For decades, monetary economists viewed central banks as the “last movers.” They were relatively nimble in their ability to adjust policy to stabilize the economy as signs of a slowdown arose. In contrast, discretionary fiscal policy is difficult to implement quickly. In addition, allowing for the possibility of a constantly changing fiscal stance adds to uncertainty and raises the risk that short-run politics, rather than effective use of public resources, will drive policy. So, the ideal fiscal approach was to set policy to support long-run priorities, minimizing short-run discretionary changes that can reduce economic efficiency.
Today, because conventional monetary policy has little room to ease, the case for using fiscal policy as a cyclical stabilizer is far stronger. Unless something changes, there is a good chance that when the next recession hits, monetary policymakers will once again find themselves stuck for an extended period at the lower bound for policy rates. In the absence of a monetary policy offset, fiscal policy is likely to be significantly more effective.
Against this background, a new book from The Hamilton Project and the Washington Center for Equitable Growth, Recession Ready: Fiscal Policies to Stabilize the American Economy, makes a compelling case for strengthening automatic fiscal stabilizers. These are the tax, transfer and spending components that change with economic conditions, as the law prescribes…. Read More
In the March 2018 general election, two Italian political parties (the League and the Five Star Movement) that eventually formed the current government campaigned against many of the structures that are the foundation of the European Union. One part of their agreed policy program, a proposal that resurfaced in the past week, concerns the possibility of issuing mini-BOTs (which stands for Buoni del Tesoro). These would be small denomination “bonds”—non-interest-bearing, tradeable securities—issued by the Italian government to pay debts and usable to pay taxes or purchase goods and services provided by the state. Printed in the size and shape of currency notes, recipients could view them as a new means of exchange.
In this post, we discuss the possibility of Italy leaving the European Monetary Union, and why there is an increased incentive for the government to plan for an abrupt and unanticipated exit. The strategic analogy is to the appearance of a first-strike capacity that undermines nuclear peace. In our view, however, that appearance is misleading: any attempt to exit would not only be a disaster for Italy, as we explained in our post from a year ago, it would be the “mother of all financial crises” …. Read More
Nobody likes taxes, so public spending frequently exceeds revenues, leading governments to borrow. These budget deficits are a flow that add to the stock of debt. Since the Great Financial Crisis of 2007-2009, public debt in a number of advanced economies has surged. In the United States. the Congressional Budget Office (CBO) recently projected that―in the absence of policy changes―federal debt held by the public is headed for record highs (as a ratio to GDP) in coming decades.
Importantly, there is a real (inflation-adjusted) limit to how much public debt a government can issue (see Sargent and Wallace). Beyond that limit, the consequences are outright default or, if the debt is in domestic currency bonds that the central bank acquires, inflation that erodes its real value leading to a partial default.
Ultimately, debt sustainability requires that a country’s ratio of public debt to GDP stabilize. Otherwise, debt eventually will rise above the real limit and trigger default or inflation. In this note, we derive and interpret a simple debt-sustainability condition. The condition states that the government primary surplus―the excess of government revenues over noninterest spending—must be at least as large as the stock of outstanding sovereign debt times the difference between the nominal interest rate the government has to pay and the rate of growth of nominal GDP. If it is not, then the ratio of debt to GDP will explode…. Read More
After years of calm, fears of a currency redenomination—prompted by the attitudes toward monetary union of Italy’s now-governing parties and the potential for another round of early elections—revived turbulence in Italian markets last week. We have warned in the past that an Italian exit from the euro would be disastrous not only for Italy, but for many others as well (see our earlier post).
And, given Italy’s high public debt, a significant easing of its fiscal stance within monetary union could revive financial instability, rather than boost economic growth. Depositors fearing the introduction of a parallel currency (to finance the fiscal stimulus) would have incentive to shift out of Italian banks into “safer” jurisdictions. Argentina’s experience in 2001, when the introduction of quasi-moneys by the fiscal authorities undermined monetary control, is instructive…. Read More
The problem of time consistency is one of the most profound in social science. With applications in areas ranging from economic policy to counterterrorism, it arises whenever the effectiveness of a policy today depends on the credibility of the commitment to implement that policy in the future.
For simplicity, we will define a time consistent policy as one where a future policymaker lacks the opportunity or the incentive to renege. Conversely, a policy lacks time consistency when a future policymaker has both the means and the motivation to break the commitment.
In this post, we describe the conceptual origins of time consistency. To emphasize its broad importance, we provide three economic examples—in monetary policy, prudential regulation, and tax policy—where the impact of the idea is especially notable.... Read More