Threat of Fiscal Dominance?

Abstract

The massive expansion of central bank balance sheets to contain the worst financial crisis in living memory raises questions about the theory and practice of monetary policy. The persistence in many advanced countries of large fiscal deficits and the prospect of high public debt/GDP ratios for many years is likely, at some point, to create policy dilemmas not only for central banks but also for public debt managers. Some countries have already had to cope with higher sovereign risk.

Worries about both "fiscal dominance" and "financial repression" have certainly gained ground. Whatever view is taken of this, the boundary between monetary policy and government debt management has become increasingly blurred. Policy interactions have changed in ways that are difficult to understand. The current delineation of policy mandates may need to be reassessed.

The aim of this BIS-OECD workshop was to better understand these issues. Theoretical perspectives draw on a long and rich body of monetary theory, but the theory is far from settled. Analysis of the history of fiscal/debt/monetary policy interconnections shows how such linkages have varied across countries and over time - there is no "one size fits all". And careful review of empirical studies shows that precise estimates of the impact of large-scale central bank purchases of government bonds need to be treated with caution.

There is great uncertainty about the impact of increased government debt on inflation, on interest rates and on future growth. Much will depend on future policies. Do monetary policies need to be better coordinated with other macroeconomic or financial policies? Could government financing decisions and financial sector regulation drive the long-term interest rate too low, at least in the short-term? What medium-term risks could this create? What could be the implications for the efficiency and stability of the financial system?

The papers and discussions in this volume do not, of course, converge on simple answers to any of these questions. Indeed, opposite views are expressed. The aim rather is to stimulate discussion about the complex interactions between fiscal deficits, government debt management and monetary policy in unusual macroeconomic circumstances. Some of these interactions are new, but many would be very familiar to an earlier generation of central bankers faced with heavy government debts and thin financial markets.

While the full publication can be downloaded using the above link, individual contributions are available separately:

1. Thread of Fiscal Dominance? Workshop Summary, by Richhild Moessner & Philip Turner

2. Government Debt Management and Monetary Policy in Britain Since 1919, by William A. Allen

3. Keynes's Monetary Theory of Interest, by Geoff Tily

4. Thoughts on Policies and the Policy Framework After a Financial Crisis, by Lex Hoogduin & Peter Wierts

5. Sovereign Debt Management as an Instrument of Monetary Policy: An Overview, by Fabrizio Zampolli

6. Monetary Policy and the Natural Rate of Interest, by Matthew Canzoneri, Robert Cumby & Behzad Diba

7. Is the Standard Micro Portfolio Approach to Sovereign Debt Management Still Appropriate, by Han Blommestein & Anja Hubig

8. Sovereign Debt Management and Fiscal Vulnerabilities, by Alessandro Missale

9. Debt Management and Optimal Fiscal Policy with Long Bonds, by Elisa Faraglia, Albert Marcet & Scott Andrews

10. Interactions Between Sovereign Debt Management and Monetary Policy Under Fiscal Dominance and Financial Instability, by Hans Blommestein & Philip Turner

11. The Effectiveness of Federal Reserve's Maturity Extension Program - Operation Twist 2: Portfolio Rebalancing Channel and Public Debt Management, by Torsten Ehlers

12. The Financial Crisis and the Changing Dynamics of the Yield Curve, by Morten Bech & Yvan Lengwiler

13. The Financial Market Impact of UK Quantitative Easing, by Francis Breedon, Jagjit Chadha & A. Waters

JEL Classification: E43, E44, E63, E61