How does the crisis in financial markets affect economic growth in the real economy? What are the appropriate policy reactions to minimize the negative impact? If monetary policy is the crucial instrument to stabilize the banking system, its efficiency depends on the interaction with fiscal and wage policies.
At the core of the financial crisis was the risk of solvability which translated into a liquidity crisis and credit crunch. As the value of asset based securities became uncertain, banks were concerned about maintaining their liquidity. Instead of lending and providing liquidity to each other in the money market, they were forced to borrow from central banks when they were in need of cash. The tension in the short term money market pushed risk premia for three-month money market rates over the official central bank rate, and widened the spread between low and high quality industrial paper. These developments curtailed banks’ disposition to provide loans and credit to the real economy, constrained productive investment and slowed growth expectations down.
In times of liquidity crisis, central banks have to “keep the discount window open”; they need to provide unlimited access to central bank money. If this is in doubt, bank runs can develop, as witnessed by Northern Rock. The Fed, the ECB and the Bank of England were therefore well advised to provide huge amounts of liquidity to the banking system. The Fed even lowered official interest rates in order to ease banks’ provision of liquidity and to prevent a lasting growth slow-down. However, lower interest rates and massive creation of central bank money is not without risks for inflation.
Few people would subscribe today to the simplistic version of monetarism, whereby increases in money supply will automatically translate into higher prices. The mechanism is more complex. It depends fundamentally on the supply-side on wage and price setting and on the demand side on fiscal policy. If wage bargains keep salary increases below the inflation target and productivity growth, unit labour costs remain consistent with price stability. Lower interest rates will then stimulate real investment and economic growth. However, if fiscal policy is expansive, creating additional demand for public goods without taxing income, prices will rise. Sooner or later higher prices will spill over into wage bargaining and a price-wage spiral will accelerate inflation. At this point the central bank must intervene, raise interest rates and constrain liquidity. Interest rates in the bond market will also shoot up. The subsequent disinflation process will reduce growth, employment and tax income; public debt will increase. It may take a long time until a deeply engrained inflation process is broken up and stability has returned, as the 1980s and 1990s have shown.
By rapidly and decisively tightening monetary policy in response to inflationary pressures, a central bank will minimize the social cost of macroeconomic disequilibria within a given policy environment, because it prevents inflationary expectations to become deeply engrained. However, these costs can be further reduced, if fiscal policy supports the maintenance of low equilibrium interest rates.
Equilibrium interest rates are the yard stick by which firms evaluate the return on investment over the medium term. If they are low, investment projects are profitable and economic growth will expand productive capacities. The opposite occurs, when interest rates are high. Yet, there is a trade-off between monetary and fiscal policy. When the central bank lowers interest rates, governments have to lower deficits in order to preserve equilibrium between aggregate supply and demand. Hence, it is the interaction, the policy mix, of monetary and fiscal policy that determines the perspectives of economic growth. Blaming insufficient growth on only one or the other is an obstacle to better policies.
After the recent banking crisis, a reconsideration of the optimal policy mix is necessary. Taking the liquidity considerations of the banking system seriously requires lower interest rates, either in the short term money market by supplying large amounts of central bank money or by cutting the official rate or both. Fiscal policy must back up this action by consolidating budget deficits. This is a general policy rule that applies to all industrialized economies affected by the banking crisis, although the consolidation in Europe may have to be more moderate than in the US, due to the strength of the euro.
In the Euro Area, the implementation of this policy recommendation is handicapped by institutional shortcomings. The problem is a “collective action problem”, namely the incentive to free-ride on others. What matters for the definition of macroeconomic equilibrium is the aggregate budget position of all governments in the Union. But member states are autonomous in their decisions on fiscal policy. As a consequence, the aggregate policy stance is a random outcome of 13 independent decisions. It is only constrained by the fiscal rules of the excessive deficit procedure in the Maastricht Treaty which stipulates to avoid deficits larger than 3 percent. In principle, the Stability and Growth Pact (SGP) imposes the additional rule to balance all structural (i.e. cyclically adjusted) deficits, but only few member states conform to it. If they would, the equilibrium interest rate would be low. But then, individual member state governments may find it politically less costly to borrow in the capital market than to increase taxes or lower expenditure. Therefore, the European fiscal framework has an inbuilt incentive to violate the SGP. This individually optimal behaviour pushes the equilibrium interest rate for monetary policy up: the European Central Bank must keep interest rates at a higher level, in order to compensate for the excessive demand impulse created by national borrowing. Thus, individually optimizing behaviour by member state governments will have negative consequences for the whole of Euroland, including the citizens in the member state where the government violates the common agreement, for it causes interest rates to be higher than would be desirable for economic growth.
Since the beginning of European monetary union in 1999, several countries have repeatedly caused suboptimal policy mixes for everyone. The latest gross violation is the budget policy imposed by the French President, Nicolas Sarkozy. By contrast, the first budget implemented by the Prodi/Padoa-Schioppa government in 2006 was a contribution to all European (including Italian) citizens’ welfare. Unfortunately, no mechanism exists today, whereby a centralized fiscal policy stance could be defined and implemented at the European level, although different proposals have been made*. A centralized definition and implementation of the aggregate fiscal policy stance would overcome and abolish the free-rider incentive. But more centralized European decision making is only defendable if it is subject to the democratic control by institutions, which represent the interests of the citizens concerned. The so-called reform of the SGP in 2005, which gave member states more autonomy, went in the opposite direction. Recent proposals by some economists of “re-nationalizing” fiscal policy in the sense of weakening even the weak constraints under the excessive deficit procedure and the SGP, would make things even worse. They are not what monetary union requires for its efficient functioning and higher growth. Instead, European fiscal policy needs to become truly European, centralized but democratically controlled. The appropriate response to the financial crisis by policy makers would be to reduce budget deficits in the short run and to create democratic institutions at the European level in the long run.
*See for example Amato, G. 2002. “Verso un DPEF Europeo”; in: NENS No.4 (Nuova Economia Nuova Società), luglio, p.15-19.