I’ve been away and busy at the IMF, so did not respond immediately to this speech from ECB Executive Board member Benoît Cœuré on the new OMT policy. In econblog terms, the speech would be described as wonkish, but I think the ideas I want to focus on are reasonably intuitive. They are worth exploring, because they illuminate the key issue of conditionality.
In a classic paper, Eric Leeper distinguished between active and passive monetary and fiscal policies, within the context of simple policy rules. The concept of an active monetary policy is by now familiar: monetary policy should ensure that real interest rates rise following an increase in inflation, so that higher real interest rates deflate demand and put downward pressure on inflation. Leeper’s use of active and passive for fiscal policy is a little counterintuitive. A passive fiscal policy is where, following an increase in debt, taxes rise or spending falls by enough to bring debt back to some target level. If neither taxes nor spending respond to excess debt, debt would gradually explode as the government borrowed to pay the interest on the extra debt. This is the extreme case of what Leeper calls an active fiscal policy.
Now you might be forgiven in thinking that the only policy combination that would bring stability to the economy was an active monetary policy (to control inflation) and a passive fiscal policy (to control debt). This would correspond to what I have called the consensus assignment. However Leeper showed that there was another: an active fiscal policy combined with a passive monetary policy. A simplified way of thinking about this is that it represents the opposite of the consensus assignment: fiscal policy determines inflation and monetary policy controls debt, because debt becomes sustainable by being reduced through inflation. This idea, which became known as the Fiscal Theory of the Price Level (FTPL), is very controversial. (For once, divisions cut across ‘party’ lines, with John Cochrane and Mike Woodford both contributing to the FTPL.) However for current purposes you can think of the FTPL policy combination as being a form of fiscal dominance. You can also think of this combination as being inferior to the consensus assignment from a social welfare perspective (see this post).
So why did Cœuré invoke Leeper’s definitions of active and passive in his speech? To quote:
“central bank independence and a clear focus on price stability are necessary but not sufficient to ensure that the central bank can provide a regime of low and stable inflation under all circumstances – in the economic jargon, ensuring “monetary dominance”. Maintaining price stability also requires appropriate fiscal policy. To borrow from Leeper’s terminology, this means that an “active” monetary policy – namely a monetary policy that actively engages in the setting of its policy interest rate instrument independently and in the exclusive pursuit of its objective of price stability – must be accompanied by “passive” fiscal policy.”
Now OMT involves the ECB being prepared to buy government debt in order to force down interest rates so that fiscal policy becomes sustainable. To some that seems like fiscal dominance: monetary policy is being used in a similar way to the FTPL, in order to make debt sustainable. Cœuré wants to argue that with OMT we can get back to the consensus assignment, because OMT will allow fiscal policy to become passive again.
Now current fiscal policy in the Eurozone can hardly be described as ignoring government debt, as in the polar case of active fiscal policy outlined above. However, for fiscal policy to be passive it has to counteract the tendency for debt to explode because of debt interest payments. If interest rates are very high, because of default risk, this may require destructive and perhaps politically impossible rates of fiscal correction. In other words, default risk forces fiscal policy to be active. Although this problem is just confined to one part of the Eurozone, as Campbell Leith and I showed here, this is sufficient to force monetary policy to become passive if it wants to preserve stability.
I think this is a very clever way of describing OMT to those who believe this policy goes beyond the ECB’s remit. OMT is necessary to allow fiscal policy to become passive in countries subject to significant default risk, and therefore for monetary policy to ensure price stability. The argument, like the FTPL, is controversial: many of those who dislike the FTPL would argue that an active monetary policy is sufficient to ensure price stability. This analysis also ignores the problem of the Zero Lower Bound (ZLB) for nominal rates, which one could reasonably argue forces monetary policy to become passive. For both reasons I did not use this argument in my post on conditionality, but without length constraints I would have.
I want to make two final points which Cœuré does not. First, a feature of passive fiscal policy at ‘normal’ (largely default risk free) levels of real interest rates is that debt correction does not have to be very rapid, and as Tanya Kirsanova and I show here, it should not be very rapid. Almost certainly the speed of debt correction currently being undertaken in periphery countries is more rapid than it needs to be to ensure a passive fiscal policy at normal interest rates. The current Eurozone fiscal rules also probably imply adjustment that is faster than necessary. As a result, no additional conditionality is required before the ECB invokes OMT. Second, this analysis ignores the problem of the ZLB, which is as acute for the Eurozone as it is elsewhere. Cœuré says that OMT is not Quantitative Easing (QE), but does not explain why the ECB is not pursuing QE. It has taken the ECB about two years too long to recognise the need for OMT – let’s hope that it does not take another two before it realises that for monetary policy to stay active in the sense described above, it also needs QE.