Synching monetary policy with fiscal policy

by Manshu on February 5, 2013

in Economy

Ams posted a comment on the article about the difference between monetary and fiscal policy, and asked how are these kept in synch since one is formed by the government and the other by the central bank.

This is an interesting question, and within the same country being in synch is not such a big problem but it has been a problem for the Eurozone, where 17 countries share a common currency and their monetary policy is controlled by ECB while their fiscal policies are controlled by each member country.

Ashok brought up this great point in the previous post. Here is his comment.

Ashok February 2, 2013 at 7:26 am

Simple and good article. Very easy to understand.

Is it the case in EU countries that the monetary policy is administered centrally by the ECB and the fiscal policy is administered individually by each country and that is why the views may not converge and leads to a crisis in EU? For e.g. Greece may want the interest rates to go down, but the central bank may not want it because it may lead to inflation in other countries (just an example….).

REPLY

Interest rates and money supply are controlled by the ECB (European Central Bank) and they target inflation at 2% which is how the monetary policy is transmitted across all Eurozone countries.

But the fiscal policy is a bit harder to control because each country has its own budget and are free to tax and spend as they like. The Eurozone countries have an overall deficit target of bringing down their fiscal deficit to 3% of GDP, but because each country’s current fiscal situation varies so widely it is hard for all of them to bring down their deficit to 3% immediately, and so they have intermediate targets, but largely, they get missed too.

For example, in March last year Spain said that it wouldn’t be able to meet its target of a deficit of 4.4% of GDP and would be at somewhere around 5.8%. Spain had overshot its target in 2011 also, and I’m unable to find the final number for 2012.

The Eurozone countries all have quite varied fiscal positions, and this link shows the latest numbers for all countries that are part of the EU. You can see that this ranges from Sweden’s 0.2% surplus to Ireland’s 31.3% deficit!

Last year the EU countries also came up with a ‘golden rule’ which had certain conditions that each EU country that agrees to it will abide by like retaining the deficit under 0.5% if your debt is more than 60% of GDP, and under 1% if the your debt is less than 60% of your GDP.

There are a lot of other rules as well, and framing these rules and having these intergovernmental treaties is a way to synch up fiscal policies with monetary policy.

The last few years have shown that this has not been really successful and there is little reason to believe that things will change in the future. They do however are a good example of what needs to be done, and in a perfect world how it could be done.

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{ 5 comments… read them below or add one }

Ashok February 5, 2013 at 8:17 pm

Thank you for making a note of my comment and replying in such great detail.

It is a pleasure reading your blog.

Reply

Manshu February 11, 2013 at 11:11 pm

Thanks Ashok!

Reply

valueofdissent February 5, 2013 at 8:29 pm

Thanks for your wonderful blog. The golden rule mentioned by you in your blog reminds me of the fact that countries like Germany which did not adhere to this rule , did not get into financial mess while others did. So actually following or not following this rule was not the main reason for this credit crisis in EU. I have presented the European Credit Crisis in a nutshell, based on my understanding. Please correct wherever I am wrong.
————-
Eurozone Crisis
a. Eurozone countries agree to limit their govt. structural borrowings to 0.5% of GDP !!
b. The countries did the same thing in 1997 when they formed Euro. That time the borrowing limit was set at 3%
c. Italy was the worst offender , followed by Germany and France who did not obey the borrowing limit rule. Spain was top of the class. Greece did not obey the 3% rule but manipulated its books to look it had obeyed.
d. Inspite of it Germany, France continue getting cheaper funds(low interest rates) from market, while spain got funds at rates comparable to Italy(which was running high on debts).
e. There was a big build-up of debts in Spain and Italy before 2008, but it had nothing to do with governments. Instead it was the private sector – companies and mortgage borrowers – who were taking out loans. Interest rates had fallen to unprecedented lows in southern European countries when they joined the euro. And that encouraged a debt-fuelled boom.
f. All that debt helped finance more and more imports by Spain, Italy and even France. Meanwhile, Germany became an export power-house after the eurozone was set up in 1999, selling far more to the rest of the world (including southern Europeans) than it was buying as imports. That meant Germany was earning a lot of surplus cash on its exports.
g. Another problem apart from rising debts was wage rise. During the boom years, wages rose in the southern europe (and in France). But German unions agreed to hold their wages steady. So Italian and Spanish workers now face a huge competitive price disadvantage. Indeed, this loss of competitiveness is the main reason why southern Europeans have been finding it so much harder to export than Germany.
h. Countries in Sovereign Debt crisis
i. Greece, Portugal, Spain, Ireland, Cyprus
i. Spain’s problem of sovereign debts illustrates the fact that eurozone’s problems run far deeper than the issue of excessive borrowing by ill-disciplined governments. Private borrowings and uncompetitive labour is also a problem.

Reply

Ams February 7, 2013 at 11:02 am

Thanks Manshu for replying to my comment !

Reply

Manshu February 11, 2013 at 11:12 pm

Thanks for your comment Ams.

Reply

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