Central bank independence at risk: Low rates, new risks by Jean Barthélemy, Eric Mengus, Guillaume Plantin published by VOXEU (1/2020).
“Real interest rates are at historically low levels in advanced economies. This column looks at the implications for central bank independence. It argues that low rates, even though they relax the budget constraint of the public sector, will not necessarily strengthen central bank independence. Quite counterintuitively, in the current context of low inflation, preserving central bank independence may require that the public deficit be financed with helicopter money, rather than government debt, to prevent the government from entering into uncontrollable spending.
Real interest rates are currently at historically low levels in advanced economies, pushing some economists to call for more public spending. Risk-free real interest rates, including those on government bonds, have persistently decreased since the 1980s (Fahri and Gourio 2019). As a result, governments can finance new spending at low fiscal costs – that is, with little, if any, need to raise current or future fiscal surpluses. Blanchard (2019) argued that there is not only no fiscal cost but also a limited crowding out of private investment by public spending in this context. Some policymakers advocate that in this environment, fiscal rules – at least under their current design – are “a debate that belongs to another century”.
However, in the past century, limits to fiscal policies were considered to be important for multiple reasons, foremost among which is central bank independence. It was thought that to guarantee such independence, one should not only grant the central bank a specific statute, instruments, or objectives, but also make sure that the central bank can achieve its objectives given the available instruments. Fiscal policy and, in particular, public debt were considered major threats to this capacity, as they may force the central bank to monetise public debt and ultimately lose control of inflation. Therefore, limits to fiscal policy were considered as essential for central bank independence.
More specifically, the standard view was that fiscal authorities have to make sure that they remain solvent taking as given the paths of price level and monetary policy decisions – in jargon, fiscal policy has to be Ricardian (Woodford 2001). In the euro area, this takes the form of the Stability and Growth Pact, which includes caps on debts and deficits.
What, then, is the effect of low rates on the independence on central banks? Can we abandon fiscal rules to benefit from the current low cost of spending without abandoning central bank independence? Are we condemned to abandoning central bank independence to fight against below target inflation?
In a recent paper (Barthelemy et al. 2019), we extend workhorse models in two directions to answer this question. We first posit that the public sector has a unique ability to supply liquidity vehicles to the economy and thus generate resources above and beyond fiscal surpluses, for example in the form of ‘low rates’. This may relax the interdependence between fiscal and monetary policies that derives from a standard intertemporal budget constraint. Second, rather than assuming that fiscal and monetary authorities commit indefinitely to policy rules, we endow both authorities with objectives and instruments and study the subgame-perfect outcome from their strategic interactions. Put simply, we offer a formal game-theoretic analysis of Wallace’s ‘game of chicken’ between fiscal and monetary authorities…”
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