Transcript Seigniorage and the relationship between monetary and

JEM027
Monetary Economics
Seigniorage and the fiscal dominance
problem
Tomáš Holub
[email protected]
November 10, 2014
Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague
Motivation (1/2)
▪ The need of monetary policy to generate seigniorage in order
to cover fiscal costs may in extreme (but historically quite
common) cases generate hyperinflation: Cagan (1956)
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Motivation (2/2)
▪ In less extreme – but still quite unpleasant – situations,
the “fiscal dominance” problem may emerge
----------------------------------------------Seminar topic:
▪ But central banks are not always “money-making machines”
– there are even loss-making central banks (including the
CNB in the past)
▪ Does financial weakness force a CB to resort to higher
inflation?
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What is seigniorage?
Monetary seigniorage
Monetary income (opportunity cost seigniorage)
… where
▪ MB is monetary base
▪ CU is currency
▪ RE is bank reserves
▪ P is price level
▪ Y is real GDP
▪ i is nominal interest rate
▪ Ir is interest rate on bank
reserves
Note: There are other definitions of seigniorage (fiscal seigniorage, total seigniorage etc.), but I do not find them very useful. Let us stick to
the traditional ones
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Monetary seigniorage and income
▪ Monetary income is not equal to monetary seigniorage; they
are equal only in special cases
▪ If the real IR = 0, then monetary income = “inflation tax”
(Friedman, 1971)
Inflation tax
… where p is rate of inflation
▪ Economic relationship between monetary seigniorage
and monetary income: analogy with cows and milk
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Stylized balance sheet of a central bank
Assets
Liabilities
Net foreign assets (FACB) Monetary base (MB) =
Net claims on gov’t (GDCB) currency (CU) + reserves (RE)
Net other assets (OACB) Net equity (ECB)
Example: effect of permanent increase in MB on CB‘s profits
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Cagan model
S
▪ “Laffer curve”
μ*
Inflation
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Optimal rate of inflation
S
μ*
Inflation
▪ Trade-off between distortionary taxation and distortions due
to inflation
▪ Optimal inflation is generally positive
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Sargent and Wallace (1981) (1/4)
▪ ”Some Unpleasant Monetarist Arithmetic“
▪ Assume an economy in which the quantity theory of money holds perfectly
▪ Monetary policy dominated by fiscal needs, must monetize budget deficits
▪ Economy grows at an exogenous rate (g)
▪ Real interest rate on government bonds assumed to exceeds economic
growth (r>g)
▪ Result: lower money supply growth and inflation at present means higher
inflation in the future
▪ If money demand depends on expected inflation: lower money supply
growth may even lead to higher inflation now
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Sargent and Wallace (1981) (2/4)
A spectacular example of the potential effects of tight and loose
monetary policy
For more detail see: http://www.minneapolisfed.org/research/QR/QR531.pdf
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Sargent and Wallace (1981) (3/4)
Primary deficit Seigniorage “Snowball effect”
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Sargent and Wallace (1981) (4/4)
bt+1
r>g
▪ If r>g, primary deficits
r<g
must be covered by
seigniorage to make the
budgets sustainable
dt-μtht
bt
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Darby (1983)
▪ ”Some Pleasant Monetarist Arithmetic“
▪
▪
▪
In reality r<g, i.e. the key assumption of the paper does not hold empirically
In defence of Sargent and Wallace – if government debt exceeds some threshold,
risk premium may increase, causing r>g (see the EA sovereign debt crisis)
Note: this might lead to some self-fulfilling prophecies
10Y government bond yields (Maastrichat criterion)
Percent p.a.
10Y gov't bond yileds (Maastricht criterion)
30
Euro area
20
Belgium
15
Germany
Ireland
10
Greece
5
Spain
France
2012M01
2011M09
2011M05
2011M01
2010M09
2010M05
2010M01
2009M09
2009M05
2009M01
2008M09
2008M05
2008M01
2007M09
2007M05
2007M01
2006M09
2006M05
0
2006M01
in % p.a.
25
Italy
Portugal
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“Fiscal dominance” literature
Monetary policy
Fiscal policy
Active
Pasive
Pasive
Textbook
P-level
good case indetermin.
Active
Fiscal
dominance
▪ Note: inflationary surprises not only lead
to higher seigniorage, but also erode
nominal government debt
▪ Eric Leeper, 1991 (and
▪
▪
others, e.g. Sims)
Textbook case: MP is
unconstrained and can
actively pursue price stability
by reacting sufficiently
strongly to inflation; FP
passively adjusts direct taxes
to balance the budget
Fiscal dominance: FP
refuses to adjust taxes
strongly, deficits are not
financed entirely with future
taxes; MP allows the money
stock to respond to shocks to
fiscal deficit
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Modern practice (1/2)
▪
▪
▪
CBs focus on price stability as their main goal
Independent from government
Prohibition of monetary financing
Article 123 (ex Article 101 TEC)
“
▪
Overdraft facilities or any other type of credit facility with the European Central
Bank or with the central banks of the Member States (hereinafter referred to
as ‘national central banks’) in favour of Union institutions, bodies, offices or
agencies, central governments, regional, local or other public authorities, other
bodies governed by public law, or public undertakings of Member States shall
be prohibited, as shall the purchase directly from them by the European
Central Bank or national central banks of debt instruments.
”
Seigniorage taken as a welcome by product helping to keep the central bank
financially independent from the government, but generally low (less than 0.5 % of
GDP, but typically even lower) in a low-inflation environment
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Modern practice (2/2)
▪ Crisis has changes the things a lot, stretching the mandates (and reviving
interest in the fiscal dominance literature)
Overview of selected central banks primarily influencing long-term interest rates and
the exchange rate
Outright purchases of financial assets
Bank
Government
bonds
Covered bonds
Other private
assets
Foreign currency
Fed
BoE
ECB
SNB
Enforced in 2010 by the Greek crisis
(SMP: EUR ≈220 bn.; OMT not activated)
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Conclusions
1
Seigniorage often misused in the past as a source of government
financing
2
Potentially disastrous consequences (hyperinflations, or at least fiscal
dominance)
3
Financial independence of CB and strong prohibition of monetary
financing an important element of modern institutional set-up
4
Seigniorage typically well below 0.5% of GDP if inflation is low
(a welcome by-product of monetary policy, but nothing more…)
5
During the crisis : quantitative easing/SMP  the modern set-up
stretched to the extreme
6
Some central banks (e.g. CNB) making losses (sterilisation
costs/revaluation of FX reserves), others could follow soon; but this is
unlikely to imply a threat of high inflation in countries with strong
institutional background
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