Some time ago Scott Sumner did a number of blog posts on fiscal policy and why he believes that the budget multiplier is zero. At the time I was somewhat frustrated that the amount of time Scott was using to focus on an issue that I found quite obvious. However, I now found myself doing exactly the same thing – I can’t let go of the game played by central banks against governments and impact this has on the economic policy mix. This is maybe because I find empirical evidence for the so-called Sumner Critique popping up everywhere.
The Sumner Critique basically says that the central bank can always overrule any impact of expansionary fiscal policy on aggregate demand by tightening monetary policy and if the central bank is targeting for example inflation or nominal GDP then it will do so. Therefore, under inflation targeting or NGDP targeting the budget multiplier will always be zero even if the world is Keynesian.
Last week’s policy announcement from the ECB gives further (quasi) empirical support for the Sumner Critique. Hence, the ECB announced that it would conduct what it calls “Outright Monetary Transactions” (OMT) – that is it would (or rather could) buy euro government bonds.
But see here what the ECB said about the conditions for OMT:
“A necessary condition for Outright Monetary Transactions is strict and effective conditionality attached to an appropriate European Financial Stability Facility/European Stability Mechanism (EFSF/ESM) programme. Such programmes can take the form of a full EFSF/ESM macroeconomic adjustment programme or a precautionary programme (Enhanced Conditions Credit Line), provided that they include the possibility of EFSF/ESM primary market purchases. The involvement of the IMF shall also be sought for the design of the country-specific conditionality and the monitoring of such a programme.
The Governing Council will consider Outright Monetary Transactions to the extent that they are warranted from a monetary policy perspective as long as programme conditionality is fully respected, and terminate them once their objectives are achieved or when there is non-compliance with the macroeconomic adjustment or precautionary programme.
Following a thorough assessment, the Governing Council will decide on the start, continuation and suspension of Outright Monetary Transactions in full discretion and acting in accordance with its monetary policy mandate.”
The important term here is “conditionality”. The ECB’s condition for buying government bonds is that the individual euro zone country has a EFSF/ESM macroeconomic adjustment programme. Such a programme is basically a pledge of a given government to tighten fiscal policy. In other words – the ECB could buy for example Spanish government bonds, but the condition would be that the Spanish government should tighten fiscal policy.
Therefore, what the ECB is doing is basically asking the Spanish government and other euro zone governments to be the “Stackelberg leader”: First you tighten fiscal policy and then we will ease monetary policy.
As a consequence the ECB has basically said that the fiscal multiplier should be zero – the ECB will “neutralize” any impact on aggregate demand of changes in fiscal policy. This is better news than it might sound. Obviously European monetary policy is much too tight in the euro zone and I would have liked to see a lot more action from the ECB. However, one could understand “conditionality” to mean that the ECB will fill the possible hole in aggregate demand from fiscal consolidation in euro zone – monetary policy will be eased in response to fiscal tightening. That is good news.
However, the crucial problem of course is that the euro zone needs higher aggregate demand and therefore I would have been much happier if the ECB had announced a clear plan to increase aggregate demand (or rather nominal GDP) – it did not do that. However, if the ECB at least will try to counteract the possible negative impact on aggregate demand from fiscal consolidation then that is good news. One could of course say that this is a completely natural consequence of the ECB’s inflation targeting regime – if fiscal tightening reduces aggregate demand then the ECB should ease monetary policy to avoid inflation undershooting the inflation targeting.
Concluding, “conditionality” is another term for the Sumner Critique and it is in my view yet another illustration that expansionary fiscal policy is unlikely to bring us out of this crisis if central banks is not playing along.
Related posts:
In New Zealand the Sumner Critique is official policy
Policy coordination, game theory and the Sumner Critique
The fiscal cliff and why fiscal conservatives should endorse NGDP targeting
The Bundesbank demonstrated the Sumner critique in 1991-92
“Meantime people wrangle about fiscal remedies”
Please keep “politics” out of the monetary reaction function
Is Matthew Yglesias now fully converted to Market Monetarism?
Mr. Hollande the fiscal multiplier is zero if Mario says so
Maybe Jens Weidmann and Francios Hollande should switch jobs
There is no such thing as fiscal policy
The Market Monetarist 
Norme
/ September 26, 2012The Sumner critique is interesting, and appears to be valid at a glance. It does seem reasonable the central bank could squelch bank money creation at the same time more employed folks are earning a wage constructing some infrastructure project, for example. Sure. Both bank money creation and government spending add to the money supply.
The problem seems to be how one might access the money supply. It can either remain in limbo at low rates due to Fed reserve injections and lack of inflation expectations (supply and demand of safe assets?) Or it can be directly injected into the hands of the consuming work force. Either way increases the money supply (if banks lend) and produces inflation and we hope to see that form of inflation with a healthy middle class consuming it into being.
Bank lending is absolutely necessary, say for home loans. All one needs is an employed, creditworthy borrower who can meet higher lending standards and has the ability to service his debt, i.e., a wage commensurate with productivity and inflation. (The problem is, wages kept pace with “moderate” inflation, but not with the housing bubble or commodity prices.)
One would hope the central bank would not exactly offset fiscal policies and stagnate the economy – actively or passively. That would be silly and probably be a one off policy.
Same problem in Spain, the government cannot inject money through austere spending so there is a heavy reliance on the massively unemployed private sector to borrow. Of course, low wage competitiveness is the answer they seem to choose – internal devaluation – to improve exports. That’s another way to get some money flowing in the economy, especially when you’re worried about price stability and depend on import revenue. You gotta get some money from somewhere: imports, foreign investment, government borrowing, or bank money creation. The latter two are out of the question.
But, low wage competitiveness lowers the standard of living and reliance on debt. Peripheral nations loved the euro for the rising standard of living it offered, they felt wealthy, took on debt and consumed imports as wealthy nations do. And even Greece was servicing it’s debt until the financial rug was pulled from under them. It had a money supply until then.
It’s not inflation that’s a problem, until you try to stoke it. Some level of inflation is good for everyone (and innovative deflation, too.) But, it’s how you define it and stoke it that beggars the mind. I would not mind much if the government said, hey it’s gonna be 5% inflation from here to eternity. But, so will your wages, entitlements, and equity grow (at close to that, accounting for promotions and more stable home equity growth – no bubbles.) Take on debt and service it with a wage that tracks productivity. It’s important to service it, or the system collapses and everyone is left poorer and scrambling for federal reserve notes.
But it seems when M grows, V has not grown. Something is disconnected and not driving some healthy inflation (just a bump in producer price inputs with unemployment high.) Could that roadblock to inflation be Fed asset buying, the very process that is supposed to drive nGDP? Maybe. So, what’s left? Fiscal policy without the Fed cancelling it out. At ZIRP, that should not be a problem immediately. In the US, imports are a small portion of the consumption based economy. So, that’s out for now. What’s left to try…again…(sigh)
Interesting times, in any case. Thank you for taking the time to write some interesting, engaging posts.