In a sea of academic economic literature, there are a handful of essays that provide lifelong analytical anchors. One of these, at least for me, is the famous 1981 paper by Tom Sargent and Neil Wallace titled “Some Unpleasant Monetarist Arithmetic,” published in the Minneapolis Fed Quarterly Review.¹ I wrote about that article on these pages back in February 2003,² recalling that it had a profound impact on me while in graduate school, enlightening me to the concept of the sustainability of any given monetary/fiscal policy mix.

Sargent and Wallace argued, using simple arithmetic, that sustainability came down to the relationship between three variables:

• The level for short-term real interest rates maintained by the monetary authority.
• The real growth rate of the economy.
• The growth path for the real stock of debt incurred by the fiscal authority, as determined by real fiscal deficits as a share of real GDP.

The authors demonstrated that it is not possible for (1) the monetary authority to sustainably peg real short-term interest rates above the real growth rate of the economy if (2) the fiscal authority insists on running a fiscal deficit as a percent of GDP that is higher than the growth rate of real GDP. Such a combination implies exponentially rising growth for real fiscal interest costs as a share of real GDP, which is axiomatically unsustainable.

But, when Sargent and Wallace wrote their essay, that’s what Volcker and Reagan were doing, implying that in the fullness of time, either the monetary authority would have to loosen up or the fiscal authority would have to tighten up. Put differently, there were limits to the ability of the monetary authority to enduringly fight inflation, if the fiscal authority’s deficit trajectory implied fiscal unsustainability because of the high real interest rates associated with the monetary authority’s restraint. At some juncture, Sargent and Wallace argued, either the monetary authority or the fiscal authority would have to blink, settling the game of chicken.

As secular time unfolded over the 1980s and 1990s, Sargent and Wallace’s question was answered: The Fed sustained its course of disinflation, while the fiscal authority blinked, with presidents Reagan, Bush and Clinton all raising taxes. And so it was that by the turn of the century, America had achieved price stability: The two-decades-long war against inflation was won!

The Game Changes and So Does the Meaning of Central Bank Independence

Ever since that super-secular victory over inflation, the dominant secular risk has been deflation, not inflation, as evidenced by the Fed’s extraordinary – and successful! – pre-emptive fight against deflation in the recession of 2001 and its even more extraordinary – and so far successful! – fight against deflation in the recession that started in December 2007, which presumably ended last summer.

And in both of these most recent cases, Fed Chairman Greenspan and Fed Chairman Bernanke openly welcomed old-fashioned Keynesian fiscal stimulus. In a nutshell, Sargent and Wallace’s question as to who disciplines whom was turned upside-down: When deflation risk dominates inflation risk, particularly in the context of a liquidity trap with the Fed funds rate penned near zero, the fiscal authority dominates the monetary authority. Indeed, in such conditions, the monetary authority may be required to pursue quasi-fiscal policy actions – such as Credit Easing and Quantitative Easing – to augment conventional fiscal policy stimulative actions.

To some, this implies a diminution in the monetary authority’s independence in the political arena, threatening insidious inflation on some distant horizon. I understand that argument. But I actually prefer to view the matter through a more benign lens, as articulated by Chairman Bernanke when offering analysis and advice to the Japanese fiscal and monetary authorities in May 2003:

“The Bank of Japan became fully independent only in 1998, and it has guarded its independence carefully, as is appropriate. Economically, however, it 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 the current circumstances, greater cooperation for a time between the Bank of Japan and the fiscal authorities is in no way inconsistent with the independence of the central bank, any more than cooperation between two independent nations in pursuit of a common objective is inconsistent with the principle of national sovereignty.”

Japanese authorities, notably the Bank of Japan, have never fully taken on Mr. Bernanke’s cogent argument that central bank independence means different things in inflation and deflation fat tails. In the former, it is vital; but when deflation (or even too-low inflation) is the dominant risk, it is prudent, nay vital, for the monetary authority to act cooperatively and collaboratively with the fiscal authority.

Mr. Bernanke is presently walking his 2003 talk. Bravo! And if and when recovery matures into expansion, with inflation risks dominating disinflation/deflation risk, I have no doubt that Mr. Bernanke and his colleagues will re-assert the Fed’s independence by tightening up, even if the fiscal authority were to prefer continued negative real interest rates, so as to hold down debt service expense.

Which Brings Us to Euroland

The ECB was part of the shock-and-awe package of policy steps announced last month to arrest the very real risk of a debt-deflationary spiral in Europe. The ECB is buying government bonds of troubled members of the monetary union, taking on their credit risk, paying for them with newly created money. To be sure, the ECB stresses that it is sterilizing its creation of reserves, quickly pulling those new reserves out of the system in exchange for term deposits on itself. Thus, technically, the monetary base is left unchanged.

But as a practical matter, reserves and term deposits are both newly created ECB liabilities that are very close substitutes. So it is ineluctably the case that the ECB has ventured into the fiscal policy realm, de facto monetizing the debt of the troubled members. If there is any doubt about that, the fact that the Bundesbank opposed the action should end that doubt. It was and is what it was and is, and the Bundesbank’s objection speaks directly to that reality.

Was it wise? The answer depends entirely upon your view as to the viability of the current European arrangement of monetary union without political union and thus, fiscal union. The Achilles’ heel of the arrangement, since inception, has always been that circumstances could evolve, or devolve, to the present state of affairs. How so? It comes back to the question of who disciplines whom. And the troubled members of union were never disciplined in their fiscal affairs.

To be sure, the Growth and Stability Pact, insisted upon by Germany at the outset, theoretically was supposed to discipline the fiscal policy of all members. But it didn’t work, that simple. And the ECB, with a mandate of price stability for the eurozone, which it has largely achieved, was not in a position to play the role of Paul Volcker to Ronald Reagan of some thirty years ago, or Alan Greenspan to George Bush or Bill Clinton subsequently.

Thus, Euroland faces grave choices and the independence of the ECB will necessarily morph into a more cooperative and collaborative stance with the members’ fiscal authorities, themselves suffering from the lack of federalism. There are no easy answers. But so long as the member states, politically, do not want to countenance a default of a member state, which could trigger a cascading of defaults in other weak members, putting banking systems of the entire region at risk, the stark reality is that the stronger states are going to have to lend their credit standing to the weaker members, while the ECB stands ready to engage in de facto fiscal policy.

What is more, the greater is the fiscal austerity imposed on the weaker members as a quid pro quo for support from the stronger members, the greater will be the deflationary fat tail hovering over the entire region. Which, in turn, means the greater will be the ECB’s subordination to the collective fiscal authorities of the region.

Bottom Line

For the last thirty years, around the world, the changing relationship between monetary authorities and fiscal authorities has been at the center of economic and financial developments: the course of growth and inflation and the path of asset prices. At the beginning of the period, virulent inflation demanded robust monetary authority independence, so as to pursue draconianly tight monetary policy, including disciplining fiscal authorities when their loose policies contradicted the overriding goal of winning the war against inflation. Victory was achieved a decade ago.

And ever since, a more cooperative and collaborative relationship between monetary and fiscal authorities has been required, so as to cut off the fat tail of deflation risk, notably in recessions. Some bemoan this development as a loss of central bank independence. And indeed  it is. But central bank independence, by definition, is all about cutting off the fat tail of inflation risk. When the fat tail becomes deflation, a stubbornly independent central bank becomes much less of a virtue, and potentially a deflation-abetting vice.

In my view, the ECB needs to come to this conclusion. Following such a course will, of course, be fraught with risks, notably an unmooring of long-term inflation expectations. The ECB should not have ever been put in this place. But the inherent design flaws of monetary union have come home to roost. Call it some unpleasant Keynesian-Minsky logic, in contrast to Sargent and Wallace’s unpleasant Monetarist arithmetic of three decades ago.

Paul McCulley
June 2, 2010
mcculley@pimco.com