Monetary Monetary and Fiscal and Fiscal ManagemeManagement, nt, Finance, Finance, and and GrowthGrowth

Thorvaldur Gylfason

Overview: Three partsOverview: Three parts

1.1. Implications of economic Implications of economic integration for monetary and integration for monetary and fiscal policyfiscal policy Narrow focus on inflation as the Narrow focus on inflation as the

main objective of monetary policymain objective of monetary policy

2.2. Inflation, finance, and growthInflation, finance, and growth Long-run goals of stabilizationLong-run goals of stabilization

3.3. Fiscal policy and growthFiscal policy and growth Long-run goals of allocation and Long-run goals of allocation and

distributiondistribution

Implications of Implications of economic integrationeconomic integration Monetary policyMonetary policy

Single currencySingle currency 12 out of 15, soon at least 22 out of 12 out of 15, soon at least 22 out of

2525 Concerns about common currency Concerns about common currency

despite different languages have despite different languages have subsidedsubsided

Number of official EU languages and Number of official EU languages and costs of translation are on the risecosts of translation are on the rise

Independent European Central Independent European Central Bank committed, by law, to Bank committed, by law, to low low inflationinflation Fundamental implications, of two Fundamental implications, of two

kindskinds

1

Implication of narrow Implication of narrow focus on inflationfocus on inflation New regime dictates narrow New regime dictates narrow

focus on focus on low inflationlow inflation as the as the main objective of monetary main objective of monetary policypolicy Inflation targeting, also outside Inflation targeting, also outside

EMUEMU Inflation depends on various Inflation depends on various

factors besides monetary policy factors besides monetary policy undertakings undertakings Fiscal policy, efficiency, Fiscal policy, efficiency,

institutions, etc. institutions, etc. After all, there are considerable After all, there are considerable

inflation differentialsinflation differentials within within EuropeEurope

Implication of narrow Implication of narrow focus on inflationfocus on inflation So, if ECB and, by extension, So, if ECB and, by extension,

national central banks are held national central banks are held responsible for maintaining low responsible for maintaining low inflation, they may need to inflation, they may need to reserve the right to address reserve the right to address allall sources of inflationsources of inflation How? Mainly through attempts at How? Mainly through attempts at

friendly persuasion, like U.S. Fedfriendly persuasion, like U.S. Fed This suggests a general This suggests a general

principle:principle: If it helps reduce inflation, the If it helps reduce inflation, the

Central Bank should support itCentral Bank should support it

Implication of narrow Implication of narrow focus on inflationfocus on inflation This is why central banks would This is why central banks would

be right to argue for be right to argue for more more competitioncompetition

Simple mechanismSimple mechanism Greater efficiency in resource Greater efficiency in resource

allocation imparts a boost to the allocation imparts a boost to the supply side, thereby putting supply side, thereby putting downward pressure on pricesdownward pressure on prices, , as ifas if demand had been reduceddemand had been reduced

Moreover, supply stimulus does not Moreover, supply stimulus does not have the same disadvantageous have the same disadvantageous side effects as side effects as demand restraintdemand restraint

Implication of narrow Implication of narrow focus on inflationfocus on inflation This is why I also think that This is why I also think that

central banks would be right to central banks would be right to criticize, e.g., the inefficiency of criticize, e.g., the inefficiency of the the CAPCAP

It is the same story:It is the same story: Increased efficiency stimulates the Increased efficiency stimulates the

supply side, thereby helping supply side, thereby helping contain inflation, at least for a contain inflation, at least for a whilewhile

Generally, central banks would be Generally, central banks would be right to support growth-friendly right to support growth-friendly reforms because reforms because growth helps growth helps restrain inflationrestrain inflation

Implication of narrow Implication of narrow focus on inflationfocus on inflation Some might object that a central Some might object that a central

bank involving itself in, e.g., the bank involving itself in, e.g., the macroeconomic consequences of macroeconomic consequences of agricultural policy could be agricultural policy could be accused of accused of political meddlingpolitical meddling

My answer is My answer is No, not reallyNo, not really Central banks have been granted Central banks have been granted

more independence precisely in more independence precisely in order to give them order to give them greater freedomgreater freedom to pursue the objectives assigned to pursue the objectives assigned to them by law to them by law

Increased Increased independence independence requires requires depolitizationdepolitization Newfound independence of Newfound independence of

central banks is a natural central banks is a natural extension of a long-standing extension of a long-standing depolitization processdepolitization process

Need independent, yet Need independent, yet accountable accountable Courts of lawCourts of law UniversitiesUniversities News mediaNews media And now, central banksAnd now, central banks What next? What next? Fiscal policy?Fiscal policy?

Should fiscal policy Should fiscal policy also be more also be more independent?independent? Begin by an example of Icelandic Begin by an example of Icelandic

fisheries managementfisheries management Intimately linked to fiscal policyIntimately linked to fiscal policy Resource rent amounts to 5% of Resource rent amounts to 5% of

GDPGDP Macroeconomic and fiscal concernMacroeconomic and fiscal concern Rather than giving the rents to boat Rather than giving the rents to boat

owners for free, government could owners for free, government could raise substantial revenue and reduce raise substantial revenue and reduce taxestaxes

Fish stocks are Fish stocks are common propertycommon property by by lawlaw

Objection: Objection: Politicians would Politicians would squander revenue from fishing feessquander revenue from fishing fees

Should fiscal policy Should fiscal policy also be also be moremore independent?independent? If so, the determination of fees If so, the determination of fees

and allocation of revenues could and allocation of revenues could be decoupled from the political be decoupled from the political process by setting up, yes, an process by setting up, yes, an independent independent Open Market Open Market Fisheries CommitteeFisheries Committee Thus, urgent fiscal reform can be Thus, urgent fiscal reform can be

assured, free from political assured, free from political interferenceinterference

Should this principle be applied Should this principle be applied more widely in the fiscal policy more widely in the fiscal policy sphere? sphere?

Should fiscal policy Should fiscal policy also be more also be more independent?independent? Fiscal policyFiscal policy belongs at national belongs at national

levellevel Yet, we have common rules Yet, we have common rules

involving involving numerical targetsnumerical targets in in Maastricht Treaty and Stability and Maastricht Treaty and Stability and Growth PactGrowth Pact

Do numerical targets call for Do numerical targets call for common standardscommon standards for fiscal for fiscal institutions? Laws governing fiscal institutions? Laws governing fiscal policy framework?policy framework?

Can budget discipline and fiscal Can budget discipline and fiscal efficiency be improved through efficiency be improved through delegationdelegation – i.e., depolitization? – i.e., depolitization?

Should fiscal policy Should fiscal policy also be more also be more independent?independent? Blinder’s Blinder’s Fiscal Policy Committee Fiscal Policy Committee

Vested with authority to determine Vested with authority to determine the the tax structuretax structure, but not the level , but not the level or composition of government or composition of government spendingspending

Need for (a) long-run perspective, Need for (a) long-run perspective, (b) freedom from special interest (b) freedom from special interest groups, (c) shorter decision lagsgroups, (c) shorter decision lags

Other proposals involve Other proposals involve debt limitsdebt limits Separate Separate stabilizationstabilization from from

allocationallocation and and distribution distribution – i.e., – i.e., depoliticize the stabilization depoliticize the stabilization function of fiscal policyfunction of fiscal policy

Should fiscal policy Should fiscal policy also be more also be more independent?independent? Basic idea here is this Basic idea here is this

National parliaments set the path – National parliaments set the path – i.e., i.e., medium-term targetsmedium-term targets – of – of government spending and taxes, government spending and taxes, based on allocation and based on allocation and distribution objectivesdistribution objectives

Fiscal policy committee determines Fiscal policy committee determines cyclical variationscyclical variations around that around that path, e.g., by setting individual tax path, e.g., by setting individual tax rates (such as VAT) or individual rates (such as VAT) or individual expenditure items (such as grants expenditure items (such as grants to regions)to regions)

Should fiscal policy Should fiscal policy also be more also be more independent?independent? But if so, why not depoliticize the But if so, why not depoliticize the

allocationallocation function of fiscal policy function of fiscal policy on similar efficiency grounds as on similar efficiency grounds as well? – including agricultural well? – including agricultural policy policy

But clearly, this argument But clearly, this argument cannot be taken too farcannot be taken too far We do not want to completely We do not want to completely

depoliticize politics, do we? depoliticize politics, do we? Like it or not, Like it or not, politics is necessarypolitics is necessary: :

let’s try to restrain it without let’s try to restrain it without stifling itstifling it

Distribution cannot be delegated!

Inflation, finance, and Inflation, finance, and economic growtheconomic growth Argument for decoupling Argument for decoupling fiscalfiscal

as well as monetary as well as monetary stabilizationstabilization from politics concerns the long from politics concerns the long runrun Inflation is perceived to be bad for Inflation is perceived to be bad for

long-run economic growthlong-run economic growth What is the evidence for this? What is the evidence for this?

What is the mechanism?What is the mechanism? Inflation hurts growth through Inflation hurts growth through XX

wherewhere XX can be saving, trade, finance, can be saving, trade, finance,

etc. etc.

2

From high inflation From high inflation viavia finance to slow finance to slow growthgrowth

Growth

Financial depth

Growth

Inflation

Financial depth

+ =Inflation

Let’s look at the financial linkage

What is the empirical evidence?

Financial depth and Financial depth and economic growtheconomic growth

-8

-6

-4

-2

0

2

4

6

0 20 40 60 80 100 120

Money and quasi-money 1965-98 (% of GDP)

Gro

wth

of

GN

P p

er

cap

ita 1

965-9

8, ad

juste

d

for

init

ial in

co

me (

% p

er

year)

r = 0.66

Japan

Switzerland

Jordan

Indonesia

Austria

87 countries

r = Spearman

rank correlation

Botswana

Inflation and Inflation and financial depthfinancial depth

87 countries0

20

40

60

80

100

120

0,00 0,20 0,40 0,60 0,80 1,00

Inflation distortion 1965-98

Mo

ney

an

d q

uas

i-m

on

ey 1

965-

98 (

% o

f G

DP

)

Brazil

NicaraguaArgentina

Austria

Switzerland

Japan

Add these two correlations,

and an inverse correlation

between inflation and

growth follows

r = -0.45

Inflation and Inflation and economic growtheconomic growth

Austria

However, the relationship However, the relationship between inflation and growth between inflation and growth turns out to be too complicated turns out to be too complicated to be discernible to the naked to be discernible to the naked eye as a two-dimensional eye as a two-dimensional correlationcorrelation

So, let us go the regression So, let us go the regression routeroute Estimate series of growth Estimate series of growth

regressionsregressions Same 87 countries during 1965-Same 87 countries during 1965-

19981998 Data from World Bank´s Data from World Bank´s WDIWDI

Inflation and Inflation and economic growtheconomic growth

Austria

Regress growth on inflation Regress growth on inflation distortion, defined as distortion, defined as /(1+ /(1+ ) ) where where is rate of inflation is rate of inflation

Then, test robustness by adding Then, test robustness by adding further explanatory variablesfurther explanatory variables Initial income, natural resourcesInitial income, natural resources InvestmentInvestment EducationEducation Population growthPopulation growth

Now, switch to Now, switch to EViewsEViews

DISTORT =

/(1+/(1+ ) )

Natural resource

curse

Conditional convergence

Investment is good for

growth …

… as is education, with

diminishing returns

Population growth hurts per

capita growth in medium

term

Inflation and Inflation and growth: growth: What is the What is the upshot?upshot?

Austria

High inflation hurts growthHigh inflation hurts growth An increase in inflation from 0% An increase in inflation from 0%

to 10% per year reduces per to 10% per year reduces per capita growth by more than capita growth by more than 0.15% per year0.15% per year Accords with existing studiesAccords with existing studies For comparison, per capita growth For comparison, per capita growth

was 1.3% per year in sample on was 1.3% per year in sample on averageaverage

Effects of inflation on growth are Effects of inflation on growth are economically significanteconomically significant

Inflation and Inflation and growth: growth: What is the What is the upshot?upshot?

Austria

Hence, if it is the need to Hence, if it is the need to immunize the immunize the stabilizing stabilizing function of monetary policyfunction of monetary policy from from political interference for long-political interference for long-term gain that has produced term gain that has produced independent central banks, then independent central banks, then ……

… … a similar argument can be a similar argument can be applied to the applied to the stabilizing role of stabilizing role of fiscal policyfiscal policy

If so, how about allocation and If so, how about allocation and distribution? distribution?

Now the plot thickens!

Fiscal policy and Fiscal policy and economic growtheconomic growth3 Let us now move from Let us now move from

stabilization to stabilization to allocationallocation and and distributiondistribution

The allocation role of The allocation role of government has important government has important consequences for consequences for long-run long-run growthgrowth EducationEducation Health careHealth care InfrastructureInfrastructure

Education Education and and economic growtheconomic growth Is education, like price stability, Is education, like price stability,

too important to be left to too important to be left to politicians? politicians?

Due to externalities, the Due to externalities, the government has a role to play in government has a role to play in educationeducation Without government involvement, Without government involvement,

not enough education would be not enough education would be provided in free markets, provided in free markets, thwarting social efficiencythwarting social efficiency

Even so, myopic governments Even so, myopic governments tend to devote too few resources tend to devote too few resources to educationto education

Open Market Education Open Market Education Committee?!Committee?!

Secondary-school enrolment and growth

87 countries87 countries-8

-6

-4

-2

0

2

4

6

0 50 100

Secondary-school enrolment 1980-97 (%)

Per

cap

ita e

co

no

mic

gro

wth

1965-9

8,

ad

juste

d f

or

init

ial in

co

me (

% p

er y

ear)

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

Tertiary education Tertiary education 19981998 (% of cohort)(% of cohort)

0

10

20

30

40

50

60

70

80

Austria EU OECD USA

In education, Europe lags behind America

Education Education and and economic growtheconomic growth So, education is good for growth, So, education is good for growth,

but it tends to be but it tends to be undernourished in Europe undernourished in Europe compared with Americacompared with America

Perhaps delegation of authority Perhaps delegation of authority in education would better in education would better safeguard the long-run interests safeguard the long-run interests of the populationof the population One example of an allocation One example of an allocation

function of fiscal policy that could function of fiscal policy that could be delegatedbe delegated

Is Is health carehealth care also a candidate? also a candidate? Similar problems, but more difficultSimilar problems, but more difficult

Another candidate:

Pension reform

Distribution Distribution and and economic growtheconomic growth So, some part of allocation So, some part of allocation

function of fiscal policy could, in function of fiscal policy could, in principle, be delegated – that is, principle, be delegated – that is, depoliticizeddepoliticized

Not the Not the distribution functiondistribution function, , however, which is however, which is inherently inherently politicalpolitical Even so, distribution seems to Even so, distribution seems to

matter for long-run growthmatter for long-run growth What is the evidence? What is the evidence? What are the mechanisms? What are the mechanisms?

Inequality and economic growth

What is the empirical evidence?

-8

-6

-4

-2

0

2

4

6

0 20 40 60 80

Gini coefficient (various years)

Per

cap

ita

eco

no

mic

gro

wth

196

5-98

, ad

just

ed f

or

init

ial i

nco

me

(% p

er y

ear)

75 countries75 countries

A 1212 point increase

in Gini coefficient

goes along with a

decrease in per

capita growth by

1%1% per year

r = -0.50

Korea

Brazil

Sweden

Austria

South Africa

France

Mechanisms:Social cohesionEducation

No sign that

excessive equalization

hurts growth

ConclusionConclusion4 These slides can be viewed on

my website:

www.hi.is/~gylfason

The EndThe End Distribution belongs in political Distribution belongs in political

arena, even if it matters for arena, even if it matters for growthgrowth

Distributional implications of Distributional implications of education and, especially, health education and, especially, health care complicate delegation of care complicate delegation of these key allocation roles of these key allocation roles of fiscal policy fiscal policy

Even so, some degree of Even so, some degree of delegation beyond mere delegation beyond mere monetary stabilization may be monetary stabilization may be worth consideringworth considering