Economists often trace back the institutional linkages between fiscal and monetary authorities to ‘Unpleasant Monetary Arithmetic’ (UMA) of Thomas J Sargent and Neil Wallace. This UMA regime deals with the question of who “dominates” and who gets the “first mover advantage” in policy decisions to finance the fiscal deficits.
The Reserve Bank of India (RBI) published its last Report of Currency and Finance (RCF) in 2013. RCF 2013 was titled “Fiscal-Monetary Co-ordination”. It was prepared under the guidance of Subir Gokarn, when he was the Deputy Governor of RBI. When there is wide concern about the tendency to dichotomise the effects of monetary and fiscal policies on growth slowdown, I remember Subir’s contributions to the plausible linkages between the two.
Since 2013, India has embarked into a new monetary framework, through the Urjit Patel Committee report recommendations and the subsequent signing of an agreement by Government of India and RBI on a “new monetary framework” (NMF) on February 2015, based on these recommendations. As per the NMF, the single objective of RBI is price stability through an inflation targeting (flexible) framework.
The NMF also has envisaged central bank independence—operational independence (not goal independence) through the formation of the Monetary Policy Committee (MPC) to vote on repo rate adjustment announcements, whether to maintain “status quo” with regard to policy rates or alter. The MPC has announced its policy rate decisions, based on the detail analytics of global and internal macroeconomic environment. Now, is there a clamour to relook the monetary policy stance—the new monetary framework? Is there any pressing concern to return to the previous framework of fiscal-monetary linkages?
Economists often trace back the institutional linkages between fiscal and monetary authorities to ‘Unpleasant Monetary Arithmetic’ (UMA) of Thomas J Sargent and Neil Wallace. This UMA regime deals with the question of who “dominates” and who gets the “first mover advantage” in policy decisions to finance the fiscal deficits. The monetary arithmetic turns “unpleasant” as the fiscal policymaker “dominates” and monetary policy “follows” in these policy decisions. They believed that the bond financing of deficits (the pre-dominant method of financing fiscal deficit in India) becomes, sooner or later, unsustainable, and the central bank has to step in and generate the monetary seigniorage revenues (by printing money) for the “eventual monetization of deficits”.
Yet another point to recall is that in the “fiscal dominance” regime, the attempts by the central bank to keep inflation low through inflation targeting cannot last and must ultimately give into higher inflation in the longer run. The compelling reality under this regime, therefore, would be “inflation today or inflation tomorrow”.
Now, one may ask whether the macroeconomic environment gets better if the “roles are reversed” and the “first mover advantage” is transferred to monetary policy stance, with central bank independence (CBI). Economists refer this situation of central bank independence (CBI) and inflation targeting with no fiscal policy dominance as ‘Unpleasant Fiscal Arithmetic’ (UFA).
The Unpleasant Fiscal Arithmetic believes in introducing strict “fiscal policy rules”, and it obliges fiscal agencies to adjust to the anti-inflationary policy of the independent central bank. Here, I do remember Subir’s question—“does monetary rule need a prelude, a fiscal rule?.” It was during the period when India has started experiencing a macroeconomic transition from “discretion” to “rules” or even towards “controlled discretion”. A recent treatment of the fiscal-monetary policy linkages is the “fiscal theory of the price level”. This is an interesting rewind of fiscal-monetary linkages especially when “price determination” is perceived not strictly as a monetary phenomenon. These “fiscalists” argue that the price level depends on fiscal policy and the price level “indeterminacy” problems can be solved by having the central bank peg the nominal interest rate at a level consistent with the central bank’s desired inflation rate, rather than by controlling the growth rate of the (base) money supply.
The new avatar of fiscal-monetary linkages—fiscal route to price determination—is about strict fiscal rules and inflation targeting. This requires the fiscal authorities to keep the deficits within the numerical threshold level of deficits normalised to GDP. Apparently, the numerical fiscal rules have become the name of game to achieve greater fiscal discipline, with or without its impending adverse consequences on economic growth.
If we empirically examine the Indian context, the fiscal-monetary linkages have been prominent under two channels. One is through “monetary seigniorage”—automatic monetization of deficits—which India contained long back. The second channel is through “fiscal seigniorage” which takes into account the central bank’s profit transfer to the government. Neumann defined fiscal seigniorage as [Net Profit] minus [Dividend paid to member banks minus Book Loss on FOREX minus Investment in Loans and Foreign Assets], where the Net Profit is monetary seigniorage minus Operating Costs. This can be derived through Central Bank’s balance sheet, and is very relevant to understand Bimal Jalan’s panel recommendations on surplus transfer to the government.
When India is thinking of external financing—sovereign bond—of fiscal deficits, monetary seigniorage financing attains renewed attention as it is an internal source of financing deficits. Excessive mode of any source of financing the fiscal deficits has specific macroeconomic consequences. However, economists often believe that the monetary seigniorage financing of fiscal deficits is technically a “free lunch” if the economy has not attained the full employment levels. From the point of view of public debt, the “free lunch” applies if r<g, where r is the real rate of interest and g is the real growth of economy. Unpacking these debates on fiscal-monetary linkages in India is thus contextual for more reasons than one.
The author is Professor, NIPFP