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Macroeconomic policy coordination and central bank independence after the crisis

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Breaking the ‘taboo’?

Following the seminal work by Kydland and Prescott (1977) and the vast literature that ensued, [1] central bank independence has become an established, rock solid truth in the theory and practice of monetary policy. A concrete case about the negative consequences of less-than-full central bank independence was recently discussed by Wyplosz (2015), with specific reference to the ECB. However, no discussion has taken place in a long time within academic and policy circles about cases where central bank independence might be called into question, not even after the deep reconsideration of optimal macroeconomic policy prompted by the global crisis.

In fact, the crisis has offered an important opportunity to discuss if and under what circumstances, and rules, central bank independence might be temporarily revoked or suspended, so that the central bank and government would coordinate their action for the purpose of achieving some specific priority macroeconomic objective. Regrettably, this debate has not happened thus far. In summarizing the conclusions of last April’s IMF conference on ‘Rethinking Macro Policy’, Blanchard (2015) noted that there was general consensus among participants “that central banks should retain full independence with respect to traditional monetary policy”.[2]

Why have academics and policymakers been so reluctant to even put the issue on the table, even in the face of such an extreme event as the global crisis (and the ongoing crisis in the Eurozone) and the various attempts to draw lessons from it, not just to minimize chances of its re-occurrence but to identify instruments to reduce its costs should it ever re-occur?

The reason for not having such a debate, in my opinion, is that central bank-government policy coordination is perceived as the backdoor re-introduction of governments financing their deficits the easy way (i.e., through the money printing press), eventually leading to inflation and possibly hyperinflation. In this sense, especially after the hard-won central bank independence had rescinded that long-lasting dangerous liaison, central bank-government policy coordination has become a “taboo,” that is, a policy characterized not merely as being undesirable, but as something we should not even think about let alone propose (Turner 2013), lest the risk of re-creating perverse incentives for unscrupulous politicians to exploit.

However, going beyond taboos — as scientists should always be ready and willing to do — begs the question of whether it makes economic sense, and under which conditions, for monetary and fiscal policies to be coordinated, and what this coordination would entail from the institutional standpoint.

When fiscal and monetary policies should be coordinated

The idea to combine monetary and fiscal stimuli was revived by Bernanke (2002), as he recommended that Japan fight deflation through public deficits explicitly financed with incremental — and permanent — central-bank purchases of government debt. The money created would finance tax cuts or new spending programmes (overt money financing, OMF, or money financed fiscal stimulus aka ‘helicopter money’). If the money had gone to finance tax cuts — Bernanke argued — consumers and businesses would likely spend their tax-cut receipts, since no current or future debt-service burden would be created to imply future taxes. Note that the key element here is the permanency of central bank purchases of public debt, which rules out that the new debt will ever be placed on the market. Permanency eliminates Ricardian equivalence effects and prevents new public debt accumulation.

The idea of OMF was considered more recently in greater depth. McCullay and Pozsar (2013) and Turner (cit.) have compared it to existing policy alternatives concluding it to be superior, and Buiter (2014) has evaluated its effectiveness through a formal model, identifying the conditions under which it boosts aggregate demand. [3] One of these conditions is the irreversibility of the new money base stock creation, which constitutes a permanent addition to the total net wealth of the economy. [4] Both the impact of OMF and the importance of the irreversibility condition can be appreciated by considering the intertemporal budget constraints of the individual agents and the government. As part of the deficit is irreversibly funded through money creation, the government budget constraint is permanently relaxed by an equivalent amount, implying in turn that agents’ disposable income can be equally raised. Since irreversibility pre-empts Ricardian equivalence effects, consumption increases permanently. [5]

There is no question that OMF is the most effective solution to deflation, especially for highly-depressed and largely-indebted economies with limited or no fiscal space available. OMF is certainly more effective than monetary policy alone, since i) the latter’s transmission mechanism needs to rely on indirect, uncertain and possibly week interest rate and portfolio effects, ii) the net wealth effect is smaller (all else equal) than under OMF, and iii) the newly issued money goes to agents who possess assets and likely have a lower than average propensity to consume. As well, OMF is more effective than fiscal policy alone since it necessarily requires new debt liabilities to be issued by the public sector:  in largely-indebted economies, this could trigger market confidence problems and feed back on interest rate premia that would tend to neutralize the spending inducement effect. In short, OMF is the most powerful reflationary policy options that one can think of in a depression as it enables the public sector to create new purchasing power and to allocate it to those who need it most and are eager to spend it.

Yet, even in the middle of the deepest crisis in almost a century, very few mainstream economists invoked the use of OMF as a way out of it. Instead, the turf of economic policy activists mostly split in two camps: those believing that monetary policy can do it all, on one side, and those thinking that at the ZLB only fiscal policy matters, on the other. Why was this so?

Guessing is hard. But if the “taboo” referred to at the outset may provide an answer to this question, another answer may be that in some countries (for instance, UK and US) the views of the fiscal authorities did not necessarily coincide with those of the monetary authorities. Whereas the former became pretty soon concerned with regaining fiscal prudence after an initial flexible budget response to the demand shock, precisely because of their preoccupation with the rising level of debt and its repercussion on financial fragility, the responsibility to keep on fighting the recession and the mounting deflation was thought to fall upon the monetary authorities. There was no persuasion that a central bank-government coordinated response was required; rather, it was expected that the monetary authorities would react and adapt their response based on the fiscal stance decided by government.

A cooperative attitude, on the other hand, would have led people to appreciate that those very exceptional economic circumstances could have been countered more effectively and efficiently by using the fiscal and monetary levers together and in conjunction with one another. Japan did adopt that approach under Abenomics, but policymakers badly failed to realize that monetary policy should have been committed to permanently purchasing government debt while fiscal policy should have been directed at giving money to sectors and people most willing to spend it immediately. This would have averted new debt accumulation and would have affected spending decisions much more directly and swiftly, instead of wasting time and efforts in trying to affect inflationary expectations first and stimulate spending as a result.

“Silent enim leges inter arma”

Pronounced in a famous speech by Cicero, one of the greatest orators of Ancient Rome, these words mean: “In times of war, the law falls silent.” [6] During times of crisis, Rome suspended democracy to allow a temporary dictator to run things, since it was felt that decisions needed to be made more quickly and effectively than in normal times. [7] In macroeconomic policy terms, this would suggest that temporary suspensions of usual law provisions might be contemplated during times of emergency or very serious crisis, when all relevant public bodies – as part of one nation state – would be expected to coordinate their acts together under government direction in the pursuit of collective aims considered to be priority or strategic objectives, and possibly in the context of well-defined limits and parliamentary controls. In particular, central bank independence might fall under this special suspension regime, if the objective were to use monetary and fiscal policies in combination with a view to reducing the output gap and to supporting prices as effectively and efficiently as possible.

On this Bernanke (2003) had a related point as he noted that:

“[I]t is important to recognize that the role of an independent central bank is different in inflationary and deflationary environments. In the face of inflation, which is often associated with excessive monetization of government debt, the virtue of an independent central bank is its ability to say ‘no’ to the government. With protracted deflation, however, excessive money creation is unlikely to be the problem, and a more cooperative stance on the part of the central bank may be called for. Under [these] circumstances, greater cooperation for a time between [central banks] and fiscal authorities is in no way inconsistent with the independence of the central banks, any more than cooperation between two independent nations in pursuit of a common objective is inconsistent with the principle of national sovereignty.”

Unfortunately, this important notation has not resonated within the international academic and policymaking community and has been totally ignored during the crisis. In fact, no lesson from the crisis has apparently been drawn that would point to how macroeconomic policies and institutions might need to be re-articulated during in crisis environments, and specifically for crisis environments, to make sure that people’s welfare is protected as best as feasible. Economists should not stop at taboos (Wren-Lewis 2015) and should feel under an ethical obligation to explore all possible means to public safety in worst-case scenarios and extreme but plausible circumstances.


Bernanke B (2002) “Deflation: making sure ‘it’ doesn’t happen here”, Remarks by Governor Ben S. Bernanke before the National Economists Club, Washington, D.C., November 21

Bernanke B (2003) “Some thoughts on monetary policy in Japan”, Remarks by before the Japan Society of Monetary Economics, Tokyo, 31 May

Blanchard O (2014) “Ten takeaways from the ‘Rethinking Macro Policy. Progress or Confusion’?”

VoxEu, 25 May 2015

Bossone B (2014) “Secular stagnation”, Economics, Discussion Paper No. 2014-47, November 19

Buiter W H (2004) “Helicopter money: irredeemable fiat Money and the liquidity trap”, CEPR Discussion Papers 4202, January

Buiter W H (2014), “The simple analytics of helicopter money: why it works – always”, Economics, Vol. 8, 2014-28

Kydland F E and E C Prescott (1977) “Rules rather than discretion: the inconsistency of optimal plans”, Journal of Political Economy, Vol 85, No 3, June, 473-492

Rogoff K (1985) “The Optimal Degree of Commitment to a Monetary Target” Quarterly Journal of Economics, Vol 100, No 4, November, 1169-90

Turner A (2013) “Debt, money and Mephistopheles: how do we get out of this mess”, Cass Business School Lecture, 6 February

White W (2013) “Overt monetary financing (OMF) and crisis management”, Syndicate Project, 12 June

Wren-Lewis S (2015) “Helicopter money and the government of central bank nightmares”, Mainly Macro, 22 February 2015

Wyplosz C (2015) “Grexit: The staggering cost of central bank dependence”, VoxEu, 29 June 2015


[1] Most notable among which is Rogoff (1985).

[2] Subtly enough on the use of the adjective ‘traditional’, one could interpret Blanchard’s passage as implying that central bank independence might acceptably be less than full when it comes to non-traditional (unconventional) monetary policy. In fact, this is exactly the point of this article.

[3] In a recent working paper, which is now submitted for publication, I have formally shown OMF to be superior to other forms of unconventional monetary policies. See Bossone (2015) for the working paper. The substantially revised version submitted for publication is available from the author on request.

[4] This is made possible by the (‘fiat’) money base constituting an asset for the holder but not a liability for the issuer. Operationally, irreversibility can be attained if OMF is executed either by: i) having the government issue interest bearing debt, which the central bank would buy and hold in perpetuity, rolling over into new government debt when the existing debt on its balance sheet reaches maturity (in this case, the government would face a debt interest servicing cost, but the central bank would make an exactly matching profit from the difference between the interest rate it receives on its debt and the zero cost of its money liabilities, and would return this profit to the government), or by ii) having the central bank purchase special government securities that are explicitly non-interest bearing and never redeemable. In terms of the fundamentals of money creation and government finance, the two options would be identical. See Turner (cit.).

[5] A comment on irreversibility. The irreversibility condition would not be neutralized by the central bank deciding, at any point in time, to withdraw part or all of the liquidity injected in the system by selling bonds from its portfolio (as White (2013) erroneously argues). In this case, the holders of liquidity would exchange money for the bonds sold by the central bank but the economy’s total financial net worth would not change, only its composition would (shifting from more to less liquid assets): the addition to the economy’s financial net worth originally operated through the monetary financing of the deficit would not (and could not) be undone by any new open market operation. Also, the overall debt profile of the public sector after the central bank withdrawal operation would not change, since the government bonds swapped by the central in exchange for liquidity were not covered by any permanence commitment (see footnote 4), and were therefore accounted all across as outstanding public debt even when they were owned by the central bank and kept in its portfolio. True, the government would be liable for paying interest on the debt that is now held by the public and that until now was given back to it by the central bank.

[6] In “The Pro Tito Annio Milone ad iudicem oratio” (Pro Milone), a speech by Marcus Tullius Cicero in 52 BC.

[7]  Even modern democracies practice this, as in the case of the Presidential War Powers Act in the U.S.


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