The blockade in monetary and fiscal policy

Since the early 1990s, monetary policy has taken over the management of the economy and fiscal policy has held back. As inflation was structurally low, monetary policy pushed interest rates lower and lower. Inflation is back and fiscal policy is becoming more expansionary to mitigate the consequences. To compensate the expansion, monetary policy would now have to become very restrictive, but this would threaten new financial crises. It has therefore become hardly possible to fight inflation effectively.

The British bomb

On September 23, the newly formed British government led by Liz Truss announced a stimulus package aimed at boosting growth in the medium term through deregulation and the most generous tax cut of the last 50 years. Without a government financing plan for the tax cuts, the financial markets reacted with panic. Since the Bank of England was about to begin selling its bond portfolio, the markets feared a wave of new bond issues at the same time as one of the largest buyers withdrew. The market for British government bonds collapsed and pension funds, which had not expected an interest rate turnaround of this magnitude, got in trouble.

To avoid a new financial crisis, the Bank of England switched from the planned “Quantiative Tightening” to a renewed “Quantitative Easing”. And this with an inflation rate of 10%. The government gave up and softened its tax plans ten days later. The British zigzag course of monetary and fiscal policy illustrates the dilemma in which the countries of the euro zone also find themselves.

Monetary vs Fiscal Policy

At the end of 2021 at the latest, when the central banks of the largest currency areas recognized that inflation was not temporary, a new era for economic policy began. The U.S. Federal Reserve and the Bank of England, in particular, attempted to combat inflation by raising key interest rates, initially hesitantly and later more sharply (Fig. 1). 

At the same time, citizens demanded compensation from their governments for rising prices. The transfers granted in return, however, lead to higher budget deficits and fiscal policy becomes more expansionary. To neutralize the positive stimulus from fiscal policy, monetary policy would have to become even more restrictive. But sharply rising interest rates endanger financial stability.

Monetary and fiscal policy in the 1980s

The Federal Reserve was in a similar situation when Paul Volcker was appointed Chairman in 1979. The inflation rate was above 11% and the unemployment rate was 5.7% (Fig. 2).¹  With inflation seen as the greater evil, the Fed raised the federal funds rate from 10% to 17.5% in November 1980. Previous rate hikes had already been unpopular, and Jimmy Carter lost the presidential election to Ronald Reagan.

Reagan cut taxes and the government debt ratio rose rapidly (Fig. 3). The Fed countered by raising its policy rate to 20%. Reagan allowed it to happen even though the economy fell into recession and unemployment rose to over 10%. Inflation finally fell to acceptable levels.

Warning for the euro area

The European Central Bank has been slow to follow the lead of the Federal Reserve and Bank of England and has a great deal of catching up to do. At the same time, however, pressure is mounting for a more expansionary fiscal policy in the euro area. The German government has adopted a 200 billion euro credit-financed "gas price brake." The new Italian government wants to cut taxes and increase spending. The French government has long pushed for the possibility of higher government deficits. The Stability Pact, suspended during the pandemic, has not yet been reinstated.

Against this backdrop, it should be difficult for the ECB to sell the bonds it has bought “for monetary policy purposes” - i.e. to fuel inflation - to extinguish the inflationary fire. In the euro area, the threat is likely to come less from indebted pension funds but from highly indebted governments. It remains to be seen whether the Bank of England's experience will deter the ECB from stepping up tightening or whether it will first have to experience the threat of a financial crisis itself. But an effective fight against inflation is hardly possible under these circumstances.

¹ For a detailed analysis of the "Great Inflation" and the role of economic ideas, see Kleinheyer (2022), "The Great Inflation: Learning from Pain," Flossbach von Storch Research Institute.

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