Interest rate vs fiscal policy stabilisation

Trading binary options

One divide between mainstream and many heterodox economists is on whether monetary or fiscal policy should be used for macroeconomic stabilisation (controlling demand to influence inflation and output). What makes a good instrument in this context? As I have argued before, a key difference between the mainstream and MMT involves different answers to this question. I think the following issues are critical.

  1. How quickly do changes in the instrument (e.g. increases in interest rates) influence demand?

  2. How quickly can the instrument be changed? Are there limits to how far it can be changed?

  3. How reliable is the impact of the instrument on demand? In other words how uncertain is the impact of a change in the instrument on demand?

  4. How certain can we be that whoever has power over the instrument will use it in the necessary way?

  5. Does changing the instrument have ‘side effects’ which are undesirable?

If we apply these questions to whether to use interest rates or some element of fiscal policy, what answer do we get?

Before doing that, it is worth noting this is all about the quickest and most reliable way to influence demand. It is quite separate to how demand influences inflation (as long as we are talking about underlying inflation).

The first question is important because long lags between changing the instrument and it influencing demand mess up good policymaking. Imagine how good your central heating would be if there was a day’s delay between it getting cold and the heating coming on. It is also perhaps the most interesting question for a macroeconomist. A full discussion would take a textbook, so to avoid that I’m going to suggest that the answer is not critical to why the mainstream prefers monetary to fiscal stabilisation.   

The second question is as important for obvious reasons. If an instrument can only be changed every year, that is like having very long lags before the instrument has an effect. On this question monetary policy seems to have a clear advantage given current institutional arrangements. Some of this difference is difficult to change: it takes time for a bureaucracy to move. As I notedwith the fiscal expansion implemented by China after the crisis, about half of the projects were underway within a year. Others delays are in principle easier to change: there is no reason why tax changes need only happen during Budgets in the UK, for example.

The second part of the second question is a clear negative for interest rates, because they have a lower bound. This is not the case for fiscal instruments: you can always cut taxes further for example. Because this is a critical failure for interest rate policy, effectively the discussion in this post is just about what happens when interest rates are not at the lower bound. Even so, potentially having two different instruments for different situations is a count against monetary policy.

The third question is often not asked, but it is absolutely critical. Imagine raising the temperature on a room thermostat which not only had no calibration, but which acted in different ways each day or even each hour. OMT is a clear example of a poor instrument because central banks have far less idea of how effective it is than interest rate changes, partly because of less data but also because of likely non-linearities.

Are interest rate changes more or less reliable than fiscal changes? The big advantage of government spending changes is that their direct impact on demand is known, but as we have already noted such measures are slow to implement. Tax changes are quicker to makes, but many mainstream economists would argue that their impact is no more reliable than the impact of interest rate changes. In contrast some heterodox economists (especially MMTers) would argue interest rate changes are so unreliable even the sign of the impact is unclear.

The fourth question is only relevant if the power to change interest rates is delegated to central banks. Let me assume we have a UK type situation, where the central bank has control over interest rates but it has to follow a mandate set by the government. A strong argument is that, by delegating the task of achieving that mandate to an independent institution, policy is less likely to be influenced extraneous factors (e.g. there is no way interest rates rise until after the party conference/election) and therefore policy becomes more credible. (There is a whole literature involving similar ideas.)

This advantage for monetary policy simply follows from the fact that it can be easily delegated. However even if it is not delegated, fiscal policy has the disadvantage that changes are either popular (e,g, tax cuts) or unpopular (tax rises). In contrast interest rate changes involve gains for some and losses for others. That makes politicians reluctant to take deflationary fiscal action, and too keen to take inflationary fiscal action. So even without delegation, it seems likely that interest rate changes are more likely to be used appropriately to manage demand than fiscal changes.

The fifth and final issue could involve many things. In basic New Keynesian models the real interest rate is the price that ensures demand is at the constant inflation level. Therefore nominal interest rates are the obvious instrument to use. Changing fiscal policy, on the other hand, creates distortions to the optimal public/private goods mix or to tax smoothing.

So the case against fiscal policy as the main stabilisation tool outwith the lower bound might go as follows: it is slower to change and it cannot be delegated. Even if monetary policy is not delegated politicians may allow popularity issues to get in the way of effective fiscal stabilisation. While government spending changes have a certain direct effect, they are also the most difficult to implement quickly.

A potentially strong argument against monetary policy is the lower bound problem. You could argue that having monetary policy as the designated stabilisation instrument gets government out of the habit of doing fiscal stabilisation, so that when you do hit the lower bound and fiscal stabilisation is essential it does not happen. Recent experience only confirms that concern. I personally do not think mainstream macroeconomists talk enough about this problem.

The fiscal rule that Jonathan Portes and I developed, a version of which is Labour’s fiscal credibility rule, does attempt to address this very issue. Switching from monetary to fiscal at the lower bound is a key part of the rule. It is also worth stressing that this rule does not prevent temporary changes in fiscal policy to counteract a downturn outwith the lower bound. (Anyone who says otherwise does not understand the rule.) For example if interest rates are already low, a fiscal expansion that is planned to last less than five years is consistent with the rule, and might be a sensible precautionary measure. (Public investment, which is outside the rule, could also be used in this way.) So Labour’s fiscal rule allows monetary policy to do its job, but fiscal policy is always there as a back up if needed.


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