Au UK, the announcement of the mini-budget on September 23, and the events that followed until the announcement of Prime Minister Liz Truss resigns, on October 20, sparked renewed interest in the risk of “ budget dominance i.e. a situation in which the central bank abandons its objective of price stability to help the government finance its deficits.
But to what extent should this sequence of events push us to rethink the relationship between governments, in charge of fiscal policy, and independent central banks, in charge of monetary policy with a price stability mandate? What does it tell us about this risk of budgetary dominance?
The canonical way of analyzing fiscal and monetary interactions was introduced by American economists Thomas Sargent and Neil Wallace 40 years ago. In their context, the main question is who adjusts its policy between the government and the central bank so that the government satisfies its budget constraint. If the government succeeds in imposing a trajectory of future deficits – it “acts first” in the parlance of Sargent and Wallace – the central bank is forced to “chicken down” and finance the future needs of the government.
Pressures on central banks
Such a situation is unmistakably similar to the mini budget Britain and its commitments to drastic reductions in certain taxes. But events in the UK show that it may be more difficult than we thought for the government to 'act first' and 'trap' the central bank by imposing a path of future deficits. the finance minister resigned October 14 – before Liz Truss left 10 Downing Street herself. Almost all announced budget plans have been withdrawn.
In the end, “monetary dominance” – ie a situation where the central bank privileges its mandate of price stability and obliges the government to adopt a trajectory of more sustainable deficits – could eventually prevail. This is also noted by a number of observers such as Jason Furman, former chairman of the council of economic advisers under the presidency of Barack Obama in the United States.
However, such monetary dominance is not self-evident today, in a context of increased pressure on central banks due in particular to the high level of public debt, the imported nature of part of inflation and significant financing needs, for example, of the green transition.
Strong market reaction
So what are the determinants of who ultimately wins the game between the central bank and the government? Among these many determinants, the British experience shows that the most important – which is missing in most analyzes – is the functioning of the debt market.
To borrow the language of Princeton economics professor Markus Brunnermeier, monetary dominance stems in part from "financial dominance" : the exposure of the financial sector to British debt and, in particular, of pension funds was key in the strong reaction of the markets and the sharp rise in rates.
If investors in the debt market react strongly to unbalanced fiscal policy – resulting in a shortage of liquidity in these key markets – then central bank action becomes essential to avoid default and reduce the cost to the government of s engage in this fiscal policy.
But these interventions by the central bank are not neutral either and this central bank may prefer to limit its interventions as much as possible: in a context of already high inflation and fears about the credibility of the pound sterling, excessive monetization of deficits would have been catastrophic for monetary stability in the United Kingdom.
Thus, three elements were decisive for the central bank to prevail and for monetary dominance to materialize: (i) the market reacted strongly to the British budgetary news, (ii) the central bank was sufficiently willing to deter budgetary dominance , (iii) the UK government realizes that the cost of fiscal dominance to the government exceeds its expected gains.
As a result, three “players” mattered for the outcome of the game between the central bank and the government, thus echoing our recent research in which we wondered: “ The Central Bank, the Treasury or the market: which determines the price level? ».[Nearly 80 readers trust The Conversation newsletter to better understand the world's major issues. Subscribe today]
What does this role of the market imply for central banks in this question of the risk of budgetary dominance? First, it is key for central banks and their price stability mandates that they influence investors' beliefs: when investors think the central bank is going to "chicken down", markets will not react to overly expansionary fiscal policies and fiscal dominance will prevail.
Second, central banks must also let prices in debt markets reflect investors' beliefs about fiscal policy risks. This is not necessarily satisfied when central banks are too interventionist in these markets, although other motives may justify interventions such as a possible market exuberance.
This last point should lead central banks such as the European Central Bank (ECB), especially with regard to its new instrument – its “anti-fragmentation” tool, the Transmission Protection Instrument – which allows it to act in the event of a change in a country's financing rate.