By Steven K. Beckner

JACKSON HOLE, Wyo. (MNI) – A coming “era of fiscal stress” will
make it difficult for central banks to control inflation unless steps
are taken to curb deficit and entitlement spending, participants in the
Kansas City Federal Reserve Bank’s annual symposium were warned
Saturday.

Just as the Fed and other central banks seek to “anchor” inflation
expectations, fiscal expectations need to be better anchored if high
inflation is to be avoided, argues Indiana University Professor Eric
Leeper in a paper presented to a conference that includes Fed Chairman
Ben Bernanke, a host of other Fed officials and prominent foreign
central bankers.

Part of the problem, according to Leeper, is that fiscal policy is
overly political. He likens it to “alchemy,” whereas he says monetary
policy is more of a “science.” Fiscal policy needs to become more
scientific and be better coordinated with monetary policy.

And Leeper encourages central bank chiefs to speak out more
forcefully about the direction fiscal policy should take.

Whether or not they are coordinated, “monetary and fiscal policies
are intrinsically intertwined and their distinct impacts are difficult
to disentangle,” he writes.

In some ways, fiscal policy is a “more powerful” and flexible tool
than monetary policy, says Leeper. Yet, “monetary policy has scientific
ambitions, while fiscal policy is mired in pre-science.”

In normal times, this doesn’t matter much to central banks, but
“normal times may be nearing their end,” he writes, noting that the
International Monetary Fund has estimated that the net present value
impact of deficits of aging-related government spending averaged across
the advanced G-20 countries is over 400 percent of GDP. And the
long-term budget imbalance associated with Social Security and Medicare
in the United States this year is over $75 trillion in present value.

“These numbers portend an extended era of fiscal stress,” Leeper
writes. And that means trouble for the Fed and other central banks.

“Problems for central banks become far more pressing during periods
of fiscal stress,” he says. “Combined with fiscal alchemy, fiscal stress
threatens to undermine the advances made by monetary policy.”

“Threats do not arise only from insufficient resolve by central
bankers to control inflation,” Leeper continues. “Threats arise from
unanchored fiscal expectations that can make it difficult or impossible
for central banks to control inflation, regardless of the central
bankers’ resolve.”

Fiscal expectations are “unanchored” when markets and the public do
not know the size of future deficits and government borrowing
requirements. For example, at the moment, there is uncertainty about
whether or not the Bush tax cuts will be extended, and there is even
greater long-term uncertainty about the ability or willingness of the
federal government to curb rapid growth in entitlements and other
spending programs.

That presents a huge challenge to central banks, Leeper contends.

“It turns out that the central bank’s ability to control and target
inflation rests fundamentally on fiscal behavior and people’s
expectations of fiscal behavior,” he writes.

“When those expectations center on the appropriate fiscal behavior,
the central bank can control inflation in the usual way,” he goes on.
“But when fiscal expectations are anchored elsewhere, it’s quite
possible that monetary policy can no longer do its job controlling
inflation and stabilizing real activity.”

“In the coming era of fiscal stress with no of credible government
plans to confront the growing fiscal strains, unanchored fiscal
expectations become a certainty,” he adds.

Leeper warns that “fiscal stresses will rise around the world in
the coming years and, if they remain unresolved, the likelihood of still
worse economic outcomes rises commensurately.”

Governments cannot simply rely on their central banks to keep
inflation under control if they are running large deficits, he argues.
“If monetary policy is to successfully control inflation, then fiscal
policy must do much of the heavy lifting, freeing monetary policy to
pursue that objective.”

Complicating the picture, Leeper warns that some advanced countries
are approaching their “fiscal limit” — the point at which “fiscal
policy can no longer adjust to stabilize debt.”

In this climate, Leeper advises central bankers to “break the taboo
against saying anything substantive about fiscal policy and, instead, to
talk precisely and forcefully about how unresolved fiscal stresses can
make it difficult or impossible for monetary policy to do its job.”

He does not believe, however, that central bankers should give
legislatures specific advice on tax and spending programs. Former Fed
Chairman Alan Greenspan was often criticized for giving too much fiscal
policy advice, and successor Bernanke has been much more reticent.

Leeper has a low opinion of U.S. government forecasts’ of its own
budgets, remarking that the Congressional Budget Office’s “projections
do little to help people form expectations over future fiscal policies.”
Pointing to multiple interpretations of the CBO’s 2009-10 projections,
he writes, “While this might be useful politics, it is not helpful
economics and it does not constitute science.”

He is also skeptical of “multipliers” — the estimated impact of
fiscal stimulus on GDP. Those estimates are “all over the map,” he says.

Leeper’s main focus is on the interacton of monetary and fiscal
policy. Although it has been said by late Nobel Prize winner Milton
Friedman, among others, that inflation is “a monetary phenomenon,” in
reality fiscal policy has a big role to play, he argues.

The “dirty little secret,” he says, is that “for monetary policy to
successfully control inflation, fiscal policy must behave in a
particular, circumscribed manner.”

In normal times, monetary policy has the responsibility of
“providing a nominal anchor — inflation,” while fiscal policy plays
“the role of providing a real anchor — the real value of government
debt,” Leeper writes. “Because fiscal policy is assigned to stabilize
debt, monetary policy is free to target inflation.”

“If monetary policy is attending to inflation targeting, then
fiscal policy must handle debt targeting by adjusting taxes enough to
achieve the debt target,” he writes. “When an increase in debt induces
taxes to rise by more than the real interest rate, future taxes are
assured to be sufficient both to service the new debt and to eventually
retire debt back to target.”

In this so-called “passive” fiscal policy scenario, “fiscal policy
is doing the heavy lifting by ensuring that higher debt-financed
transfers today create the expectation of higher taxes in the future,”
Leeper writes. “Those higher taxes are just sufficient to gradually
retire debt back to target, eliminating the wealth effect of the higher
transfers and relieving the pressure on inflation to rise.”

Fiscal policies are deemed “passive” in the sense that the tax
authority has limited discretion; in the face of rising government debt
taxes must be raised. But as Leeper points out, “this does not always
happen. Sometimes political factors — such as the desire to seek
reelection — prevent taxes from rising as needed to stabilize debt.”

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