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

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Presentation on theme: "Monetary and Fiscal Management, Finance, and Growth Thorvaldur Gylfason."— Presentation transcript:

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

2 Overview: Three parts 1.Implications of economic integration for monetary and fiscal policy nNarrow focus on inflation as the main objective of monetary policy 2.Inflation, finance, and growth nLong-run goals of stabilization 3.Fiscal policy and growth nLong-run goals of allocation and distribution

3 Implications of economic integration nMonetary policy nSingle currency n12 out of 15, soon at least 22 out of 25 nConcerns about common currency despite different languages have subsided nNumber of official EU languages and costs of translation are on the rise nIndependent European Central Bank committed, by law, to low inflation nFundamental implications, of two kinds 1

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

5 Implication of narrow focus on inflation nSo, 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 nHow? Mainly through attempts at friendly persuasion, like U.S. Fed nThis suggests a general principle: nIf it helps reduce inflation, the Central Bank should support it

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

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

8 Implication of narrow focus on inflation nSome might object that a central bank involving itself in, e.g., the macroeconomic consequences of agricultural policy could be accused of political meddling nMy answer is No, not really nCentral 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 nNewfound independence of central banks is a natural extension of a long-standing depolitization process nNeed independent, yet accountable nCourts of law nUniversities nNews media nAnd now, central banks nWhat next? Fiscal policy?

10 Should fiscal policy also be more independent? nBegin by an example of Icelandic fisheries management nIntimately linked to fiscal policy nResource rent amounts to 5% of GDP nMacroeconomic and fiscal concern nRather than giving the rents to boat owners for free, government could raise substantial revenue and reduce taxes nFish stocks are common property by law nObjection: Politicians would squander revenue from fishing fees

11 Should fiscal policy also be more independent? nIf 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 nThus, urgent fiscal reform can be assured, free from political interference nShould this principle be applied more widely in the fiscal policy sphere?

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

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

14 Should fiscal policy also be more independent? nBasic idea here is this nNational parliaments set the path – i.e., medium-term targets – of government spending and taxes, based on allocation and distribution objectives nFiscal 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? nBut if so, why not depoliticize the allocation function of fiscal policy on similar efficiency grounds as well? – including agricultural policy nBut clearly, this argument cannot be taken too far nWe do not want to completely depoliticize politics, do we? nLike it or not, politics is necessary: let’s try to restrain it without stifling it Distribution cannot be delegated!

16 Inflation, finance, and economic growth nArgument 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? nWhat is the mechanism?  Inflation hurts growth through X where  X can be saving, trade, finance, etc. 2

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

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

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

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

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

22  /(1+  ) 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 Inflation and growth: What is the upshot? Austria nHigh inflation hurts growth nAn increase in inflation from 0% to 10% per year reduces per capita growth by more than 0.15% per year nAccords with existing studies nFor comparison, per capita growth was 1.3% per year in sample on average nEffects of inflation on growth are economically significant

29 Inflation and growth: What is the upshot? Austria nHence, 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 … n… a similar argument can be applied to the stabilizing role of fiscal policy nIf so, how about allocation and distribution? Now the plot thickens!

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

31 Education and economic growth nIs education, like price stability, too important to be left to politicians? nDue 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 87 countries r = 0.72 Diminishing returns: Additional benefit from education becomes smaller as enrolment increases Austria Nicaragua Korea Finland Jamaica Botswana What is the empirical evidence? Education is good for growth

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

34 Education and economic growth nSo, education is good for growth, but it tends to be undernourished in Europe compared with America nPerhaps 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 nSo, some part of allocation function of fiscal policy could, in principle, be delegated – that is, depoliticized nNot 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? 75 countries 12 1% A 12 point increase in Gini coefficient goes along with a decrease in per capita growth by 1% per year r = -0.50 Korea Brazil Sweden Austria South Africa France Mechanisms: Social cohesion Education No sign that excessive equalization hurts growth

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


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