Fiscal retrenchments and the transmission mechanism of the sovereign risk channel for highly indebted countries

We formalize sovereign and private sector default probabilities into a monetary model in order to test the hypothesis, which recently appeared in the literature, of whether the consideration of a sovereign risk channel affects the sign and size of output fiscal multipliers. The model is estimated for the most vulnerable Eurozone countries-characterized by high debt-to-GDP ratio-and stochastically simulated conditional on expenditure and revenue policy measures. We show that, conditional on specific fiscal shocks, the risk channel can operate in a pro-cyclical direction, amplifying the temporary contractionary effects of fiscal retrenchments. We show that both the relations between economic fundamentals and sovereign debt spreads and that between sovereign and credit spreads are weak. Therefore, the effectiveness of the risk channel for fiscal consolidations is small, irrespective of the direction of change in the sovereign default probability.     

The determinants of austerity in the European Union 2010–16

This paper aims at decteting what drove the adoption of austerity policies over the period 2010–16 in a panel of 28 European countries. Austerity is identified by year increases in the ratio between the structural primary balance and potential GDP. By means of principal component factor analysis we select the aggregate factors that might affect austerity, namely (i) fiscal consolidation (correction of high deficits and debts), (ii) market discipline (high sovereign spreads, low ratings), (iii) rule-based fiscal discipline (compliance with the Eurozone rules), and macroeconomic stabilisation (consideration for the cyclical position of the economy). Then we estimate a dynamic panel model with the system-GMM method. Results show that the most important contributions to austerity are provided by the market discipline and fiscal consolidation factors together with Excessive Deficit Procedures, with no significant role played by concomitant macroeconomic conditions. Overall, governments complied with orthodox fiscal principles and rules.     

The Conduct of Monetary Policy Without Monetary Aggregates

A central dilemma for the monetary authorities is how to determine monetary policy. The increasing unreliability of monetary aggregates has led over the past few years to less concern for monetary targeting, both in the UK and elsewhere, and a greater influence for the exchange rate on monetary policy. But in the UK, most recently, there has been a move away from setting monetary policy in relation to the exchange rate and external considerations in favour of setting monetary policy in relation to domestic demand. Not surprisingly, this shift has occurred at a time of rising concern about domestic overheating. It illustrates the dilemma of whether monetary policy should be driven by domestic demand considerations or by external, exchange rate considerations. This dilemma is not just confined to the UK for it is a real source of conflict underlying the Louvre Accord and its successors that seek to determine G7 exchange rates in a cooperative manner. In what follows, we argue that exchange rate developments should have an appreciable influence on monetary policy, since this is helpful in attaining stable inflation. But we also suggest that this influence should not go too far, since this stability of inflation may be at the expense of stability of domestic demand and output. Targeting of exchange rates within narrow bands is unlikely to be desirable, unless fiscal policy can be used more flexibly to stabilize domestic demand. This suggests that, in the period up to the spring, the use of monetary policy to hold the £/JDM exchange rate within narrow limits may have been overdone. More seriously, international exchange rate agreements among the G7 countries are likely to founder under adverse market pressures, unless current imbalances in fiscal policy are adjusted. In the absence of greater flexibility in fiscal policy, policy makers will have to trade off domestic and exchange rate considerations in determining monetary policy. An important outstanding issue that needs further consideration is what indicators should be used for monetary policy, in a world in which monetary aggregates provide unreliable signals.     

Restoring Credible Economic Governance to the Eurozone

This paper discusses new institutional rules for a stable and lasting European Monetary Union (EMU). We propose a return to a strict and sustainable economic governance framework, which is mainly driven by market forces within a smart rule‐based environment. Our recommendations are: (a) ex ante conditionalities with a tough monitoring process to avoid moral hazard in the future; (b) further enhancement of the Stability and Growth Pact; and (c) ultimo ratio punishment to be able to respond to the unique constellation of fiscal–monetary interaction and new rescue facilities. Countries violating fiscal rules for more than four years in a row will thus lose their fiscal sovereignty or will have to resign from the Eurozone. After fulfilling the ex ante conditionalities as well as all required criteria, the country either will recover its fiscal sovereignty, or, in case of exclusion, will be given the option to rejoin EMU under certain conditions.     

The Independence of the Bank Of England: an Update

In this article, Stephen Hall and Brian Henry reconsider the arguments for further coordination of fiscal and monetary policy in the UK. The recent inflation-unemployment performance in the UK has been good, but it appears mainly the result of beneficial developments in the world economy. Further improvement in the policy-making framework in the UK is called for. Many of the present drawbacks could be dealt with by treating fiscal policy on a par with monetary policy. There are arguments that further cooperation is not needed but these are unpersuasive. They recommend the setting up of an independent committee charged with reviewing fiscal decisions, and coordinating these with monetary decisions by the MPC.     

Fiscal policy

Although the economic recovery is steadily being reflected in an improvement in the fiscal numbers, the UK is still only half‐way though the Government's planned fiscal austerity. But whether the spending cuts that are still to come are really deliverable remains questionable…     

Fiscal Policy in the Eurozone: Stimulus or Consolidation?

Fiscal policy is one of the three pillars of what Dr. Ottmar Issing (2002) has called the Maastricht Assignment. For the Eurozone as a whole, the Central Bank is responsible for area-wide price stability. The twelve national fiscal authorities are responsible for fiscal policy — country by country — subject to the provisions of the Stability and Growth Pact (SGP). The third pillar involves supply-side issues and wage/price developments and is the responsibility of "national governments and the social partners". Issing has argued that this assignment provides a clear division of roles and responsibilities — and that no further macroeconomic coordination is necessary or desirable¹. In this article, Christopher Allsopp² assesses the framework for fiscal policy in the Eurozone, arguing for a system that is more decentralised; ensures 'sustainability' as a primary objective; and, subject to that, allows for activist stabilisation policy against country-specific shocks.     

Greece in the Eurozone: Lessons from a decade of experience

This study examines Greece's experience as a member of the Eurozone over the period 2002 to 2011. In evaluating the Greek experience within the Eurozone, we derive the following fundamental policy lessons that apply both to similar small peripheral EU countries that plan to enter the Eurozone, or any other economic union, and to the Eurozone itself in terms of facilitating their integration in a large monetary union. First, countries with inefficient public systems must re-engineer and restructure the decision making process in the public sector before they become members of an economic union. Second, countries must generate a friendly environment toward business and provide (a) a simple, stable tax system, (b) an effective and efficient justice system, and (c) a high quality educational system. Third, the living standards of the people are determined by the productivity and competitiveness of the economy and not by an inefficient and overspending public sector. Fourth, structural funds should be used to improve the competitiveness of the economy, not serve the political clientele of the party in power. Fifth, the admission requirements to an economic union must be strict and these requirements must be enforced. Sixth, capital market investors must always differentiate default risk within the country-members of a monetary union.     

Banking and sovereign debt crises in a monetary union without central bank intervention

We analyze the conditions of emergence of a twin banking and sovereign debt crisis within a monetary union in which: (i) the central bank is not allowed to provide direct financial support to stressed member states or to play the role of lender of last resort in sovereign bond markets, and (ii) the responsibility of fighting against large scale bank runs, ascribed to domestic governments, is ensured through the implementation of a financial safety net (banking regulation and government deposit guarantee). We show that this broad institutional architecture, typical of the Eurozone at the onset of the financial crisis, is not always able to prevent the occurrence of a twin banking and sovereign debt crisis triggered by pessimistic investors’ expectations. Without significant backstop by the central bank, the financial safety net may actually aggravate, instead of improve, the financial situation of banks and of the government.     

Forecast in detail

Recent months have seen a significant shift in the UK fiscal backdrop. Statistical changes have caused a significant upward revision to the level of borrowing last year, while muted growth in tax receipts and faster‐than‐expected rises in public spending have pushed up the deficit in 2019–20 to date. Moreover, the political climate has shifted against austerity, with both Conservative and Labour party pledges implying a rising deficit for the foreseeable future.     

The Impact of Shocks on the UK Economy in and Out of EMU

Entry to EMU at an inappropriate exchange rate could trigger a full-blown business cycle in the UK. Once inside EMU, the UK's response to a number of different economic shocks would change — partly because of the fixed exchange rate, and partly because of the common monetary policy. In particular, when an asymmetric shock occurs — one that hits the UK harder than other Eurozone economies — the UK response is generally likely to be more pronounced inside EMU than outside. We find that that result still applies even in a reformed EMU — one in which the ECB and the labour market are reformed to bring them closer to the Anglo–Saxon model.     

Political Macroeconomics: A Survey of Recent Developments

The paper surveys political macroeconomics, covering its development from Rogoff's conservative central banker to the most recent discussions of monetary policy and institutional design. Topics include the inflation-stabilization trade-off, central bank independence with escape clauses and overruling with costs, inflation targets, performance contracts for monetary authorities, and the consequences of output persistence for these issues. Further topics are the political business cycle when output is persistent, the political macroeconomics of fiscal policy, the government spending bias, and the game-theoretic interaction between fiscal and monetary policy. All work is discussed within a coherent analytical framework.     

Financial crises and economic growth

This paper constructs a simple yet robust model of financial crises and economic growth where financial markets affect real economic activity. Financial markets increase real output by facilitating investment through the borrowing/lending of capital. However, the borrowing of capital is risky due to randomness in the firms’ production. Financial crises occur when output and liquid capital are insufficient to meet required loan payments and systemic defaults occur. In this model, a financial crisis caused by systemic defaults can shift the economy from an equilibrium with positive borrowing/lending to an equilibrium with no borrowing/lending. In this no-lending equilibrium, neither traditional fiscal or monetary policy tools are effective in increasing output. Fiscal and monetary policy can only increase the likelihood of the equilibrium evolving to a borrowing/lending equilibrium.     

The Road Not Taken: A Comparison Between the Hard ECU and the Euro

In the context of the Eurozone crisis this paper re‐examines the Hard ECU using the concepts of the macroeconomic trilemma and the political trilemma. We find that the Hard ECU would have been less economically and politically damaging than the euro. We conclude that it was a superior approach to monetary union.     

World Economic Prospects

Overview: Global deflation – a genuine risk?

• The notable decline in inflation in the Eurozone, US and UK since mid-2013 has led to suggestions that a period of widespread price deflation across the major economies is a risk. Adding to these concerns has been the trajectory of producer prices – already declining in the Eurozone and China and showing very subdued growth elsewhere.
• Our global GDP forecasts do not, in isolation, point to a worldwide deflation risk. We expect growth at 2.8% this year and 3.2% next, little changed from last month.
• But the starting point for this growth matters, specifically the gap between actual and potential output last year. Even with reasonable growth, an initially large output gap would imply downward pressure on inflation over the next two years.
• Unfortunately, the size of the output gap is very uncertain. There is a wide range of estimates for the major economies, especially Japan. Part of the problem is that it is hard to know how much potential output was (or was not) permanently lost during the global financial crisis and recession.
• Assuming substantial permanent losses, output gaps might be relatively modest now, but a more optimistic view of the supply side of the economy would suggest output gaps could be quite large – and arguably this fits better with the recent evidence from inflation.
• Overall, while we see a genuine risk of deflation in the Eurozone (with around a 15% probability) we are more upbeat about the other major economies, where growth in the broad money supply and nominal GDP do not seem to be signaling deflation risks.
• But the difficulty of measuring ‘slack’ in the economy for us underlines the case for central banks to err on the side of caution when setting monetary policy, and either not tightening too soon or easing further. This month we have built in a further ECB rate cut to our Eurozone forecast. In Japan, we have revised down growth for 2014–15 with recent data strengthening the case for additional monetary easing this year.

     

Fiscal and monetary interdependence

Where classical economics integrates the quantity theory of money with the concept of Ricardian equivalence, the tendency of recent macroeconomic presentations is to focus either upon money and inflation or upon taxation and debt. That neglect of classical monetary–fiscal integration is surprising, given an initiative by the International Monetary Fund that set credit, money, and fiscal policy within a single structure. This article places those ‘credit counterparts of broad money’ in the context of the Great Depression and the recent global financial crisis. The upshot is a set of conclusions: that, to counter the prospect of deflation, quantitative easing is a weak policy response; that fiscal deficits are better; and that cuts in taxation are preferable to increased government spending.     

Structural breaks in public finances in Central and Eastern European countries

This article studies the evolution of quarterly government Total Deficit (TD) to Gross Domestic Product (GDP) and debt to GDP ratios of seven Central and Eastern European member states (CEEC-7) of the European Union over the period 2000 Q1 to 2011 Q2. Alternative unit root tests are applied to identify the number and date(s) of structural break(s) in the fiscal ratios. The breakpoint date(s) are estimated endogenously. The best performing unit root test is determined by the adjusted R-squared metric. The level and trend of fiscal ratios are estimated by using breaking trend regression models. Unit root tests performed for the period 2000 Q1 to 2007 Q4 identify the number and date(s) of structural break(s) in fiscal variables before the global economic crisis. Unit root tests and breaking trend regressions are estimated for total Eurozone TD to GDP and debt to GDP to compare the evolution of total Eurozone fiscal ratios with those of each CEEC-7.     

Fiscal Policy in the UK

Although the conduct of macroeconomic policy in the UK has been very good by historical standards, Brian Henry argues in this article that there are shortcomings in the framework which mean it is less well suited to adverse shocks than it should be. He recommends that an extension of the present framework be made setting up a committee charged with the independent assessment of fiscal policy. This would help mitigate the lack of balance between monetary and fiscal policy which is evident at present. Fiscal judgements based on cyclical adjustments are too heavily dependant on domestic factors and underestimate the effects of the cycle on revenues. In consequence, fiscal policy, rather than supporting monetary, has been loosened and this indirectly accounts for the continuing strength of the exchange rate.     

Fiscal policy and asset markets: A semiparametric analysis

Using a flexible semiparametric varying coefficient model specification, this paper examines the role of fiscal policy on the US asset markets (stocks, corporate and treasury bonds). We consider two possible roles of fiscal deficits (or surpluses): as a separate direct information variable and as a (indirect) conditioning information variable indicating binding constraints on monetary policy actions. The results show that the impact of monetary policy on the stock market varies, depending on fiscal expansion or contraction. The impact of fiscal policy on corporate and treasury bond yields follow similar patterns as in the equity market. The results are consistent with the notion of strong interdependence between monetary and fiscal policies.     

Leaning into the Wind: A Structural VAR Investigation of UK Monetary Policy*

This paper adapts Uhlig's [Journal of Monetary Economics (2005) forthcoming] sign restriction identification methodology to investigate the effects of UK monetary policy using a structural vector autoregression (VAR). It shows that shocks which can reasonably be described as monetary policy shocks have played only a small role in the total variation of UK monetary and macroeconomic variables. Most of the variation in UK monetary variables has been due to their systematic reaction to other macroeconomic shocks, namely non‐monetary aggregate demand, aggregate supply, and oil price shocks. We also find, without imposing any long run identifying restrictions, that aggregate supply shocks have permanent effects on output.