1. FISCAL & MONETARY: IT TAKES TWO TO TANGO Robert TCHAIDZE, ISET For the NBG conference on monetary policy

2. June 26, 2009Robert Tchaidze: FISCAL & MONETARY2 The Main Messages  Coordination of fiscal and monetary is … … important; … even more so in a country like Georgia; … under any monetary regime; … in any macroeconomic circumstances.  NB: this presentation is not about the country of Georgia. It is about a country like Georgia.

3. June 26, 2009Robert Tchaidze: FISCAL & MONETARY3 Outline 1. Motivation and theoretical arguments; 2. What should be coordinated; 3. Why it could be worse in a country like Georgia; 4. Example of Iceland.

4. June 26, 2009Robert Tchaidze: FISCAL & MONETARY4 Motivation and Theory  Simple macroeconomic models show that a policy measure by monetary can be undone or exaggerated by fiscal and vice versa.  Wrong moves do not need to be actually happening. Expectations that they may happen are enough to screw things up.

5. June 26, 2009Robert Tchaidze: FISCAL & MONETARY5 Motivation and Theory  This needs to be sufficiently appreciated.  Lack of coordination shows up in variables (inflation, interest rate, exchange rate) that are easier to attribute to monetary than fiscal.  Hence, very tempting to take actions driven by political agenda and place the blame with monetary.

6. June 26, 2009Robert Tchaidze: FISCAL & MONETARY6 What can go wrong:  Traditional story: Spending → inflation; Domestic borrowing → interest rates; FX privatization/borrowing → exchange rates.  Less so: Quasi-fiscal operations; Functioning of T-bill/liquidity market.

7. June 26, 2009Robert Tchaidze: FISCAL & MONETARY7 Coordination  Macroeconomic management: Level of deficit; Domestic and foreign borrowing; Composition of spending (current/capital).  Liquidity management: Timing of spending, borrowing, payments, FX conversion; Maintenance of T-bill market.

8. June 26, 2009Robert Tchaidze: FISCAL & MONETARY8 Coordination is important under any monetary regime  Fixed exchange rate regime (peg): Persistent budget deficits drain reserves forcing CB to abandon the peg.  Currency board/dollarization/currency union: Loose fiscal policy (excessive spending or low taxes) leads to real exchange rate appreciation.  Free float (either IT or Dual Target) : Loose fiscal policy (excessive spending or low taxes) leads to inflation.

9. June 26, 2009Robert Tchaidze: FISCAL & MONETARY9 Structurally changing economies  I.e., transitional/developing economies, emerging markets where new rules, mechanisms, structures are being set up.  Often these are small open economies with their own currencies.  In such economies the issues become much more problematic than in developed economies.

10. June 26, 2009Robert Tchaidze: FISCAL & MONETARY10 Structurally changing economies  Potential of monetary is limited;  Scale of things is much bigger (massive inflows, total privatization, sweeping reforms);  Politics dominated by one party; party dominated by few individuals;  Business-politics connections tighter;  Public awareness is limited.

11. June 26, 2009Robert Tchaidze: FISCAL & MONETARY11 Examples  These are clearly economic decisions but they could to a larger than warranted degree be reflective of political considerations: Social safety net spending; Tax cuts; Privatization; Donor aid.  These are reasonable and warranted actions that may have very unpleasant consequences.

12. June 26, 2009Robert Tchaidze: FISCAL & MONETARY12 Iceland  Banks were a big part of the story but not the only one.  The other parts are reflective of politics and structural changes: Investment into aluminum industry; Tax cuts; Housing fund.  Directly contributed to overheating.  Indirectly, as these helped establish an image of a dynamic transforming country, inducing foreigners to invest into it and Icelanders to spend.

13. June 26, 2009Robert Tchaidze: FISCAL & MONETARY13 Iceland  Consequences: Exchange rate appreciation; Inflation; Asset (real estate and stock market) bubbles; Huge current account deficit; High level of household and external debt.  Very different views held by the Central Bank and Ministry of Finance staff. E.g. output gap estimates: +5 percent (CBI); +1 percent (MoF)  Budget surpluses of 5 percent of GDP, creating an impression of tight fiscal policy.

14. June 26, 2009Robert Tchaidze: FISCAL & MONETARY14 The Main Messages  Coordination of fiscal and monetary is … … important; … even more so in a country like Georgia; … under any monetary regime; … in any macroeconomic circumstances.  NB: this presentation is not about the country of Georgia. It is about a country like Georgia.