Separating monetary policy and public finance

  • History teaches us that fiscal and monetary separation is a relatively new invention….

When business stories start making headlines, it’s usually bad news. When these articles contain obscure technical terms, it is often an even more worrying sign. The latest is “fiscal dominance”.

Ever since central bank independence became commonplace, advanced economies have had a clear division of labor: governments control fiscal policy (taxes, spending, debt, and deficits), while central banks control monetary policy (interest rates and quantitative easing/tightening) – usually with the objective of achieving an inflation target.

Many advanced economies have spent years in a system of “currency dominance,” with central banks free to change policy to control inflation as they see fit. “Fiscal dominance”, on the other hand, occurs when monetary policy becomes constrained due to concerns about the impact it might have on public finances.

The central bank is no longer able to take the necessary measures to achieve its inflation target, which means that monetary policy is effectively dictated by the government. At the most extreme end, we see central banks financing government deficits. Even a milder case could see the central bank acting against its own interests: after all, high inflation erodes the real value of public debt, and raising interest rates to meet soaring prices would only increase the cost of public borrowing.

Concerns about fiscal dominance in advanced economies arise periodically, usually in times of high government spending. After high levels of pandemic stimulus in 2020, the ECB’s Isabel Schnabel stressed that “the euro was built on the principle of monetary dominance” and dismissed fears that high public debt could induce the central bank to deviate from its monetary policy objectives.

For the UK, the specter of fiscal dominance was raised last week when the Bank of England (BoE) suspended active quantitative tightening and was forced to intervene to stabilize the gilt market. ING economists noted that while ‘hard-core sterling bears’ saw it as evidence that the BoE was offering the government the chance to continue with its aggressive fiscal program, the case was not compelling. The intervention was firmly aimed at financial stability, and ING economists concluded that fears of fiscal dominance sounded like “hyperbole”.

Nevertheless, accusations of fiscal dominance do little to bolster the UK’s economic credibility (as my colleague Dan Jones writes here), and the government was quick to issue a statement confirming that “the Chancellor is committed independence from the Bank of England.

But this has not always been the case: the two pillars of economic policy were once closely (and deliberately) linked. In an extensive history of central banks, NBER economists Michael Bordo and Pierre Siklos argue that many of the first central banks were created specifically to manage public debt. The first (the Swedish Riksbank and the Bank of England) were created in the late 1600s with the added mandate of financing wars. The Federal Reserve was only founded in 1913 and started inflation targeting in 2012, 20 years after the BoE.

The move towards policy separation has generally been welcomed. Historically, many episodes of hyperinflation have been associated with central bank financing of public debt: think of Weimar Germany in the 1920s and Latin America during the debt crisis of the 1980s. More recently, the IMF identified governments borrowing from their central banks to finance deficits as an “urgent problem” in sub-Saharan Africa, with hyperinflationary episodes in Zimbabwe acting as a stark warning.

There are also implications for less severe cases of fiscal dominance. The ECB’s Schnabel says past experience “teach us that financial repression usually crowds out private investment and thus leads to lower growth and employment”. Schnabel also points out that “history suggests that society is better off under a regime of monetary dominance,” adding that the safeguards put in place to preserve central bank independence remain “important pillars of stability and prosperity”.

But as the chart shows, government debt-to-GDP ratios and inflation are rising, as are interest rates. The independence of monetary and fiscal policies in many advanced economies is well established, but some link between interest rates and public finances remains.


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