An Unconventional Collaboration

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Since the conquest of inflation in the 1980s, advanced-economy policy has converged on a model where monetary policy targets low inflation to stabilize activity, and fiscal policy focuses on public goods and redistribution while leaving stabilization largely to automatic stabilizers.
Current challenges create "cracks in the vase":
- Low average nominal interest rates lead to the “effective lower bound” constraint, limiting monetary policy’s room for expansionary cuts.
- High government debt can pressure monetary and regulatory authorities to keep rates too low for too long, especially when inflationary shocks require credible monetary tightness.
- High private debt and leverage, intertwined with financial markets, combined with high government debt, increase systemic vulnerability to liquidity and solvency crises and may distort monetary and fiscal conduct.
The COVID-19 period produced an explosion of public liabilities that tests the resilience of the orthodox model and the political feasibility of required primary surplus adjustments.

Tobin’s “funnel” model: aggregate nominal stimulus can be generated by different combinations of monetary (M) and fiscal (F) policy, implying substitutability in delivering nominal demand.
When policy rates are at the effective lower bound and deflationary pressures arise, a coordinated unconventional mix can, in theory, avoid a deflationary spiral:
- Fiscal authority temporarily scales up deficits and commits not to raise taxes or cut spending during the episode.
- Central bank temporarily commits to guaranteeing the face value of outstanding government liabilities in nominal terms and does not react to short-run inflation changes, effectively letting the economy run hot.
- Necessary conditions for success include the element of surprise or long enough nominal debt maturities, temporariness and strict limits to the suspension of normal “good-behavior” rules, and strong independent institutions.
The mix can operate in reverse: running budget surpluses that increase the real value of debt would help reduce inflation.

Preserve medium- and long-term price stability: central banks must pursue price stability over the medium and long term.
Fiscal authorities must guarantee debt sustainability and adjust policies consistent with the inflation objectives of the central bank, specifically by credibly raising the structural primary surplus—and with sufficient intensity—in response to any rise in the stock of debt.
In a high-inflation, high-debt environment:
- Stick to policy prescriptions that prioritize price stability and fiscal consolidation to avoid an inflation premium that raises government borrowing costs.
- Recognize that fiscal consolidation (spending cuts or higher taxes) can ease the burden on monetary policy by containing aggregate demand, allowing for a less severe monetary contraction.
Maintain precautionary budget saving during expansions to preserve fiscal space for episodes when monetary policy is constrained (the rationale for controlling spending and/or maintaining tax revenues in expansions).

Since the global financial crisis central banks have assumed or reclaimed supervisory, regulatory, and resolution powers in the banking sector and expanded unconventional policies, including large-scale purchases of government bonds and other assets.
A credible monetary backstop can prevent self-fulfilling sovereign risk crises by deterring coordination on a high-interest-rate equilibrium; credibility often depends on fiscal cooperation because bond purchases expose the central bank to balance sheet losses.
For backstops to be credible without undermining price stability, fiscal authorities may need to provide contingent fiscal guarantees on the central bank balance sheet; otherwise investors may doubt the central bank’s willingness to intervene.
Stability ultimately depends on fiscal policy: central bank engagement in government debt markets can only be stabilizing if debt is on a sustainable path conditional on the backstop.

The unconventional joint strategy (temporary fiscal expansion + central bank guarantee/monetization) is complex and risky:
- Success depends on strong constitutional rules and independent institutions to limit temporariness and prevent erosion of credibility.
- If the arrangement becomes permanent or expected, it risks prompting inflation premia that raise borrowing costs and worsen fiscal dynamics.
Even with a negative r minus g (real interest rate below growth rate), which can mechanically help contain debt-to-GDP dynamics, such an environment may co-exist with low productivity growth and political pressure for large deficits that can generate high risk premia and fiscal instability.

After the global financial crisis central banks often acted as a monetary backstop to public debt; a leading example cited is the European Central Bank’s Outright Monetary Transactions program in 2012.
A credible threat of intervention can be sufficient to discourage market speculation without actual bond purchases, but credibility rests on fiscal–monetary cooperation and mechanisms to address central bank balance sheet risks.

An Unconventional Collaboration — GIANCARLO CORSETTI, March 2023.

Corsetti Unconventional Collaboration
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