Credibility is key to policy success

By Martin Wolf Published: April 2 2009 19:29 Last updated: April 2 2009 19:29 The UK has followed the US and Japan into “unconventional monetary policy”. Meanwhile, Mervyn King, governor of the Bank of England warns the UK government of the dangers of further discretionary fiscal stimulus. Yet what are the implications of the policies followed by central banks? Are these not the big threat to monetary stability? According to forecasts from the International Monetary Fund, the UK’s general government deficit will be 9.5 per cent of gross domestic product this year and 11 per cent in 2010, the largest in the Group of 20. As I argued earlier this week (“Why G20 leaders will fail to deal with the big challenge”), the rise in the deficit, from 2.7 per cent of GDP in 2007, is the counterpart of the swing in the private balance, forecast at 8.9 per cent of GDP between 2007 and 2009. As my colleague, Samuel Brittan, asked last week, why should such a temporary increase in the fiscal deficit be terrifying? UK net public debt – forecast at 61 per cent of GDP this year – remains well below the average of advanced country members of the G20. At the end of the Napoleonic and second world wars, UK public debt was close to 2.7 times GDP. Yet even this triggered none of the hyperinflationary consequences now widely feared. As the IMF also notes, even a 100 percentage point increase in the debt ratio should require an offsetting shift in the primary fiscal balance (with interest payments removed from spending) of no more than 1 per cent of GDP, provided fiscal credibility is maintained. The condition for this is evident: in his Budget, the chancellor of the exchequer should lay out fiscal measures to go into effect, automatically, once the economy recovers. In short, what is needed is a far more credible fiscal regime. Yet it is very peculiar to be agitated about the inflationary impact of fiscal deficits, yet relaxed about monetary expansion by central banks. Is the latter not the true danger? Or are these not just two sides of one coin, the ultimate inflationary risk being the central bank financing of deficits? Yet, even before reaching that point, reliance on aggressive expansion of the balance sheet of the central bank has dangers, including for the fiscal position, as my colleague Willem Buiter has noted in his Maverecon column. Unconventional monetary policies work by expanding the money supply (“quantitative easing”), by easing credit constraints (“credit easing”) and by altering relative yields on assets, particularly through direct purchases of longer-term assets. The Bank of Japan focused on the first; the Federal Reserve has concentrated on the second; and the Bank of England has now initiated the last, with direct purchases of gilts. Carried out with sufficient single-mindedness, such programmes will “work”. At the limit, a modern central bank can drown an economy in infinite quantities of fiat (or man-made) money. The question is the obverse: it is whether the longer-term inflationary impact of monetary expansion can be reversed in time. To this, again, two answers exist: one concerns feasibility; and the other concerns credibility. On the former, the broad answer is that a central bank’s unconventional monetary operations are reversible: if it buys bonds, it can resell them; if it buys short-dated paper, it can allow it to expire; if it directly finances government deficits, it can sell the public debt to the public; and even if it sends cheques directly to every citizen, which would be closest to a purely fiscal operation, the government can always sterilise the monetary effects by issuing new bonds. So, if and when economies and, as important, financial systems, recover, aggressive action by the authorities would unwind the inflationary impact of even these unconventional policies. So, as over fiscal policy, the fundamental question – as Spencer Dale, the Bank’s new chief economist, notes in an important recent speech – is the credibility of the commitment to stability.* If, for example, the central bank takes very large credit risk and the public doubts the willingness of the fiscal authorities to reimburse resulting losses, it will expect these losses to be monetised. Similarly, the public may well doubt whether the huge expansion in central bank balance sheets – as is evident in the US – would be reversed in time. Inflationary expectations may then gain a firm hold, driving inflation-risk premia up and the exchange rates down. This would greatly increase the costs of restoring credibility on the inflationary upside, thereby further undermining the central banks’ ability to do so when the time comes. The conclusion is straightforward: the ability to navigate through the crisis, using either fiscal or monetary measures effectively and at modest overall cost, depends in both of these cases on the credibility of the authorities’ commitment to long-term monetary stability. Neither huge fiscal deficits nor massive monetary expansions are themselves an unmanageable threat, provided the regime itself remains credible. This is crucial even for a country as indispensable to the global economy as the US. For the UK, it is close to a matter of economic life and death. * Tough times, unconventional measures, www.bankofengland.co.uk Send mail to martin.wolf@ft.com