The fault lines between monetary and fiscal policies have grown since the COVID-19 pandemic (Blanchard 2023, Gopinath 2023a, 2023b). The steep tightening of monetary policy has sharply increased government borrowing costs (Adrian, 2023), at a time when fiscal deficits and debt levels remain on an upward trajectory (Figure 1). Continued loose fiscal policy could also fuel inflationary pressures, complicating monetary policy.
Figure 1 Debt and Primary balance dynamics in advanced economies
Note: Global variables are weighted by nominal GDP expressed in current USD. Trendlines are sixth-order polynomial.
Source: World Economic Outlook, Public Finances in Modern History, World Bank Development Indicators, and authors’ calculations.
To borrow a term from Disyatat and Borio (2021), the ‘corridor of stability’ between fiscal and monetary policies is shrinking.
But by how much? And what are the macroeconomic implications of potential tensions between fiscal and monetary policy? In a recent paper (Bolhuis et al. 2024), we answer these questions.
Some motivating evidence for growing fiscal-monetary tensions
Fiscal-monetary tensions may not necessarily be high even in an environment of elevated interest rates. This is because the fiscal authority can undertake fiscal consolidation to ensure debt sustainability. In other words, higher interest costs can be offset by more restrictive fiscal policy, thereby preventing the debt trajectory from entering an unsustainable path. When this occurs, fiscal policy is described as ‘passive’ (Leeper 1991). Conversely, fiscal policy is ‘active’ when the fiscal authority does not increase the primary balance in response to higher borrowing costs. Under such an active fiscal policy regime, higher interest rates would lead to growing fiscal-monetary tensions.
Bohn (1998) introduced an exercise for gauging the activeness of fiscal policy, in which the primary balance-to-GDP ratio is regressed on the first lag of the debt-to-GDP-ratio. Based on this test, others (e.g. Mauro et al. 2015) found that advanced economies tend to swing between periods of prudence (passive fiscal policy) and periods of profligacy (active fiscal policy) (see also Zaman et al. 2013).
Replicating Bohn’s exercise for a group of advanced economies between 1880-2022, we find that fiscal policy has indeed become increasingly unresponsive to rising debt levels and thus more active since the Global Financial Crisis (GFC). Specifically, the statistically significant and positive coefficient on the primary balance prior to the GFC turned negative after the GFC and increased further in magnitude after the start of the pandemic (Figure 2). This result is consistent with the results of a second set of regressions, which test whether a country’s primary balance eventually converges to its debt-stabilizing primary balance. Primary balances have become less likely to converge to their debt-stabilising levels since the GFC and have remained so after the onset of the pandemic. Thus, there is evidence that fiscal-monetary tensions may be on the rise.
Figure 2 Responsiveness of fiscal policy to debt and debt-stabilising primary balances
Note: Solid lines indicate statistical significance at 10 percent significance level, where robust standard errors are used, clustered by year.
Source: Public Finances in Modern History, Jorda et al. (2017) and authors’ calculations.
Introducing fiscal r-star and the fiscal-monetary gap
We propose two new concepts – ‘fiscal r-star’ and the ‘fiscal-monetary gap’ – to measure fiscal-monetary tensions given active fiscal policy. We derive these concepts using standard macroeconomic frameworks including the IS and Phillips curves as well as the law-of-motion of government debt.
Fiscal r-star is the real interest rate that stabilises a country’s debt-to-GDP ratio given its primary deficit path when output is growing at its potential and inflation is at target. Essentially, it represents the ceiling of real interest rates above which the debt path can become explosive. When fiscal r-star declines, the room for the fiscal authority to run deficits shrinks.
We argue that the difference between fiscal r-star and monetary r-star (the natural interest rate) – which we term the ‘fiscal-monetary gap’ – measures fiscal-monetary tensions.
When monetary r-star and fiscal r-star are equal, policymakers can simultaneously stabilise debt and keep inflation at target. But when monetary r-star moves above fiscal r-star, difficult policy trade-offs arise. When the central bank sets its real policy rate to match monetary r-star, public debt dynamics could become explosive absent fiscal adjustment. Alternatively, the central bank may keep its real policy rate below monetary r-star. This would have benefits for fiscal sustainability by reducing the cost and pace of debt accumulation, but would cause other challenges for price and financial stability.
By how much have fiscal-monetary tensions been rising?
We document the evolution of fiscal-monetary tensions by estimating the fiscal-monetary gap based on 140 years of data for 16 advanced economies.
Our results offer several insights. First, the average fiscal-monetary gap was at the highest during WWII amid wartime fiscal needs. Second, after reaching historic lows in the 1970s on the back of a post-war boom and demobilisation, the gap remained low and relatively constant from the early 1980s through the mid-2000s, primarily due to the decline in monetary r-star after the early 1980s Volcker-era disinflation. Third, the fiscal-monetary gap has been climbing since the mid-2000s. Fourth and most importantly, as of the end of 2022, fiscal-monetary tensions are at the highest levels measured since the 1950s (Figure 3).
Figure 3 Historical estimates of fiscal r-star and the fiscal-monetary gap
Note: Dashed lines represent medians of samples, while solid lines represent unweighted means.
Source: Jorda et al. (2017) and authors’ calculations.
Given high tensions today, policy adjustment is needed
Employing local projections, we find that a rise in the fiscal-monetary gap tends to be followed by a range of adverse macroeconomic outcomes (Figure 4). These include rising inflation, higher debt, and weaker exchange rates. Larger gaps also subsequently correlate with the so-called liquidation of government debt, which is the use of low real interest rates and surprise inflation to reduce the real debt burden over time. Larger gaps are also associated with elevated risks of several types of crises.
Given currently high fiscal-monetary tensions, policy adjustments may be needed to avoid these outcomes. The fiscal-monetary gap can be closed by a combination of policy tools. Our paper discusses the challenges and potential trade-offs associated with some of these policy actions.
Growth-enhancing structural reforms can help fiscal and monetary policies regain their space, as we showed analytically in the paper. But in the presence of several headwinds weighing on global growth, medium-term growth prospects are likely to remain tepid (IMF 2024). This potentially calls for more immediate measures.
One such measure is fiscal consolidation, which can raise fiscal r-star and therefore alleviate fiscal-monetary tensions. But implementation may be limited by political economy constraints. It is unclear whether advanced economies have the requisite social cohesion necessary to achieve a politically sustainable fiscal consolidation plan (Balasundharam et al. 2023).
In fact, there could be a two-way relationship between political polarization and the fiscal-monetary gap (Figure 5), with both polarization and tensions rising to levels not seen in decades. One possible explanation for this co-movement is that as societies become more polarised, implementing the fiscal adjustments required to reduce the fiscal-monetary gap becomes more challenging (Roubini and Sachs 1989a, 1989b, Alesina and Tabellini 1990, Alesina and Drazen 1991). Pressures posed by fiscal-monetary tensions may also feed back into polarisation (Gabriel et al. 2023; Hubscher et al. 2023).
Figure 4 Shocks to the fiscal-monetary gap and selected macroeconomic indicators
Notes: 1) USA not included in sample. Units expressed in foreign currency units per 1 unit USD. 2) Expected difference in cumulative probability of crisis within time window due to a 1 percentage point increase in the fiscal-monetary gap. 3) Debt crisis if either in domestic or external default according to data by Carmen Reinhart. 4) Definitions from same dataset. A systemic crisis is defined following Caprio et al. (2005), who characterize modern systemic crises as “those episodes where there are bank runs, a significant share of non-performing assets, bank liquidations, and large-scale policy intervention to support banks” (Reinhart and Rogoff, 2014).
Source: Authors’ calculations
Figure 5 Political polarisation and the fiscal-monetary gap
Note: Sample includes Australia, Belgium, Canada, Denmark, Finland, France, Germany, Italy, Japan, the Netherlands, Norway, Spain, Sweden, Switzerland, United Kingdom, and United States
Source: Varieties of Democracy Dataset (version 13) and authors’ calculations. Political polarization is measured via a survey-based approach, whereby survey respondents in each country are asked questions to elicit the degree to which society has separated into distinct, antagonistic political camps based on the likelihood of disparate groups to engage in friendly interactions with non-likeminded parties.
Politicians may be tempted to engage in various forms of financial repression to liquidate large debt stocks or pressure central banks to ‘accommodate’ additional spending. Central bank institutional independence could and should prevent fiscal authorities from undermining the central bank’s ability to play an active role in stabilising inflation.
Perhaps less discussed is that achieving price stability could also result in fiscal dividends. When inflation expectations are well-anchored, inflation risk premia on government debt would be reduced, thereby enhancing fiscal sustainability. Furthermore, any de-anchoring of inflation expectations resulting from overly accommodative monetary policy could subsequently necessitate even tighter monetary policy that increases fiscal-monetary tensions even more.
Given uncertainty about the future path of monetary r-star, policymakers probably should not assume that real interest rates will remain lower for longer. In such an environment, strong policy actions are needed to reduce fiscal-monetary tensions over time.
Authors’ note: The views expressed here are exclusively those of the authors and do not necessarily represent those of the IMF, its Executive Board, or management.
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