Session 6: Links between central banking and fiscal policy

Isabel Correia, Banco de Portugal

Pierpaolo Benigno, LUISS Guido Carli

According to Isabel Correia, the financial crisis has meant that we are now in a situation where both monetary policy and fiscal policy have been worn out. There is not much scope left to stimulate the economy, as the interest rate is already close to zero or negative, and government debt has increased. The focus has therefore shifted towards more unconventional monetary policy measures, such as quantitative easing, that is, the central bank purchases securities. The problem with these is that they create balance sheets with high-risk assets at the central banks.

Pierpaolo Benigno further argued that quantitative easing does not lead to the intended welfare effect, if the risks the central bank takes up in its balance sheet by purchasing long-term bonds do not stay with the central banks but are returned to the private sector. This occurs if the central bank makes losses covered by the treasury, that is, tax revenue. Then the assets in the private sector will remain unchanged.

For quantitative easing to have the desired effect, it needs to be backed up by a fiscal policy that does not include tax increases. This requires coordination of monetary and fiscal policies.

Isabel Correia asked how monetary policy could now stabilise the economy. One way is to introduce maximum welfare as a criterion. This means that stability policy would not merely involve reducing volatility, it might even involve increasing volatility if this is positive for welfare. It is also important to think in new ways. Taxes can sometimes be used where interest rates are usually used.