Fighting inflation with conventional and unconventional fiscal policy: The case for a new macroeconomic policy assignment

Bofinger, Peter Research Report Fighting inflation with conventional and unconventional fiscal policy: The case for a new macroeconomic policy assignment IMK Study, No. 92 Provided in Cooperation with: Macroeconomic Policy Institute (IMK) at the Hans Boeckler Foundation Suggested Citation: Bofinger, Peter (2024) : Fighting inflation with conventional and unconventional fiscal policy: The case for a new macroeconomic policy assignment, IMK Study, No. 92, HansBöckler-Stiftung, Institut für Makroökonomie und Konjunkturforschung (IMK), Düsseldorf This Version is available at: https://hdl.handle.net/10419/286383 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ STUDY No. 92 • February 2023 • Hans-Böckler-Stiftung FIGHTING INFLATION WITH CONVENTIONAL AND UNCONVENTIONAL FISCAL POLICY: THE CASE FOR A NEW MACROECONOMIC POLICY ASSIGNMENT Peter Bofinger 1 , ABSTRACT The study discusses the distribution of roles between monetary and fiscal policy in stabilising the price level. It questions the view that price level stabilisation should be the sole responsibility of central banks. It argues that there is a case for national governments also being responsible for price stability. The main results are the following: In the case of demand shocks, fiscal policy can react in a more timely and targeted manner than monetary policy. In the case of supply shocks, fiscal policy can shift the Phillips curve by varying indirect taxes, with price brakes and income policies. This is an advantage over monetary policy, which can only influence inflation indirectly by shifting the IS curve. In the recent energy crisis, the effects of this "unconventional fiscal policy" have been assessed quite positively. The case for a price stability mandate for national fiscal policy is particularly strong in the euro area. In the case of national supply and demand shocks in individual countries, the ECB can only provide an insufficient compensation, and its reaction has counterproductive effects in the rest of the monetary union. E.g., with a national price stability mandate, between 2014 and 2016, Germany would have been obliged to stimulate its economies, thereby supporting the ECB's fight against deflation. ————————— 1 University of Würzburg Fighting inflation with conventional and unconventional fiscal policy: The case for a new macroeconomic policy assignment Peter Bofinger University of Würzburg December 2023 Executive Summary For decades, inflation control has been regarded as the domain of central banks. An active role in stabilising the value of money is attributed to fiscal policy only in deflationary phases, when interest rate policy reaches the limits of the "effective lower bound" (ELB). This division of macroeconomic roles is also reflected in the Maastricht Treaty, which gives the European Central Bank sole responsibility for price stability and commits budgetary policy primarily to the objective of a balanced budget. With the wave of inflation triggered by the war in Ukraine, however, this dogma has begun to falter. Not on the basis of new macroeconomic insights, but out of a need to protect households from the huge price hikes, almost all countries have taken various measures to directly reduce inflation. These spontaneous and completely uncoordinated "unconventional fiscal policies" (Dao, Dizioli, Jackson, Gourinchas, & Leigh,2023) are generally seen as quite positive in retrospect. This study takes this innovation in economic policy as an opportunity to fundamentally rethink the widely accepted "assignment" of stabilisation policy. It begins by showing how this division of responsibilities has become established worldwide under the influence of monetarism. "Inflation targeting" by independent central banks became the model for successful monetary policy in the 1990s. Accordingly, during the discussions on the creation of a European Central Bank, there was no doubt that it had to be independent and committed to the objective of price stability. At that time, there was no discussion of the contribution that Member States’ fiscal policies could make to stabilising the price level within the national framework and, ultimately, within the overall system. Historical hindsight shows that there has also been an alternative understanding of roles. In the "functional finance" framework, which goes back to Abba Lerner, fiscal policy is given symmetrical responsibility for fighting unemployment and inflation. Almost identical formulations can be i found in the German Stability and Growth Act of 1967, and US policy at the time also gave fiscal policy a leading role in fighting inflation. The theoretical basis of this study is a simple new Keynesian model (IS/PC/MP model) which can be used to study the stabilisation contribution of monetary and fiscal policy in the presence of demand and supply shocks. In the case of demand shocks, the equivalence of monetary policy and conventional fiscal policy is shown. In this sense, there is no theoretical justification for the primacy of monetary policy in the fight against inflation. Within the framework of the model, it is also possible to illustrate the destabilizing dynamics that arise when the ELB is reached when a shock cannot be offset by fiscal policy. The equivalence of monetary policy and unconventional fiscal policy also holds when responding to supply shocks by changing aggregate demand. However, monetary policy, like conventional fiscal policy, faces the problem of a trade-off, whereby stabilisation of the price level is accompanied by adverse effects on output. This is the innovation of unconventional fiscal policy. Since it can shift the Phillips curve directly, for example by varying indirect taxes, it opens up the possibility of controlling inflation at no cost to output and, at the same time, without affecting inflation expectations in the event of temporary shocks. The equivalence of monetary policy and conventional fiscal policy can be tested beyond the model framework using the criteria of targeting ("targeted") and lagged effects ("timely"). In terms of targeting, fiscal policy has clear advantages as its measures have a direct impact on aggregate demand. Moreover, measures can be differentiated according to target groups. Monetary policy, on the other hand, faces the problem that its measures need to be transmitted through the financial system and that, in the case of aggregate demand, they primarily affect the construction industry. They also tend to have undesirable side effects on the exchange rate, the stability of the financial system, the sustainability of public finances and the distribution of income and wealth. The benefits of fiscal policy in the fight against inflation have been emphasised in recent publications by the International Monetary Fund. ii Monetary policy also does not perform particularly well in terms of transmission lags. The rapid fiscal response of many governments to the COVID pandemic and the impact of the war in Ukraine belies the textbook wisdom that fiscal policy is associated with long decision lags ("inside-lag"). Conversely, monetary policy still has transmission lags of a year or more ("outside-lag"). With regard to the benefits of unconventional fiscal policy presented in the model framework, it is important to bear in mind in practical implementation that it is not easy to tell whether large energy price shocks are permanent or temporary in nature. In the case of a persistent shock, unconventional fiscal policy should not offset the primary effect. However, it can use income policy measures to help mitigate the second-round effects associated with such a shock. An example of a successful measure is the inflation compensation premium adopted by the German government in September 2022. It has helped to dampen collectively agreed wage increases and thus also second-round effects. With regard to the reductions in energy and general excise taxes implemented in many countries, hindsight shows that they were able to make a stabilizing contribution to inflation developments, not least because the price shocks that occurred in 2022 turned out to be less persistent than initially expected. This finding is supported by analysis from both the International Monetary Fund and the European Central Bank. There may be limits to unconventional fiscal policies based on reducing indirect taxes in countries with high debt levels. Here, however, there is the possibility of compensating by increasing direct taxes, which may prove useful anyway, given the demand-enhancing effects of lower indirect taxes. The importance of fiscal policy in fighting inflation, but also in stabilising the price level in general, is particularly evident in the institutional framework of the European Monetary Union. The IS/PC/MP model can be used to describe, for a monetary union, the adverse effects of idiosyncratic shocks on the rest of the currency area. A positive demand shock in one member iii country, which is not offset by national fiscal policy, leads to negative effects in the other member countries. Because of the single nominal interest rate policy, the ECB cannot prevent such disturbances: It can pursue a targeted policy for the currency area average. However, the average then results from the coexistence of too high and too low inflation rates as well as positive and negative output gaps at the member state level. The economic policy implication of this analysis is that, at the current stage of monetary union integration, it would be sensible to commit national fiscal policies to the objective of price stability. With the benefit of hindsight, it can be shown that in this way the overheating in the periphery-countries in the first half of the 2000s could have been detected at an early stage. Similarly, in the years 2014 to 2016, when the ECB’s interest rate policy was at the zero lower bound, there would have been an obligation for most member states to pursue a more expansionary fiscal policy if inflation rates at the national level were well below 2%. Countries with debt-to-GDP ratios above 90%, for example, could have been exempted from such an obligation. Overall, this study shows that there is no theoretical or economic justification for the traditional allocation of roles in stabilisation policy, which assigns monetary policy a primacy in the fight against inflation. Monetary policy instruments have little specificity and long lags in their effectiveness. Finally, central banks are only needed in the fight against inflation if fiscal policy itself is the cause of inflation, as described, for example, in the "Fiscal Theory of the Price Level". Of course, one has to reckon with the fact that, for political-economic reasons, a government may be unable or unwilling to dampen aggregate demand with restrictive policies. But then one must be aware of the fact that stabilization by the central bank is only a "second-best" solution. iv Contents Executive Summary i Contents v List of Figures vii List of Tables viii 1 Introduction 1 2 The changing role of fiscal policy in stabilising the price level 3 2.1 Asymmetric role assignment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 2.2 A Symmetrical policy assignment for fiscal policy . . . . . . . . . . . . . . . . . . 8 2.3 Renaissance through the Unconventional Fiscal Policy . . . . . . . . . . . . . . . . 9 3 A simple macroeconomic model as a theoretical basis 11 3.1 Modeldescription..................................... 12 3.2 Demandshocks...................................... 14 3.3 Supply shocks: the role of unconventional fiscal policy . . . . . . . . . . . . . . . 17 3.4 Fiscalpolicyshocks.................................... 20 4 Limits of equivalence in demand management: side effects and impact delays 22 4.1 Targeting and undesirable side effects ("Targeted") . . . . . . . . . . . . . . . . . . 22 4.2 Insideand outside-lags of stabilisation policies ("Timely") . . . . . . . . . . . . . 27 4.3 Primacy of fiscal policy in fighting inflation . . . . . . . . . . . . . . . . . . . . . . 29 5 Use cases for unconventional fiscal policy 30 5.1 Permanent supply shortage: The problem of second-round effects . . . . . . . . . 30 5.2 Temporary supply shortages: Starting with the primary effect . . . . . . . . . . . 32 5.3 Positive evaluation of unconventional fiscal policy . . . . . . . . . . . . . . . . . . 33 5.4 Limits of unconventional fiscal policy . . . . . . . . . . . . . . . . . . . . . . . . . 34 v 5.5 The best solution: Prevent supply shocks from happening . . . . . . . . . . . . . 35 6 The importance of national fiscal policies for stabilisation in a monetary union 36 6.1 The IS/PC/MP model for a monetary union . . . . . . . . . . . . . . . . . . . . . 37 6.2 Idiosyncratic demand shock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 6.3 Idiosyncratic supply shock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 6.4 Combinedshocks..................................... 42 6.5 The advantages of coordinated national fiscal policies in a monetary union . . . . 44 7 A commitment of national fiscal policies to the objective of price stability 45 7.1 Deviations from the ECB’s inflation target . . . . . . . . . . . . . . . . . . . . . . . 45 7.2 The euro area as an incomplete monetary union . . . . . . . . . . . . . . . . . . . 48 8 Summary 51 References 54 vi 1974, Tz. 416) Even though the monetarist strategy of controlling the money supply was only implemented by the German Bundesbank and the Swiss National Bank in practical monetary policy, there has since been a widespread consensus that the main responsibility for the goal of monetary stability must lie with the central bank. Supported by empirical studies (Alesina & Summers,1993), which showed a negative correlation between monetary policy autonomy and the inflation rate, most economists in the 1990s called for the independence of monetary policy as an essential prerequisite for the realisation of this task. Michael Woodford (2001) has summed up this paradigm as follows: "On one hand, it is often argued that inflation is purely a monetary phenomenon, and hence that only the choice of monetary policy matters for what level of inflation one will have. And on the other, the celebrated "Ricardian equivalence" proposition implies that insofar as consumers have rational expectations, fiscal policy should have no effect upon aggregate demand, and hence no effect upon inflation." This thinking found its way into practical monetary policy with the strategy of "inflation targeting". It was first implemented in 1989 by the Reserve Bank of New Zealand and is currently practised by 45 central banks (IMF,2001). The comparison of inflation forecasts with the inflation target of the central bank is decisive for this. It shows whether it is possible to achieve the inflation target with the path for central bank interest rates expected by the markets (Bofinger,2021). The ECB (2021, p. ) describes this "consensus assignment" (Kirsanova, Leith, & Wren-Lewis, 2009) as follows: "By the end of the last century, a broad agreement emerged in favour of central bank independence with a medium-term price stability objective for the central bank. According to this view, an independent central bank would achieve price stability over the medium term by setting short-term interest rates. Fiscal policy would provide automatic business cycle stabilisers (such as unemployment benefits), fulfil other social efficiency and equity objectives, 5 and keep public debt stable. There would be little role for discretionary, countercyclical fiscal policy." The asymmetrical policy assignment of roles also characterises the Maastricht Treaty, developed in the early 1990s, which enshrines the ECB’s commitment to the objective of monetary stability and, at the same time, its political independence as the cornerstone of the European Monetary Union. Article 127 TFEU reads as follows: "The primary objective of the European System of Central Banks (hereinafter referred to as the ESCB) shall be to maintain price stability."2 In contrast, a responsibility of national fiscal policies for price stability is addressed only indirectly. Article 120 TFEU states: "Member States shall conduct their economic policies with a view to contributing to the achievement of the objectives of the Union, as defined in Article 3 of the Treaty on European Union, and in the context of the broad guidelines referred to in Article 121(2)."3 Article 3 of the Treaty on European Union specifies these objectives as follows: "The Union shall establish an internal market. It shall work for the sustainable development of Europe based on balanced economic growth and price stability, (...)".4 The fiscal policies of the euro area member states are thus primarily governed by the 1997 Stability and Growth Pact, which essentially limits the task of national budgetary policy to the goal of budgetary discipline: "Whereas adherence to the medium-term objective of budgetary positions close to balance or in surplus will allow Member States to deal with normal cyclical fluctuations while keeping the government deficit within the 3% of GDP reference value." (Article 4)5 The authors of the Stability and Growth Pact were not aware that there could be limits for the macroeconomic stabilization by monetary policy: 2Article 127 TFEU 3Article 120 TFEU 4Article 3, Treaty on European Union 5Article 4, Stability and Growth Pact 6 "The SGP is not designed to support monetary policy in a lower bound environment in which monetary and fiscal policies can become strategic complements rather than substitutes." (ECB, 2021, p. 59) Accordingly, there is a lack of institutional arrangements for the one stability policy responsibility of national fiscal policies: "Mechanisms supporting the explicit coordination of discretionary monetary and fiscal policymaking were not foreseen, as the optimal contribution of fiscal policy to macroeconomic stabilisation was thought to follow from allowing automatic stabilisers to operate freely and symmetrically over the cycle." (ECB,2021, p. 29) Subsequently, the idea that national fiscal policies could also bear a responsibility for the goal of monetary stability has not played a role in economic policy discourses. This is most evident in the "macroeconomic imbalance procedure" introduced in 2011. Its function is "to identify, prevent and correct potentially harmful macroeconomic imbalances that could affect the economic stability of a particular EU country, the euro area or the EU as a whole" (European Commission,2023). Specifically, 14 macroeconomic indicators are used for this purpose. However, the inflation trend is not taken into account, as no other variable is able to signal a macroeconomic imbalance. Reaching the zero interest rate limit in the monetary policy of the Federal Reserve and the ECB at least led to the recognition of the necessity of fiscal policy in the fight against deflation: "Fiscal policy, in conjunction with monetary policy, can have a more significant impact on the economy precisely when the effectiveness of monetary policy alone may be constrained by the lower bound. A rise in government consumption or investment, a consumption tax cut or an increase in government transfers are likely to have larger multiplier effects near the lower bound than further away from it. Such fiscal interventions may be expected to raise aggregate demand, output and inflation to some extent, under any circumstances." (ECB,2021, p. 7) 7 2.2 A Symmetrical policy assignment for fiscal policy With the dominance of the asymmetrical assignment of roles of fiscal and monetary policy, however, one could always find economists who advocated a symmetrical assignment for fiscal policy. This idea is particularly clear in concept of "functional finance" by Abba Lerner (1943, p. 39): "The first financial responsibility of the government (since nobody else can undertake that responsibility; my emphasis PB) is to keep the total rate of spending in the country on goods and services neither greater nor less than that rate which at the current prices would buy all the goods that it is possible to produce. If total spending is allowed to go above this there will be inflation, and if it is allowed to go below this there will be unemployment. The government can increase total spending by spending more itself or by reducing taxes so that the taxpayers have more money left to spend. It can reduce total spending by spending less itself or by raising taxes so that taxpayers have less money left to spend. By these means total spending can be kept at the required level, where it will enough the buy goods that can be produced by all who want to work, and yet not enough to bring inflation by demanding (at current prices) more than can produced." It is characteristic of this symmetrical assignment of roles to fiscal policy that monetary policy in "functional finance" is only assigned an accommodative role in combating underemployment: "In applying this first law of Functional Finance, the government may find itself (...) spending more than it collects in taxes." In this case, "it would have to provide the difference by borrowing or printing money." (Lerner,1943, p. 40) In the period after the Second World War, the symmetrical assignment initially still played an important role in economic policy thinking. E.g. Fritz Neumark (1962, p. 185), a renowned German economist at that time stated: "(...) applied fiscal policy aims at controlling both inflation and deflation." Accordingly, the German "Act to Promote the Stability and Growth of the Economy" of 1967, § 1 contains a formulation that largely coincides with Lerner’s statements on "functional finance": 8 "The Federal Government and the states shall observe the requirements of macroeconomic equilibrium in their economic and financial policy measures. The measures shall be taken in such a way that, within the framework of the market economy, they contribute at the same time to the stability of the price level, to a high level of employment and to external equilibrium with steady and adequate economic growth".6 This role assignment was probably shaped not least by the fact that Germany had been involved in the Bretton Woods fixed exchange rate system at the time. In this monetary arrangement, the Bundesbank’s room for manoeuvre in terms of stabilisation policy was very limited. However, a symmetrical fiscal role assignment is also found at the same time in the United States, which would have had sufficient room for manoeuvre in monetary policy due to its dominant role in this fixed exchange rate system. Thus, the Economic Report of the President from 1968 states: "After a hard look at the alternatives, it has been and remains the conviction of both the Administration and the Federal Reserve System that the Nation should depend on fiscal policy, not monetary policy, to carry the main burden of the additional restraint on the growth of demand that now appears necessary." (Council of Economic Advisors,1968, p. 83ff) (Council of Economic Advisors 1968) As Blinder (2023) reports, there has been no subsequent use of fiscal policy as an inflation-fighting tool in economic history. 2.3 Renaissance through the Unconventional Fiscal Policy A renaissance of the symmetrical allocation of roles to fiscal policy occurred with the wave of inflation at the beginning of the 2020s, which was mainly due to the energy price shock triggered by the Ukraine war, but also to overly expansive compensation for the COVID shock in the United States. In an effort to prevent the full impact of the rise in energy prices from being 6German "Act to Promote the Stability and Growth of the Economy" of 1967 9 passed on to private households and companies, almost all countries have taken a variety of compensatory measures. GBR FRA SVK AUT GRC LTU POL ROU ITA HRV NLD LVA PRT TUR DEU Average LUX CZE NOR EST BEL SVN SWE ESP IRL CYP HUN FIN BGR DNK ISR ISL MNE AND 0 1 2 3 4 5 Percent of GDP Total Targeted/ Non-distortionary Untargeted/ Non-distortionary Targeted/ Distortionary Untargeted/ Distortionary Figure 1: Fiscal Costs of Household Support Measures in 2022 and 2023. (Source: Amaglobeli et al. (2023)). As the chart based on calculations by the International Monetary Fund (Amaglobeli et al.,2023) makes clear, the measures can be divided into "non-distortionary" and "distortionary", whereby the former are income transfers that have no influence on the price system and the latter are interventions that have a direct impact on the prices of certain energy sources and thus on the inflation rate. On average, the countries show a clear dominance of measures with price effects that also benefit all population groups ("non-targeted"). It is remarkable that in Germany the share of non-targeted measures is far above average. For the euro area, the ECB (2023) estimates that roughly half of the fiscal support was used for measures to directly influence prices and half for direct transfers. The instruments used were mainly indirect taxes and subsidies. In line with the traditional paradigm, European economists surveyed by the Chicago Booth in June 2022 were mostly negative about these measures. They were of the opinion that it would be 10 better to raise interest rates. 7 The Scientific Advisory Council at the Federal Ministry of Finance expressed a similar opinion in a statement dated 23 August 2023: "Fiscal policy should not try to influence price developments by lowering indirect taxes." (BMF Scientific Advisory Council,2023, p. 16) It reflects the traditional view that fiscal measures that aim to curb inflation are labelled as "unconventional fiscal policy" (Dao et al.,2023). But it becomes clear that the conventional asymmetric role assignment, according to which monetary policy alone is responsible for price stability, needs to be reconsidered. The problem here is that there is comparatively little theoretical and empirical literature on the subject. On the one hand, this is due to the fact that the developed economies had not been confronted with any major inflation problems in the past decades ("Great Moderation"). Rather, in the 2010s, the risk of deflation was at the centre of the discussion. On the other hand, the discussion on fiscal policy has been so strongly influenced by the perspective of underemployment that the potential for fighting inflation has not received more attention. A current example of this is the book by Blanchard (2023), in which "functional finance" is only discussed for full employment policy. 3 A simple macroeconomic model as a theoretical basis It is therefore first necessary to create a theoretical basis for the macroeconomic role assignment to monetary and fiscal policy. A simple New Keynesian IS/PC/MP model developed by Bofinger, Mayer, and Wollmershäuser (2006) is suitable for this purpose. It consists of three elements: • an IS curve dependent on the real interest rate, • a Phillips curve extended by expectations and • a description of the behaviour of the central bank (MP), which either pursues an optimal policy by being guided by a macroeconomic loss function, or is guided by a rule, such as 7 The question was: "Fiscal measures putting a cap on consumer energy prices would be a more appropriate immediate response to increased inflation in the euro area than raising interest rates." Chicago Booth (2023) 11 the Taylor rule in particular. The main difference of this type of model compared to other simple macroeconomic models is that it is based on the real interest rate (Romer,2000), whereas the IS/LM model and the AS/AD model were formulated for the nominal interest rate. 8 We will show below that the use of the real interest rate offers considerable analytical advantages both for the case of a deflationary shock and for mapping macroeconomic interdependencies in a monetary union. Moreover, the model maps the inflation rate, whereas traditional macroeconomic models operate with the price level. Finally, the model explicitly deals with supply and demand shocks. 3.1 Model description The IS curve can be mapped with the following equation: y=a−b·r+g+ε1(1) A negative functional relationship is assumed between the output gap and the real interest rate ( r ), which is described by the parameter b . This can be derived from an Euler equation, but also from a simple Keynesian investment function. Fiscal policy is represented in simplified form by the factor g , which can be interpreted as the percentage deviation of government spending from a neutral level. Demand shocks can be represented with ε1 . The parameter a is an unspecified constant. The second building block of the model is an expectations-augmented Phillips curve: π=πe+d·y+ε2(2) Accordingly, the inflation rate is determined by inflation expectations πe , the output gap y and a supply shock ε2 . For the sake of simplicity, it is assumed that the central bank is credible. Therefore, inflation expectations πe correspond to the central bank’s inflation target π0 . It is assumed that supply shocks have no effect on aggregate demand. 8As these models are formulated for a stable price level, the nominal rate is identical wit the real rate. 12 Unconventional fiscal policy can be included in the model with a variable h which is zero in normal times. In the case of positive supply shocks, it can take on a negative value, for example, as fiscal policy reduces VAT. π=π0+d·y+h+ε2(3) The behaviour of the central bank is mapped with the concept of the macroeconomic loss function, which was developed by Svensson (2003). L= (π−π0)2+λ·y2, withλ ≥0(4) The parameter λ describes the relative preference of the central bank for the inflation gap and the output gap. At λ= 0 the central bank pursues strict "inflation targeting", as it does not take output costs into account in its policy. For values of λ > 0 , Svensson speaks of "flexible inflation targeting". Inserting the Phillips curve into the loss function and minimizing it to y , one gets the optimal output gap: yopt =−d (d2+λ)·(ε2−h)(5) Inserting it into the Phillips curve, one gets the optimal inflation rate: πopt =π0+λ (d2+λ)·(ε2−h)(6) Since both equations do not include ε1 , one can already see that demand shocks can be perfectly compensated for in this model framework. Substituting the optimal output gap into the IS equation yields the central bank’s optimal real interest rate: 13 ropt =a b+1 b·(ε1+g) + d b·(d2+λ)·(ε2+h)(7) Provided that fiscal policy behaves passively (i.e. g and h= 0 ), the optimal real interest rate results from one of the components a b , which can be interpreted as a neutral interest rate in the sense of r-star (Laubach & Williams,2003). The central bank reacts to both demand shock ( ε1 ) and supply shock ( ε2 ). At the same time, the equation illustrates that the central bank can behave passively if fiscal policy reacts to the demand shock with government spending and to the supply shock with unconventional fiscal policy. 3.2 Demand shocks In the case of demand shocks, this model shows an equivalence of monetary policy and fiscal policy in macroeconomic stabilisation. In the case of a positive shock, the IS curve shifts upwards. This leads to a positive output gap. In the π/y diagram, the Phillips curve yields an inflation rate that is above the central bank’s inflation target. As equations for Yopt and πopt show, this shock can be perfectly compensated. • Monetary policy can realise a point on the new IS curve that closes the output gap through higher real interest rates. • Fiscal policy can shift the IS curve back to its initial position through lower government spending. In this simple model framework, it does not matter whether the shock is compensated by fiscal policy directly via a variation of g (figure 2, right), or indirectly by the central bank via an interest rate reaction when g= 0 (figure 2, left). From this point of view, monetary policy and fiscal policy can be used in the same way to fight inflation. 14 (figure 7). 2017-12 2018-12 2019-12 2020-12 2021-12 2022-12 100 105 110 115 120 125 130 Index: 2018Q1=100 Euro area United States Figure 7: Household Disposable Income (Index: 2018Q1=100). (Source: FRED St. Louis FED, Eurostat). The inflationary effects of these measures are illustrated by an analysis by Di Giovanni, KalemliÖzcan, Silva, and Yildirim (2023, p. 1): "Our baseline results show that over the Dec19-Jun22 period, aggregate demand shocks explained roughly two-thirds of total model-based inflation, and that the fiscal stimulus contributed half or more of the total aggregate demand effect." In the model framework used here, such a fiscal policy would be depicted as g > 0 . From the perspective of monetary policy, this is then an inflationary demand shock, which would require a similar interest rate policy response as with ε1>0 . In principle, in this model framework the central bank is able to compensate for all expansionary fiscal shocks with an oppositely directed restrictive interest rate policy. Such fiscal shocks are the essential justification for an independent central bank. If the state’s fiscal policy comes into conflict with monetary policy, it must inevitably lose out, since, unlike the ZLB, there is no upper limit for the real interest rate. For a detailed analysis of the interaction of monetary and fiscal policy, see Bofinger and Mayer (2007). 21 4 Limits of equivalence in demand management: side effects and impact delays The simple model analysis leads to the conclusion that monetary policy and conventional fiscal policy are equally capable of controlling the inflation rate via aggregate demand, provided that the central bank does not hit the ZLB. However, if one goes beyond this model framework, substantial differences in the use of the two policies can be identified. These become clear if one takes as a criterion the generally accepted rule that stabilisation policy measures should be "timely, targeted and temporary" (ECB,2009). The differences mainly concern the targeting and the time lags of the measures used. 4.1 Targeting and undesirable side effects ("Targeted") It has become clear from the model structure that fiscal policy can directly influence aggregate demand, while conventional monetary policy can only do so indirectly via the interest rate mechanism. The COVID pandemic and the Ukraine crisis have illustrated how fiscal policy can directly and specifically control aggregate demand (IS curve) and the PC curve with a variety of conventional and unconventional measures. In Germany, for example, the purchasing power of private households was stabilised with direct transfers (such as the energy price flat rate and short-time allowance) and hybrid measures (gas price brake). Tax measures (e.g. the expansion of the loss carryback) and lump-sum transfers supported businesses during the pandemic. As part of the unconventional fiscal policy, indirect taxes were eliminated (EEG levy) or reduced (VAT on gas). The advantages of fiscal policy over monetary policy in terms of calibration are also emphasised by the International Monetary Fund: "Different fiscal policies can be calibrated and used to support the disinflation effort while mitigating the increase in poverty and income inequality at the same time. Monetary policy 22 does not have the mandate to address income inequality, nor can it be targeted in the way that fiscal policy can." (IMF,2023, p. 37) These advantages of fiscal policy can also be shown in macroeconomic models: "Fiscal policymakers are able, in principle, to design policies that target a specific subset of households or firms. As an example, macroeconomic models with heterogeneous agents suggest that the effects on aggregate demand of a budgetary transfer policy are likely to be greater if the transfer targets households that have a high marginal propensity to consume." (ECB,2021, p. 8) Compared to fiscal policy, the effects of monetary policy are thus undifferentiated and associated with major side effects. This is due to the fact that the central banks basically only have the transmission channel of short-term and, in the case of bond purchases, also longer-term interest rates. The transmission is indirect as it affects the real economy mainly via the financial system (chart). Domestic prices Wage and pricesetting Bank rate Money market interest rates Money and credit Price developments Asset prices and risk premia Exchange rate Shocks outside the control of the central bank Changes in risk preferences Changes in the global economy Changes in fiscal policy Changes in commodity prices Stage 1: Transmission through financial markets Stage 2: Transmission to the real economy Expectations Import prices Supply and demand in goods and labour markets Figure 8: Transmission process of monetary policy. Source: based on Mann (2023) 23 Theoretically, the transmission process can be accelerated via expectation effects, but the empirical evidence for this channel is low. "(...) the bulk of the evidence does not support the notion that changes in monetary policy directly affect household or firm inflation expectations in a systematic wayover and above any impact on actual inflation and activity." (Bandera, Barnes, Chavaz, Tenreyro, & von dem Berge,2023, p. 26) (Tenreyro 2023) Catherine Mann, a member of the Monetary Policy Committee of the Bank of England, therefore describes the effectiveness of monetary policy as follows: "Monetary policy is a relatively blunt instrument and works mostly at the margin, it is ill-equipped and not intended to deal with large relative price movements like the one we’re seeing currently. We do not have in our toolkit the policies that can cushion the blow for those in need or that can spread the weight across time and across the income distribution..." Mann (2022) In theoretical models, the influence of interest rates on consumption decisions plays a central role. In reality, however, it turns out that there is no empirical evidence for the Euler equation that depicts this relationship. For an overview, see Ascari, Magnusson, and Mavroeidis (2021, p. 131): "Yet, numerous studies have pointed out that the baseline Euler equation model does not fit the aggregate consumption data well. First, (...) aggregate consumption appears unresponsive to the real interest rate. In other words, the estimated EIS in consumption is very low for the standard specification of the Euler equation. Havránek (2015) conducted a meta-analysis on 169 published studies and concluded that the average estimate of the EIS [elasticity of intertemporal substitution; PB] in aggregate data is zero, once corrected for publication bias." With regard to the effects on bank lending, the problem arises that in most countries a large proportion of bank loans are granted for the real estate sector: "The share of mortgage loans in banks’ total lending portfolios has roughly doubled over the course of the past century-from about 30% in 1900 to about 60% today." (Jordà, Schularick, & Taylor,2016, p. 110) 24 As can also be seen in the current restrictive phase, interest rate policy measures thus primarily affect overall economic demand via the real estate sector. The problem with monetary policy transmission is not only the indirect effects of restrictive interest rate policy measures, but also the associated undesirable side effects. • Higher interest rates tend to lead to an appreciation of the domestic currency. This effect can be desirable because the appreciation dampens inflation (Mann,2023). But it can also be undesirable if the international competitiveness of domestic industry suffers as a result. • Higher interest rates can threaten the stability of the domestic banking system, especially if, as is currently the case in the euro area, they follow a long period of very low interest rates during which banks have engaged in a high degree of maturity transformation. • Higher interest rates also have a negative impact on the sustainability of public finances. This is especially true for countries that have a high public debt ratio. • Higher interest rates also have undesirable effects on income distribution via higher interest rates for smaller businesses and due to the fact that low-income households hold fewer interest-bearing assets (Alfaro, Faia, & Minoiu,2022) Adrian and Gaspar (2022) have examined these different effects of monetary and fiscal stabilisation in a study. They show that both approaches lead to similar effects on the inflation rate and economic growth. • However, with monetary stabilisation, higher interest rates lead to rising public debt and currency appreciation. • In the case of fiscal stabilisation, the direct negative demand effects have the advantage that no increase in interest rates is required. The currency depreciates. With lower interest rates and a lower primary deficit, public debt falls. The decline in inflation is somewhat smaller because of the devaluation. Adrian and Gaspar (2022) point out, however, that this effect could be reduced if more countries were to follow this approach. 25 Figure 9: Curbing inflation. Source: Adrian and Gaspar (2022) Adrian and Gaspar (2022) point to the problems caused by the anti-inflationary policy of the United States in 1980/81 under Federal Reserve Chairman Paul Volcker as a negative example. The sharp rise in interest rates led to a collapse of the real estate market and a historically unique appreciation of the US dollar. Since industry was hit very hard by this, there were calls for trade restrictions. The two authors conclude: "That historical episode is relevant for many countries facing similar challenges today. A more balanced removal of policy stimulus, including fiscal restraint, can reduce the risk that some parts of the economy – especially those most sensitive to interest rates – experience disproportionate effects, or that large swings in the currency heighten trade tensions." (Adrian & Gaspar,2022) 26 4.2 Insideand outside-lags of stabilisation policies ("Timely") In assessing the effectiveness of monetary and fiscal policy in combating inflation, it is not only the accuracy of targeting that is crucial but also the lags in the effects of the stabilisation policy measures. A distinction is usually made between inside lag and outside lag: • Inside-lag describes the time lag between the occurrence of a shock and the decision to take an economic policy measure to avert it. • Outside-lag is the time lag between the adoption of an economic policy measure and its effect on the shock. Despite the great importance of this topic for economic policy, there is hardly any recent literature on it. Traditionally, one disadvantage of fiscal policy is that it has a long inside-lag. For example, Mankiw (2019, p. 473) writes: "A long inside lag is a crucial problem with using fiscal policy for economic stabilization. This is especially true for the United States, where changes in spending or taxes require the approval of the President and both houses of Congress. The slow and cumbersome legislative process often leads to delays, making fiscal policy an imprecise tool for stabilizing the economy." However, the COVID pandemic and the Ukraine crisis have shown that fiscal policy can react very quickly in an emergency. In Germany, the so-called "Bazooka", a comprehensive package of fiscal measures as a protective shield for the economy, was already passed in March 2020. On 27 March 2020, the US government passed the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), a stimulus programme worth 2.2 trillion US dollars. Monetary policy has the advantage that it can make quick decisions, so that the inside-lag is low. However, due to the only indirect influence on aggregate demand, the outside-lag is relatively long compared to fiscal policy, which can directly control demand (Dupor,2023). Milton Friedman (1961, p. 87) formulated this as follows: 27 "There is much evidence that monetary changes have their effect only after a considerable lag and over a long period and that the lag is rather variable." Mann (2023) assumes a monetary policy lag of 18 to 24 months. Model analyses by the ECB (Lane,2023) show, depending on the model, impact lags of around one year to more than two years. Figure 10: Model analysis for output deviations. Source: Lane (2023) In an extreme crisis situation, the possibilities of monetary policy are limited by the fact that in the case of great uncertainty, as was the case during the COVID pandemic and the outbreak of war in the Ukraine, even very low interest rates can only provide a limited stimulus for new investments. This could be represented in the IS/PC/MP model by a temporary decline in the parameter b in the IS curve, which would then be very steep, i.e. with a low interest rate elasticity. The central bank would then very quickly hit the ELB with interest rate policy. The necessity of fiscal policy in crisis situations is also emphasised by the ECB (2021, p. 67): "Fiscal policy is the most suitable instrument for addressing the detrimental impact of the pandemic on the economy." 28 4.3 Primacy of fiscal policy in fighting inflation Unless fiscal policy is itself the cause of a positive demand shock, the lags and side effects of monetary policy clearly argue for assigning fiscal policy a leading role in fighting inflation in the case of demand shocks as well as supply shocks. The IMF (2023, p. 40) comes to a similar overall conclusion in its analysis of the stability policy role of fiscal policy: "To summarize, a generalized fiscal contraction helps contain inflation, with a smaller drop in private consumption than in the monetary policy scenario, but its impact favors higher-income groups at the expense of the lower-income groups. These adverse distributional effects can be remedied if the fiscal contraction is accompanied by a targeted transfer program." However, it is not guaranteed that fiscal policy can also fulfil this task. The measures required for this, such as tax increases, are not very popular and therefore not always easy to implement politically. This is where the political-economic advantage of an independent central bank lies. However, one must be aware of the fact that inflation control by the central bank is always a "second-best" solution. In any case, the advantages of fiscal policy in fighting inflation call for more coordination between fiscal and monetary policy. Central bank independence does not mean that monetary policy is conducted in an autistic way. A positive example for such cooperation is provided by the Bank of Canada: "Finally, recognizing the limits of monetary policy, the Government and the Bank also acknowledge their joint responsibility for achieving the inflation target and promoting maximum sustainable employment." Joint Statement of the Government of Canada and the Bank of Canada (2022) on the Renewal of the Monetary Policy Framework, December 13, 2021. 29 5 Use cases for unconventional fiscal policy Unconventional fiscal policy did not emerge from the drawing board of macroeconomic theories and analyses. Rather, it is a child of the hardship triggered by the sharp rise in energy prices in the wake of the Ukraine war. In section 3, we have therefore first presented a simple theoretical model framework to show what its advantages are in fighting inflation compared to monetary policy and conventional fiscal policy. For a more comprehensive analysis, it is necessary to specify the supply shock more precisely in order to develop the fiscal therapy that fits it. Since the first oil crisis in 1973/74, supply shocks have primarily involved an abrupt increase in the price of oil or, as in the course of the war in Ukraine, of energy sources in general. The response of stabilisation policy depends on whether the price increase is permanent or transitory. The problem for economic policy is that it is difficult to distinguish ex ante between temporary and persistent shocks (Dao et al.,2023). 5.1 Permanent supply shortage: The problem of second-round effects If the cause of higher prices is a permanent shortage of supply, the primary effect on the inflation rate should in principle be compensated neither by monetary policy nor by fiscal policy. Ideally, the shock would result in a jump in the general price level. The inflation rate would rise year-on-year for twelve months, only to fall back to the previous trend. This is referred to as a "looking through" policy (Schnabel,2022). However, experience shows that in practice it is not possible to isolate the effects of such shocks. The rise in the inflation rate usually leads to a demand from employees for at least partial compensation in wage settlements. Such a "second-round effect" can then lead to inflation expectations and inflation above the central bank’s target due to rising unit labour costs. This in turn creates the need for the central bank to slow down the economy with a restrictive monetary policy. 30 6.1 The IS/PC/MP model for a monetary union The problems that arise when national fiscal policies behave passively in terms of stabilisation policy can again be illustrated with the IS/PC/MP model, which must be extended accordingly for this purpose. We assume that the monetary union consists of two countries of equal size (country A and country B). For each country, the IS curve and the PC curve can be formulated as follows: yA=a−b·rA+gA+ε1,A =a−b·(iopt −πA) + gA+ε1,A (10) πA=π0+d·yA+hA+ε2,A (11) yB=a−b·rB+gB+ε1,B =a−b·(iopt −πB) + gB+ε1,B (12) πB=π0+d·yB+hB+ε2,B (13) The decisive factor here is that a uniform nominal interest rate applies in the monetary union, so that the real interest rate for the individual countries results from the difference between the optimal nominal interest rate determined by the central bank and the national inflation rates. Nothing fundamental changes for the central bank in the monetary union. As described above, it determines the optimal real interest rate according to the aggregate demand and supply shocks: ropt =a b+1 b·(ε1+g) + d b·(d2+λ)·(ε2+h)(14) The optimal nominal interest rate for the monetary union is obtained by adding the inflation rate to the optimal real interest rate: 37 iopt =ropt +π(15) The macroeconomic interdependencies existing in a monetary union can be discussed by analysing the effects of national demand and supply shocks in this model framework. For this purpose, we describe the model with concrete values for the individual parameters: a= 1.2; b= 0.4; d= 1; π0= 2; λ= 1 (16) The initial situation is characterized by: ropt = 3 and iopt =ropt +π0= 3 + 2 = 5 (17) y=yA=yB= 0 (18) π=π0=πA=πB= 2 (19) 6.2 Idiosyncratic demand shock For an idiosyncratic demand shock, we assume that there is a positive demand shock in country Aof εA,1= 0.8 . This shifts the IS curve in country A and the aggregate IS curve for the monetary union upwards. The ECB reacts to this shock according to equation 14 and raises the real interest rate from 3% to 4%. The central bank is thus able to compensate perfectly for the shock: the negative output gap is closed and the inflation rate in the currency area is back at 2%. The nominal interest rate, which applies to both countries, rises from 5% to 6%. The increase in the nominal interest rate leads to different adjustments in the two countries. In country A, the combination of the IS curve and the PC curve results in a positive output gap of 0.67%. From the PC curve, this results in an inflation rate of 2.67%. With a nominal interest rate 38 of 6%, the real interest rate for country A is thus 3.33%. As a result, the ECB’s interest rate hike does have a dampening effect on aggregate demand in country A. However, it is insufficient to bring about perfect stabilisation. For country B, the shock in country A has deflationary effects. It is confronted with a higher real interest rate, which has a negative impact on aggregate demand. The assumptions made here result in a negative output gap of - 0.67. The inflation rate falls to 1.33% and with a nominal interest rate of 6% the real interest rate rises to 4.67%. As a result, the insufficiently compensated demand shock in country A leads to a recession in country B. With a passive fiscal policy in country A, such a negative transmission of a shock in a monetary union is unavoidable, since the central bank with its uniform interest rate policy can only deal with the aggregate shock confronting the monetary union. For this reason, the discussion on optimal currency areas emphasises the necessity of shocks that are as closely correlated as possible among the participating countries of a monetary union (Eichengreen,1991). The problem of a unified monetary policy in the face of idiosyncratic shocks becomes clear when describing the example of the loss function discussed here earlier: L= (π−π0)2+λ·y2, withλ ≥0.(20) For the euro area as a whole, there is neither an inflation gap nor an output gap. The central bank has achieved the "bliss point" characterized by a loss of L= 0 . However, in the two Member States, an output gap of +0.67 and −0.67 and an inflation gap of also +0.67 and −0.67 result in a loss of 7.58 each. This would also be the average loss for the monetary union. 39 ! " #$ !!"# = 3 $$= 0 $$= 0 $$= 0 ! ! ! ! ! ! && & $ $ $ $ $ $ $ $ $ '( '( '( ! %= 3 1 3 !&= 4 2 3!!"# = 4 $ = + 2 3$ = − 2 3 $ = 0 ./$,% ./$,& ./$,() ./$,% ./$,& ./$,() ./*,% ./*,() &%= 2 2 3 &&= 1 1 3 &() = &$= 2 Figure 13: IS-MP-PC multi-country demand shock. Negative transmission can be avoided if fiscal policy in country A is willing to compensate for the shock by a restrictive fiscal policy, by varying g, e.g. by reducing public spending. In Chart 13, this would lead to a shift of the IS curve back to its initial position. In this case, there would be no impact of the national demand shock on the overall system and thus on uninvolved Member States. This reaction is not self-evident, since the impact on country B is a negative external effect from country A’s point of view and its stabilization effort implies positive externalities. This problem is also seen by the ECB (2021, p. 17): "(...) relative to a cooperative benchmark, the fiscal stabilisation efforts of member countries in a monetary union will be sub-optimally aligned (demand externality). Once again, this outcome is supported by an externality as changes in aggregate demand via variations of fiscal policy are decided and funded at country level, while the associated benefits are enjoyed partly by other countries, and are transmitted via spillovers in integrated markets." 40 6.3 Idiosyncratic supply shock For the idiosyncratic supply shock, we assume a negative supply shock in country B triggered, for example, by a wage moderation ( ε2,A =−0.8 ). The central bank’s reaction is again derived from equation 14: it lowers the real interest rate from 3% to 2.5% for the entire currency area. Since the supply shock cannot be perfectly compensated, the inflation rate falls to 1.8% . The common nominal interest rate for the currency area thus falls from 5% to 4.3% . There is a positive output gap of 0.2% For country B, this results in a slightly negative output gap of −0.07% and an inflation rate of 1.13% . The real interest rate is 3.17% . Again, there is a negative transmission to country A. Due to the falling nominal interest rate in the entire currency area, the inflation rate in country A increases to 2.47% and there is a positive output gap of 0.47% . Deflation in country A thus generates inflation in country B. ! " #$ !!"# = 3 $$= 0 $$= 0 $$= 0 ! ! ! ! ! ! && & $ $ $ $ $ $ $ $ $ '($,% '( '($,() ! %= 3,17 !&= 1.83 !!"# = 2.5 $ = −0.07 $ = +0.47 $!"# = +0.2 ./%./&./() ./%./&./() &%= 1.13 '(*,% '(*,() &!"# = 1.8 &&= 2.47 Figure 14: IS-MP-PC multi-country supply shock. 41 If the negative supply shock in country B were triggered by an energy price shock in that country, an unconventional fiscal policy, for example in the form of a temporary increase in energy taxes, would be the appropriate solution. This could compensate for the shift in the PC curve. Intervention by the common central bank would not be necessary. This would of course also apply in the case of a positive supply shock (ε2,A >0) with the opposite sign. 6.4 Combined shocks This simple model framework can also be used to simulate combined shocks. For example, in the early years of the European Monetary Union there was a prolonged divergence of national inflation rates (Angeloni & Ehrmann,2004). 1998-10 1999-10 2000-10 2001-10 2002-10 2003-10 2004-10 2005-10 2006-10 2007-10 0 1 2 3 4Euro area Germany Spain ECB Inflation Target Figure 15: HICP inflation 1999 - 2007. Source: ECB Statistical Data Warehouse. The reason for this can be attributed to the juxtaposition of a positive demand shock in the periphery countries, driven by a real estate bubble, with a negative supply shock in Germany due to wage moderation at the time (Bofinger,2015). The amplification of the positive demand shock by the German wage moderation can be seen if one first determines the values for the isolated demand shock in country A and then compares 42 them with those for the combined shock (table 2). Since the ECB reacts to the wage moderation (country B) with a lower real interest rate, the economic overheating in country A is amplified. Initial situation Demand shock Country A Supply shock Country B Monetary union Nominal interest rate 5.0 6.0 5.3 Real interest rate 3.0 4.0 3.5 Output gap 0.0 0.0 0.2 Inflation rate 2.0 2.0 1.8 Loss 0.0 0.0 0.08 Country A Nominal interest rate 5.0 6.0 5.3 Real interest rate 3.0 3.33 2.7 Output gap 0.0 0.66 1.1 Inflation rate 3.0 2.66 3.1 Loss 0.0 0.82 2.42 Country B Nominal interest rate 5.0 6.0 5.3 Real interest rate 3.0 4.66 4.8 Output gap 0.0 -0.66 -0.7 Inflation rate 2.0 1.33 0.5 Loss 0.0 0.82 2.74 Table 2: German wage moderation simulation in the IS-MP-PC model. Again, the comparison of the national loss functions with the aggregate loss function is of interest. For the currency area, the combination of demand shock and supply shock results in a loss of 0.08 , for country A it is 2.02 and for country B 2.74 . The average loss of 2.58 is thus considerably higher than the aggregate one of only 0.08. Since it can be assumed that the economic costs of inflation and unemployment are not experienced at the aggregate but at the national level, one should orient oneself to the average of the national loss functions and not the aggregate loss function. Therefore, the ECB’s ability to achieve its inflation target even with uncoordinated fiscal policies in the aggregate does not argue against coordinating fiscal policies: "In unconstrained environments, in which short-term policy rates are set by the central bank 43 sufficiently far away from the lower bound, the single monetary policy may be able to achieve its price stability objective even if the cyclical fiscal stance of countries is not coordinated and debt levels may show significant, but sustainable, differences." ECB (2021, p. 17) 6.5 The advantages of coordinated national fiscal policies in a monetary union An analysis by the ECB (2021) shows that national fiscal policies have often been pro-cyclical. Over the entire lifetime of the monetary union, pro-cyclical policies were consistently pursued in at least one third of the euro area (figure 16). Pro-cyclicality was particularly pronounced in the early years of the euro, during the euro crisis and in the second half of the 2010s. ECB Occasional Paper Series No 273 / September 2021 39 supported growth, the share of procyclical fiscal policies was even higher. This asymmetry in the fiscal stabilisation of the business cycle also showed up in the (lack of) compliance with the common fiscal rules, which is shown by a rise in the (GDPweighted) share of euro area countries subject to an excessive deficit procedure and by the very low share of countries with a balanced budget in structural terms or which meet their medium-term budgetary objective before 2008 (see Chart 3, panel b). An important premise in the architecture of EMU was that a budget balance “close to balance or in surplus” in good times would create sufficient fiscal space to enable the automatic stabilisers to operate in downturns (see Box 7 for estimates of the stabilisers in the euro area). Chart 3 Cyclicality of fiscal policies a) Cyclicality of fiscal policy in EMU b) Status under the SGP (left-hand scale: annual change in the output gap coinciding with the change in the structural primary budget balance in euro area countries, weighted by these countries’ share of euro area GDP, expressed as a percentage of potential GDP; right-hand scale: output gap, percentage points) (weighted by countries’ share of euro area GDP, percentages) Sources: AMECO, European Fiscal Board, own calculations. Notes: Chart 3, panel a: Fiscal policy is classified as countercyclical in a euro area country if the annual change in the structural primary budget balance (the primary cyclically adjusted budget balance before 2009) and the change in the (ex post) output gap estimated by the European Commission have the same sign, procyclical if they have the opposite sign, and neutral if the change in both is below the lowest decile in the sample. Chart 3, panel b: Status under the SGP is based on a European Fiscal Board dataset (Larch and Santacroce, 2020), with a country’s position in respect of its medium-term budgetary objective assessed, in a backwardlooking exercise, against the country-specific medium-term budgetary objectives since 2006 and a balanced budget in structural terms between 1998 and 2005. Until 2003, the structural improvement is measured by the change in the cyclically adjusted balance. Over time, insufficient and uneven consolidation in good times have reduced the fiscal space available in the euro area countries to respond to shocks, and the ability of all sovereigns to contribute equally to macroeconomic stabilisation. As insufficient buffers were built up in good times, the 3% reference value in the SGP implied there would be some restrictions on budget deficits in bad times.80 In many cases this required discretionary fiscal consolidation in the context of excessive deficit procedures, which meant that the effect of automatic stabilisers 80 The SGP foresees the possibility of opening excessive deficit procedures on the basis of debt criterion alone, but this was not operationalised until the 2011 SGP reform. After 2011, wide de facto differentiation in the required speed of debt reduction was implemented in EU fiscal surveillance through new interpretations and by extending elements of discretion and judgement (see European Fiscal Board, 2020). -4.5 -3.0 -1.5 0.0 1.5 3.0 0 10 20 30 40 50 60 70 80 90 100 1999 2003 2007 2011 2015 2019 Procyclical Neutral Countercyclical Output gap (right-hand scale) 0 10 20 30 40 50 60 70 80 90 100 1998 2001 2004 2007 2010 2013 2016 2019 Economic adjustment programme Preventive arm (< 3% deficit) Excessive deficit procedure At MTO Figure 16: Cyclicality of fiscal policy in EMU. Source: ECB (2021, p. 39) Simulations by the ECB (2021, p. 61) confirm the theoretical analysis made here and describe the benefits that would have resulted from its coordinated fiscal policy in the past: "Fiscal policies responding in a more countercyclical manner would have smoothed the real output gap and reduced the inflation gap. Compared with the baseline, less fiscal spending before the great financial crisis would have dampened the positive output gap (...) and reduced the debt-to-GDP ratio (...). In the absence of an inflation gap during those years, the results 44 are similar for both alternative scenarios. After the financial crisis, and abstracting from financing difficulties during the sovereign debt crisis, additional fiscal spending would have ensured quicker closure of the output gap and a smaller inflation gap (...), with a strongly positive output gap for the patient fiscal policy scenario." 7 A commitment of national fiscal policies to the objective of price stability Coordinating twenty national fiscal policies is a difficult task. An alternative solution could therefore be to implement a commitment of national fiscal policies to the goal of price stability by treaty. In concrete terms, such a rule could consist in obliging the governments of all member states to contribute to price stability at the national level. As a benchmark, a corridor for the national inflation rate could be envisaged, with a bandwidth of one percentage point around the ECB’s inflation target of 2%. 7.1 Deviations from the ECB’s inflation target In retrospect, such a rule in the 2000s would have helped to address early on the imbalances that manifested themselves in the euro crisis in 2010-12. Greece, Ireland, Spain and Portugal had inflation rates that were more than one percentage point above the ECB’s 2 per cent target on several occasions and in some cases for years. Conversely, price developments in Germany were subdued due to wage moderation. However, the deviations remain below the threshold of one percentage point. 45 1999 2000 2001 2002 2003 2004 2005 2006 2007 Austria -1.5 0.0 0.3 -0.3 -0.7 0.0 0.1 -0.3 0.2 Belgium -0.9 0.7 0.4 -0.5 -0.5 -0.1 0.5 0.3 -0.2 Finland -0.7 1.0 0.7 0.0 -0.7 -1.9 -1.2 -0.7 -0.4 France -1.4 -0.2 -0.2 -0.1 0.2 0.3 -0.1 -0.1 -0.4 Germany -1.4 -0.6 -0.1 -0.7 -0.9 -0.2 -0.1 -0.2 0.3 Greece 1.6 1.9 1.5 1.0 1.5 1.3 1.0 Ireland 0.4 3.3 2.0 2.7 2.0 0.3 0.2 0.7 0.9 Italy -0.3 0.6 0.3 0.6 0.8 0.3 0.2 0.2 0.0 Luxembourg -1.0 1.8 0.4 0.1 0.5 1.2 1.8 1.0 0.7 Netherlands 0.0 0.3 3.1 1.9 0.2 -0.6 -0.5 -0.3 -0.4 Portugal 0.2 0.8 2.4 1.7 1.2 0.5 0.1 1.0 0.4 Spain 0.2 1.5 0.8 1.6 1.1 1.1 1.4 1.6 0.8 Positive deviations by more than one percentage point in red. Negative deviations by more than one percentage point in blue Table 3: Deviations of national inflation rates from the 2% target of the European Central Bank (1999-2007).Source: IMF World Economic Outlook, April 2023. In the years 2014-2016, when the ECB’s interest rate policy was at the zero lower bound, a symmetrical commitment of national governments to price stability would have meant that almost all countries would have been obliged to pursue a more expansionary budget policy. 46 thing speaks in favour of assigning fiscal policy a dominant role in stabilising the inflation rate in the event of demand and supply shocks. Monetary policy is ultimately only needed when governments themselves are the cause of a positive demand shock or when they are unwilling or unable to take a stabilisation policy leadership role due to short-term interests or lack of political support. If the central bank takes over inflation control for political economy reasons, one must be aware of the fact that it is always a "second-best" solution compared to fiscal stabilisation. In a monetary union, there are even further implications for the macroeconomic policy assignment. As the New Keynesian model shows, in the event of national demand and supply shocks, the common central bank can only react to such disturbances partially - according to a country’s share in the economic output of the currency area. Thus, the shock in the country of origin is only partially compensated and transmitted with a negative sign to the rest of the currency area. Even if a target inflation rate can then be achieved for the currency area as a whole, welfare losses result at the member state level due to output gaps and deviations from the central bank’s inflation target. Such effects can only be avoided by obliging national fiscal policies to contribute to the achievement of price stability in their country. The experience with the European Monetary Union shows that with such an assignment, the overheating in the peripheral countries in the 2000s could have been recognised early and appropriate stabilisation policy measures taken. 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