## corsetti-unconventional-collaboration

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### Background: the prevailing model and its assumptions
- Since the conquest of inflation in the 1980s, economic policy in advanced economies has converged toward a model where:
  - Monetary policy targets low inflation to stabilize economic activity.
  - Fiscal authorities focus on delivering public goods and pursuing redistributive goals, leaving anti-cyclical stabilization largely to automatic stabilizers (for example, unemployment insurance).
  - Independent institutions with clear mandates implement each policy, and explicit coordination is discouraged because it "confounds responsibilities" and can erode credibility.
- The model has an international dimension: by keeping their house in order, countries contribute to global stability and welfare.

### Why reforms are needed: cracks in the vase
- Identified vulnerabilities:
  - With low average nominal interest rates, the “effective lower bound” constraint may prevent monetary authorities from delivering required countercyclical stimulus.
  - High government debt can pressure monetary and regulatory authorities to act in favor of budget sustainability (for example, keeping rates too low for too long), especially when inflationary shocks require credible monetary responses.
  - High private debt and leverage intertwined with financial markets, combined with high government debt, create systemic vulnerability to liquidity and solvency crises that weigh on policy conduct.
- Institutional changes since the global financial crisis:
  - Supervisory, regulatory, and resolution powers in the banking sector have often been returned to central banks.
  - Central banks have expanded unconventional policies, growing large balance sheets by purchasing government bonds and other assets—policies that may have significant implications for income and wealth inequality, intersecting with fiscal policy.
  - Macroprudential policy has become an important component of regulation.
  - Central banks have set up extensive currency swap lines across borders to address international liquidity.
- Policy question raised:
  - Should the economic policy model be reformed further to require closer coordination across decision-making institutions within and across borders?

### The (r)evolution of the ‘policy mix’
- Tobin’s “funnel” model summary:
  - Stimulus originates from two taps, M (monetary) and F (fiscal), but the aggregate stimulus is independent of the relative contributions of M and F.
- Role of fiscal space:
  - The social value of countercyclical fiscal expansions is highest where policy rates are stuck at their effective lower bound and inflation remains stubbornly below target.
  - Maintaining ample fiscal space during expansions (precautionary budget saving—controlling spending and/or maintaining tax revenues) is a prerequisite for effective stabilization.
- Recent theoretical perspective on coordinated action at the effective lower bound:
  - If fiscal authority temporarily scales up deficits and commits not to raise taxes nor cut spending, debt may become unsustainable and markets may charge a risk premium.
  - If the central bank temporarily commits to guaranteeing the face value of outstanding government liabilities in nominal terms and does not react to changes in inflation, it effectively monetizes the debt and lets the economy run hot with deficits.
  - Provided these policies are not anticipated by the private sector and/or the maturity of outstanding nominal government liabilities is long enough, a rise in the price level can reduce the real value of public debt in line with the present discounted value of primary surpluses.
- Important caveats:
  - Success rests on acting together in ways that are improper in normal circumstances; suspension of good-behavior rules must be temporary and limited to exceptional circumstances.
  - The policy can succeed only where constitutional rules are strict and monetary and fiscal institutions are strong and independent.
  - By symmetry, running budget surpluses that increase the real value of debt would help reduce inflation.

### Restoring moderation: joint requirements and implications
- Joint requirements for stability:
  - Central banks must pursue price stability in the medium and long term.
  - Fiscal authorities must guarantee debt sustainability, credibly raising the structural primary surplus—and with sufficient intensity—in response to any rise in the stock of debt.
- Arguments for sticking to these prescriptions amid high inflation and high debt:
  - Unexpected inflation may provide short-term fiscal relief, but sustained high and variable inflation leads markets to charge an inflation premium (higher interest rates), raising government borrowing costs and worsening the fiscal outlook.
  - Fiscal consolidation (spending cuts or higher taxes) contributes to containing aggregate demand, making the central bank’s monetary contraction less severe.
- Additional considerations:
  - The explosion of public liabilities during the COVID-19 years challenges the model’s resilience; required adjustment of primary surpluses may be difficult to achieve politically and economically.
  - A possible return to a secular stagnation scenario with low real interest rates (r) below the growth rate (g) would help contain the debt-to-GDP dynamic but may coincide with low productivity growth.
  - Governments could be pressured to run very large deficits for economic or social reasons; high debt could still result in high risk premiums that destabilize the fiscal outlook.

### A test bench for the model: the monetary backstop
- Post-global financial crisis practice:
  - Most central banks provided a monetary backstop to public debt—implicitly or explicitly standing ready to intervene in government debt markets to prevent increases in borrowing costs (example cited: the European Central Bank’s Outright Monetary Transactions program in 2012).
- How a credible backstop works:
  - It need not require actual purchases; it can work as a credible threat that discourages market speculation and prevents coordination on a high-interest-rate equilibrium.
- Conditions for credibility and the fiscal role:
  - Credibility depends on several conditions, crucially cooperation by fiscal authorities.
  - Bond purchases expose a central bank to balance sheet losses; without contingent fiscal guarantees from the Treasury (transfers to the central bank in case of losses), investors may doubt whether the central bank will intervene.
  - A well-designed monetary backstop can rule out self-fulfilling sovereign risk crises, but stability ultimately depends on fiscal policy: conditional on the backstop, debt must be on a sustainable path or central bank engagement can destabilize inflation expectations.
- Broader implication:
  - A credible understanding between fiscal and monetary authorities about how to act together to contain vulnerability to expectations-driven crises is an essential building block of a reliable economic policy regime.

*Giancarlo Corsetti, "Sometimes monetary and fiscal authorities need to break the rules and act together," Finance & Development, March 2023.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2023/march/corsetti-unconventional-collaboration.pdf_