Fiscal and monetary policy: is coordination impossible?

For just over thirty years, a near-consensus has emerged that monetary and fiscal policies should pursue distinct objectives: price stability (or rather, the inflation rate) for the former, and the maintenance of full employment and growth at its potential level for the latter. In practice, this division of responsibilities is undoubtedly less rigid: in the United States, the Fed has a dual mandate (inflation and employment) and, more generally, when a central bank assesses future inflation, it also takes growth forecasts into account. Nevertheless, the policy mix that prevails in most countries is the result of separate decisions; all the more so as, for very good reasons, the independence of central banks is also the norm.

Why coordinate?

However, it is clear that there are interactions between the two types of policy. For example, the setting of central banks’ key interest rates affects the cost of public borrowing and thus budgetary balances; whilst the state of public finances is likely to impact the country’s interest rates as well as inflation rates. Coordination between the two policies should therefore, logically, optimise their responses to cyclical shocks. Furthermore, in some cases the effectiveness of one or other of these policies is reduced, or even negated. This was notably the case in both Europe and the United States between 2012 and 2017, when, following the financial crisis (and the sovereign debt crisis in the eurozone), central banks failed to revive economic activity or raise the inflation rate, which remained below the 2% target despite highly stimulative policies, until key interest rates reached their lower bound. Shortly afterwards, the health crisis highlighted the limitations of monetary policy when it comes to responding to potentially inflationary supply shocks. Contrary to the usual argument, fiscal policy then responded more quickly and in a more targeted manner to price increases resulting from the disruption of value chains and rising commodity prices. But this came at the cost of a deterioration in fiscal balances, and monetary policy sought to limit the cost of this by keeping interest rates low. This led to a delayed response to the return of inflation.

These observations are sufficient to justify the need for coordination between the two types of macroeconomic regulatory policy. There are periods when fiscal policy is better suited to responding to the characteristics of the economic cycle, resulting in ‘fiscal dominance’; whilst other circumstances call for ‘monetary dominance’. However, the transition from one to the other requires management that can be complicated and potentially contentious, involving a challenge to the independence of central banks. This could be the case in the coming period, during which supply shocks are likely to dominate and the public finances of certain countries may once again face difficulties.

The case of Monetary Union

It is easy to see that this coordination exercise proves more complicated when it has to take place between a central bank and the independent fiscal policies of several more or less federated states. This difficulty is partly mitigated where there is a sufficiently large budget within the area in question, as well as mobility of people and capital, which limit the effects of cyclical heterogeneity between the countries concerned: this characterises a so-called ‘optimal’ currency area, as is the case in the United States. By contrast, these conditions are far from being met in the eurozone, where the federal budget is virtually non-existent, the economic heterogeneity of member states is on the rise, and the integration of banking systems and capital markets has yet to be realised. Consequently, diverging economic cycles, driven by idiosyncratic shocks, make coordination impossible and may, moreover, undermine the stability of the single currency.

To address this situation, however, the EU has, during the crises of recent years, set up funds to enable its member states to overcome one-off budgetary difficulties (as was the case, in particular, with the European Stability Mechanism and the Recovery and Resilience Facility) or to launch shared investment programmes (which is the aim of Next Generation EU). These initiatives involve capital transfers that represent the first steps towards what should be a central body for regulating intra-zone financial flows. In the coming years, there will be no shortage of opportunities for pooling investment (defence, the green transition, research), but for such a solution to be sustainable, a credible framework for national budgets must be re-established and, finally, adhered to. This presupposes that the role and authority of the Eurogroup are strengthened so that the transition from an intergovernmental model to a federal model can be achieved and the necessary coordination can be undertaken.