,
monetary policy will receive such support. When government interest costs
decrease, taxes will be reduced or expenditures increased, and this is also something
that economic agents expect. Fiscal policy and monetary policy will then again be
pulling in the same direction by interacting to raise demand and inflation.11
However, as the regime of an active monetary policy and a more passive fiscal
policy has been applied in practice in recent decades, it is not clear that this will
be the case. "Keeping public finances in good order" has often been equated with
"making sure that debt does not increase". A shrinking government debt, on the
other hand, is generally perceived as something that is always positive and not as
something that creates room for a more expansionary fiscal policy. However, from
a macroeconomic perspective, such an asymmetry in the view of the task of fiscal
policy is not entirely unproblematic.12
...particularly in the prevailing macroeconomic
environment
The problems have also been exacerbated by the fact that the macroeconomic
environment has changed quite a lot in recent decades. The most important
change is that the global real equilibrium interest rate has fallen and today is
historically low. As a result, many central banks' policy rates are now at or near their
lower bound (Figure 1). There is thus not much room to lower them further. In
most countries, they are also expected to remain at low levels for a long time
before gradually rising quite modestly.
While the low interest rate situation has made it more difficult to pursue an
expansionary monetary policy, it has made it easier to pursue an expansionary fiscal
policy. This is partly because the interest costs for government loans are very low.
I mentioned earlier that an expansionary monetary policy lowers government
interest costs. However, the biggest effect on interest costs comes from this trend
decline in real interest rates. Importantly, it is also this factor that has driven
central banks' policy rates downwards. Another key effect of the low interest rate,
which also speaks in favour of fiscal policy, is that more public investments will
become profitable.
A renewed discussion of the possibilities of fiscal policy
In recent years, the low interest rate has given rise to a renewed discussion of
fiscal policy in the research community. The reason for this is the observation that
the interest rate is lower than growth in the economy.13 When the government
can borrow at a very low interest rate, the debt burden as a share of GDP does
not need to increase, provided the economy grows at a sufficient pace. In other
words, public finances can show a deficit for a period without it being necessary
to raise taxes to address this. Growth is enough to ensure that the debt ratio
improves without any tightening.
It is not only the relationship between the interest rate and economic growth that
is important in this context, but also the level of interest rates as such. In several
developed economies, long-term interest rates are now close to zero or are even
negative, or have recently been so. This means that private actors are willing to
lend long-term to the state without any significant compensation, or are even
willing to pay to lend. This can, without exaggerating, be described as a pretty
generous offer. It is not very difficult to imagine that it is possible to find areas in which
public investment may be needed and where the funds borrowed to implement
that investment may well have a positive return because the cost is very low or
negative.
Why this has not happened to a greater extent than has been the case is not
entirely easy to understand. One probable explanation is that many countries have
put in place rules to prevent or counteract increased borrowing. The reasons for
this are good if we look at past negative experiences. However, if this is the
explanation, it is natural to start to consider whether these rules are actually adapted
to the changes that have taken place in the macroeconomic environment since
they were introduced, particularly the fact that the level of interest rates has been
historically low. If public investments, which, sooner or later, may still need to be
made, can be financed at a historically low cost, this would seem like a good
opportunity to implement them.
Ultimately, fiscal policy aims to increase the well-being of citizens. The
development of deficits and public debt may be the means to achieve this, but it is not
obvious from an economic point of view that it should be seen as an end in itself. A
comparison with monetary policy can be made here: the target is formulated in
terms of the outcome, that is, mainly how well the inflation target has been
achieved, rather than the means, that is, the monetary policy tools. I think it
would be useful if we were to start thinking more along these lines in fiscal policy
as well.14
The conclusion of this reasoning is not that public borrowing is never problematic.
For example, if the policy becomes too extensive or if it is not sufficiently
explained and followed up, investors may nevertheless begin to fear that the
government will not be able to manage its debt and may therefore demand a higher
risk compensation for lending. This, in turn, may make the commitments even
more difficult to meet - there is a risk that we will find ourselves in a bad
equilibrium, expressed in economic terms. However, the discussion that has arisen at
least indicates that there may be reason not automatically to regard public
deficits as a negative thing, as we have perhaps become too accustomed to doing.15
Trend towards lower policy rate and public debt
For Sweden, the changed conditions for monetary policy and fiscal policy are
clearly illustrated by the development of the repo rate and public finances over
the last twenty-five years or so (Figure 2).
As the real global interest rate has fallen, the repo rate has had to be lowered to
ever-lower levels for each business cycle. Despite this, it has been difficult to keep
inflation around 2 per cent on a more lasting basis. During the same period, the
consolidated gross government debt, the so-called Maastricht debt, has fallen
from just under 70 per cent of GDP to about 40 per cent. The downward trend has
certainly slowed down from time to time, most recently in connection with the
coronavirus pandemic, but is still very clear.
At a more general level and seen over the period as a whole, one may argue that
this development also reflects the fact that macroeconomic policy has not been
conducted in such a way as to keep public debt as a share of GDP stable. This has,
of course, been a deliberate strategy as Sweden has wanted to reduce its debt. At
the same time, however, it means that it has become more difficult to achieve the
inflation target.16
It has thus become more difficult for monetary policy to counteract economic
downturns. One condition that would change this would be a rise in the global
real equilibrium interest rate. Central banks' average policy rates would then also
be higher - in the same way as they have now fallen in line with the equilibrium
interest rate. However, no noticeable increase in the global real equilibrium
interest rate is on the cards in the near future, according to most analysts.17 In any
case, it will not happen so soon as to make my talk here today unnecessary.
Another condition that would at least improve the situation would be if the recent
rise in inflation were, for various reasons, to lead us closer to the inflation target
in a slightly more persistent way in the future. However, the forecast made by the
Riksbank and almost all other Swedish forecasters is that the rise in inflation is
temporary and is mainly due to various pandemic-related imbalances between
demand and supply.18 The same assessment is being made in many other parts of
the world where similar developments are being seen, even though the
persistence of inflation in the United States in particular is being discussed more and
more.
However, even if the rise in inflation were to bring us closer to the target after the
pandemic, a continued low global real equilibrium interest rate would mean that
central banks' policy rates would still reach the lower bound from time to time.
The problem of it being difficult to make monetary policy as expansionary as it
would sometimes have to be would thus remain.
A new policy regime with fiscal policy in the driver's
seat?
According to some economists, the fact that the scope of monetary policy has
been restricted has meant that, for some time, we have been in a different regime
in which it is fiscal policy instead that has ended up in the driver's seat of
macroeconomic policy.19 If that is the case - and I think there is much that suggests that it
is - then this will put higher demands on fiscal policy to be more active in the
period ahead than it has been in recent decades. And we could probably have had a
better development until now if fiscal policy had taken this more active role even
earlier.
I would like to emphasise that I am talking about much more than fiscal policy
"helping monetary policy to reach the inflation target", even if this by no means is
an unimportant aspect. I often point out that the inflation target is not just the
Riksbank's target but is a target for the economy as a whole. Of course, it is the
Riksbank that is appointed to try to fulfil it, but whether this succeeds or not is of
great importance from a much broader economic perspective. There is strong
political support for the inflation target, which, in turn, is based on the conviction
that the economy simply works better with a specific, low and stable inflation
rate. As I have just noted, this is also a feature of the recent strategy changes of
the Federal Reserve and ECB.
As a slight digression, it may be interesting to note that the tendency to see the
inflation target as merely the Riksbank's concern is not a new phenomenon.
Urban Bäckström, Governor of the Riksbank 1994-2002, already pointed out this
problem during the National Economic Association's negotiations in February
1995:
"I object to the title of today's discussion, which is 'The Riksbank's inflation
target'. Although it is natural for a central bank to strive for price stability, this
endeavour must ... permeate the entire economic policy."20
At the time, the problem was the other way around, that is, more policy areas had
to help keep inflation down. However, since the purpose of an inflation target is
to anchor inflation at a certain level, rather than for it to be as low as possible, the
argument is certainly valid even when inflation risks becoming persistently too
low.
Several good reasons for a more active fiscal policy
In recent years, maintaining confidence in the inflation target has primarily been a
matter of ensuring that monetary policy can continue to be used in the future to
counteract recessions and increased unemployment - and thus provide support
to fiscal policy in bad times. Put somewhat pointedly, the statement that
monetary policy cannot be 'the only game in town' that has been heard quite often
recently, perhaps particularly from central bank representatives, is basically about
us not ending up in a situation where instead fiscal policy will be the only game in
town for the foreseeable future. Both will certainly be needed.
However, there are also good reasons other than the development of inflation
that suggest that fiscal policy may have to play a more active role in the future.
One is that we have major structural challenges ahead of us: the population is
ageing and this means that healthcare will need more resources, the integration
of different groups into Swedish society and the economy needs to be improved,
and climate change will require major adjustments - to name but a few. Here, it
may be worth recalling what I mentioned earlier about the original motives for
using a surplus target to reduce public debt. This was not just a matter of restoring
confidence in public finances, but also of creating room for both stabilisation
policy and managing structural challenges.
Measures in these and other areas aim to make the Swedish economy and
Swedish society function better in various respects. Many of them also aim to increase
growth and production capacity in the long term - what are usually called
supplyside policies. When aggregate supply and production capacity increase,
conventional economic theory suggests this puts downward pressure on prices for a
given level of demand. However, these growth effects take quite a long time to
occur. In the shorter term, the effect is very likely to be that demand and inflation
increase. But as I have noted, this may also be positive in the situation we are in
today.
Beneficial to formalise policy?
It is possible that a system in which fiscal policy plays a more active role in
macroeconomic policy could benefit from being formalised and the rules clearly laid
down. One possibility is for the policy to be conditional on a particular measurable
target - that it becomes what economists call state contingent. Until this target is
achieved, the budget is run with a deficit.21
Another possibility is to make the policy time contingent. For example, fiscal
policy makers could announce their intention to allow the budget to run with a
deficit, let us say over a ten-year period, according to a predetermined path -
similarly to how monetary policy signals its ambitions with the policy rate. They could
also specify what they wish to achieve with this more expansionary fiscal policy.
The plan should, of course, be gradually updated and made more detailed. And
while the deficits are running, the policy is continuously evaluated with regard to
how it relates to the target path and how effective it appears to be.22
Although a time contingent strategy may be somewhat less attractive to
economists than a state contingent one, it could have some advantages: it would
probably be easier to implement and manage politically, as it has a predefined clear
sunset clause.
As long-term sustainable public finances are, of course, still a basic precondition,
once the period is over, or once the set goal has been achieved, a switch is made
to keeping the debt stabl