The risky game of “chicken” between eurozone governments and the ecb

There exists a need for coordination, however, not amongst countries. The need for coordination is urgent with regards to fiscal and monetary authorities, especially in the Eurozone. It really is obvious that at some time both monetary and fiscal policy ought to be reined in, however the issue is among sequencing. Should central banks start considering rescinding their exceptional monetary accommodation, or should governments start cutting deficits?

I mention the Eurozone because that’s where the issues have already been tabled first. The ECB has explicitly linked fiscal retrenchment and its own exit from the recent extraordinary monetary accommodation. ECB Board member Lorenzo Bini Smaghi said on :

“The more delayed the fiscal exit, ceteris paribus, the more the monetary policy exit may need to be brought forward. Indeed, given the amount of the debt accumulated generally in most advanced economies, any delay in the fiscal exit will probably impact inflation expectations, and could even disanchor them. That is a risk that monetary policy cannot take, since it would undermine its overall strategy.” (Bini Smaghi 2009).

Both governments and central banks have good arguments for postponement. The total amount sheets of finance institutions are definately not being fully repaired. Nobody really knows what would happen if the floodgates were closed and liquidity stopped flowing – and central banks certainly don’t want to determine by running an experiment. Moreover, banks, flush with cash but nonetheless unwilling to lend, are benefiting from the yield curve to borrow short and lend long, especially to governments. An abrupt upsurge in long-term rates risks turning these carry trades sour. On the other front, we don’t know from what extent the recovery that appears to have started is simply the consequence of the stimulus programmes needs to activate. This makes governments understandably reluctant to cut spending or raise taxes.

In the classic game of chicken, one possibility is that neither player yields to the other, leading to the worst outcome for both. In the event at hand, this might entail a rise in long-term interest levels resulting from a combined mix of concern with persistent deficits creating large debts, concern with inflation from persistent monetary accommodation, or just from the anticipation that central banks will move first and rather early. That is a sure way to kill the recovery. Will there be a means out?

The answer can be an irrevocable commitment by governments to cut spending later on. Such a committed action would stabilise expectations and invite central banks to hold back longer before they remove their monetary accommodation. As well, it could avoid the demand risks an immediate removal of the fiscal stimulus would impose.

Although such commitment could be difficult to attain, there are arguably method of making spending reversals credible ex ante. The prime examples are available in the region of ageing- spending. This year’s 2009 Ageing Report issued by the European Commission implies that in a few EU countries the budgetary ramifications of the projected demographic trends are much bigger than the expense of any stimulus package. The estimated upsurge in ageing- spending over another 15 years amounts to 7% of GDP each year in Holland, 5% in Spain, 3.5% in Germany, and 3.3% in the EU27. The actual fact that the budgetary ramifications of ageing are several orders of magnitude bigger than the fiscal cost of the crisis is another reason to start out addressing the problem now.

Figure 1 . The fiscal costs of the crisis in comparison to age- spending

While feasible, such reforms ought to be carefully planned and require time to be approved; work should thus begin right now – also considering that ageing- fiscal adjustment is essential whatever the current conditions. (That is also the suggestion that originates from the IMF (2009): “successful fiscal adjustment to make certain debt returns to sustainable positions will hinge on measures to contain aging- spending, for countries with looming demographic pressures.”)

Thus monetary and fiscal authorities face the decision from the place to start. Should monetary accommodation be removed first, or should we begin from fiscal policy? Absent a credible fiscal exit strategy, long rates could soon increase as financial markets start anticipating the response of central banks to having less action on the fiscal front. The upsurge in long rates would depress consumption and investment preventing internal rebalancing. A clear commitment to future spending cuts is a good way to permit central banks to keep an accommodative policy for a few more time.