Monetary and Fiscal Management, Finance, and Growth

1. Monetary and Fiscal Management, Finance, and Growth Thorvaldur Gylfason

2. Overview: Three parts • Implications of economic integration for monetary and fiscal policy • Narrow focus on inflation as the main objective of monetary policy • Inflation, finance, and growth • Long-run goals of stabilization • Fiscal policy and growth • Long-run goals of allocation and distribution

3. 1 Implications of economic integration • Monetary policy • Single currency • 12 out of 15, soon at least 22 out of 25 • Concerns about common currency despite different languages have subsided • Number of official EU languages and costs of translation are on the rise • Independent European Central Bank committed, by law, to low inflation • Fundamental implications, of two kinds

4. Implication of narrow focus on inflation • New regime dictates narrow focus on low inflation as the main objective of monetary policy • Inflation targeting, also outside EMU • Inflation depends on various factors besides monetary policy undertakings • Fiscal policy, efficiency, institutions, etc. • After all, there are considerable inflation differentials within Europe

5. Implication of narrow focus on inflation • So, if ECB and, by extension, national central banks are held responsible for maintaining low inflation, they may need to reserve the right to address all sources of inflation • How? Mainly through attempts at friendly persuasion, like U.S. Fed • This suggests a general principle: • If it helps reduce inflation, the Central Bank should support it

6. Implication of narrow focus on inflation • This is why central banks would be right to argue for more competition • Simple mechanism • Greater efficiency in resource allocation imparts a boost to the supply side, thereby putting downward pressure on prices, as if demand had been reduced • Moreover, supply stimulus does not have the same disadvantageous side effects as demand restraint

7. Implication of narrow focus on inflation • This is why I also think that central banks would be right to criticize, e.g., the inefficiency of the CAP • It is the same story: • Increased efficiency stimulates the supply side, thereby helping contain inflation, at least for a while • Generally, central banks would be right to support growth-friendly reforms because growth helps restrain inflation

8. Implication of narrow focus on inflation • Some might object that a central bank involving itself in, e.g., the macroeconomic consequences of agricultural policy could be accused of political meddling • My answer is No, not really • Central banks have been granted more independence precisely in order to give them greater freedom to pursue the objectives assigned to them by law

9. Increased independence requires depolitization • Newfound independence of central banks is a natural extension of a long-standing depolitization process • Need independent, yet accountable • Courts of law • Universities • News media • And now, central banks • What next? Fiscal policy?

10. Should fiscal policy also be more independent? • Begin by an example of Icelandic fisheries management • Intimately linked to fiscal policy • Resource rent amounts to 5% of GDP • Macroeconomic and fiscal concern • Rather than giving the rents to boat owners for free, government could raise substantial revenue and reduce taxes • Fish stocks are common property by law • Objection: Politicians would squander revenue from fishing fees

11. Should fiscal policy also be more independent? • If so, the determination of fees and allocation of revenues could be decoupled from the political process by setting up, yes, an independent Open Market Fisheries Committee • Thus, urgent fiscal reform can be assured, free from political interference • Should this principle be applied more widely in the fiscal policy sphere?

12. Should fiscal policy also be more independent? • Fiscal policy belongs at national level • Yet, we have common rules involving numerical targets in Maastricht Treaty and Stability and Growth Pact • Do numerical targets call for common standards for fiscal institutions? Laws governing fiscal policy framework? • Can budget discipline and fiscal efficiency be improved through delegation – i.e., depolitization?

13. Should fiscal policy also be more independent? • Blinder’s Fiscal Policy Committee • Vested with authority to determine the tax structure, but not the level or composition of government spending • Need for (a) long-run perspective, (b) freedom from special interest groups, (c) shorter decision lags • Other proposals involve debt limits • Separate stabilization from allocation and distribution – i.e., depoliticize the stabilization function of fiscal policy

14. Should fiscal policy also be more independent? • Basic idea here is this • National parliaments set the path – i.e., medium-term targets – of government spending and taxes, based on allocation and distribution objectives • Fiscal policy committee determines cyclical variations around that path, e.g., by setting individual tax rates (such as VAT) or individual expenditure items (such as grants to regions)

15. Should fiscal policy also be more independent? • But if so, why not depoliticize the allocation function of fiscal policy on similar efficiency grounds as well? – including agricultural policy • But clearly, this argument cannot be taken too far • We do not want to completely depoliticize politics, do we? • Like it or not, politics is necessary: let’s try to restrain it without stifling it Distribution cannot be delegated!

16. 2 Inflation, finance, and economic growth • Argument for decoupling fiscal as well as monetary stabilization from politics concerns the long run • Inflation is perceived to be bad for long-run economic growth • What is the evidence for this? • What is the mechanism? • Inflation hurts growth through X where • X can be saving, trade, finance, etc.

17. From high inflation via finance to slow growth Let’s look at the financial linkage Growth Growth Financial depth = + Inflation Financial depth Inflation What is the empirical evidence?

18. Financial depth and economic growth r = Spearman rank correlation r = 0.66 Botswana Austria Indonesia Japan Switzerland Jordan 87 countries

19. Inflation and financial depth Add these two correlations, and an inverse correlation between inflation and growth follows r = -0.45 Switzerland Japan Austria Nicaragua Argentina Brazil 87 countries

20. Austria Inflation and economic growth • However, the relationship between inflation and growth turns out to be too complicated to be discernible to the naked eye as a two-dimensional correlation • So, let us go the regression route • Estimate series of growth regressions • Same 87 countries during 1965-1998 • Data from World Bank´s WDI

21. Austria Inflation and economic growth • Regress growth on inflation distortion, defined as  /(1+ ) where  is rate of inflation • Then, test robustness by adding further explanatory variables • Initial income, natural resources • Investment • Education • Population growth Now, switch to EViews

22. DISTORT =  /(1+ )

23. Natural resource curse

24. Conditional convergence

25. Investment is good for growth …

26. … as is education, with diminishing returns

27. Population growth hurts per capita growth in medium term

28. Austria Inflation and growth: What is the upshot? • High inflation hurts growth • An increase in inflation from 0% to 10% per year reduces per capita growth by more than 0.15% per year • Accords with existing studies • For comparison, per capita growth was 1.3% per year in sample on average • Effects of inflation on growth are economically significant

29. Austria Inflation and growth: What is the upshot? • Hence, if it is the need to immunize the stabilizing function of monetary policy from political interference for long-term gain that has produced independent central banks, then … • … a similar argument can be applied to the stabilizing role of fiscal policy • If so, how about allocation and distribution? Now the plot thickens!

30. 3 Fiscal policy and economic growth • Let us now move from stabilization to allocation and distribution • The allocation role of government has important consequences for long-run growth • Education • Health care • Infrastructure

31. Education and economic growth • Is education, like price stability, too important to be left to politicians? • Due to externalities, the government has a role to play in education • Without government involvement, not enough education would be provided in free markets, thwarting social efficiency • Even so, myopic governments tend to devote too few resources to education • Open Market Education Committee?!

32. Secondary-school enrolment and growth What is the empirical evidence? Botswana Korea Education is good for growth Austria Finland Jamaica Diminishing returns: Additional benefit from education becomes smaller as enrolment increases Nicaragua r = 0.72 87 countries

33. Tertiary education 1998(% of cohort) In education, Europe lags behind America

34. Education and economic growth • So, education is good for growth, but it tends to be undernourished in Europe compared with America • Perhaps delegation of authority in education would better safeguard the long-run interests of the population • One example of an allocation function of fiscal policy that could be delegated • Is health care also a candidate? • Similar problems, but more difficult Another candidate: Pension reform

35. Distribution and economic growth • So, some part of allocation function of fiscal policy could, in principle, be delegated – that is, depoliticized • Not the distribution function, however, which is inherently political • Even so, distribution seems to matter for long-run growth • What is the evidence? • What are the mechanisms?

36. Inequality and economic growth What is the empirical evidence? A 12 point increase in Gini coefficient goes along with a decrease in per capita growth by 1% per year Korea France Austria Brazil South Africa • Mechanisms: • Social cohesion • Education Sweden No sign that excessive equalization hurts growth r = -0.50 75 countries

37. 4 Conclusion These slides can be viewed on my website: www.hi.is/~gylfason • Distribution belongs in political arena, even if it matters for growth • Distributional implications of education and, especially, health care complicate delegation of these key allocation roles of fiscal policy • Even so, some degree of delegation beyond mere monetary stabilization may be worth considering The End