Short Run vs Long Run order of moves between monetary and fiscal authorities

Who moves first, and who moves last? In a game between the monetary authority and the fiscal authority, the order of moves matters. Just like in Stackelberg duopoly, where the effect of an increase in one firm's quantity will depend on whether the other firm is the leader and has already chosen its quantity, or is the follower and will adjust its quantity in response.

But there is also a Short Run vs Long Run distinction between the order of moves. In the Short Run game, stabilisation of Aggregate Demand is what's at stake. In the Long Run game, satisfying the Long Run Government Budget Constraint is what's at stake.

When I examine my own implicit assumptions, this is what I normally assume:

Short Run. The fiscal authority moves first, and the monetary authority moves last. I think this assumption is right for Canada. If the government changes fiscal policy, it knows the Bank of Canada will adjust monetary policy in response to keep inflation at the 2% target. We saw this happen in 1995.

Long Run. The monetary authority moves first, and the fiscal authority moves last. I think this assumption is right for Canada. If the Bank of Canada adjusts the nominal interest rate or monetary base to keep inflation at the 2% target, or if it changes that monetary policy target, it knows that this will affect the flow of seigniorage profits it pays to the government, and it knows that the government will sooner or later adjust taxes or expenditure so that the Long Run Government Budget Constraint remains satisfied. We saw this happen in 1995.

When I examine my assumptions, they do look weird. Because I have the exact opposite assumption about the order of moves in the Short Run and in the Long Run. But I think my weird assumptions are right, for Canada. If I were talking about a different country, like Zimbabwe in the hyperinflation, where central bank independence was just a fiction, I would need to change my assumptions.

You might disagree with my assumptions about the order of moves. But you might nevertheless agree with me that the order of moves matters, and that different assumptions about the order of moves is at the root of the disagreement between monetarists and fiscalists. And by "fiscalists" I here include the Fiscal Theory of the Price Level.

Comments

[Kevin Donoghue]

Good post, and an excuse for me to once again plug Bénassy's "Money, Interest and Policy" which explores the optimal rules which follow from assumptions about who moves last.

[Nick Rowe]

Thanks Kevin. So Benassy was the leader in this game too! Ah well, he's a good economist to follow. But did he talk about this SR vs LR distinction?

[Lord]

There is always some ambiguity in an unending alternating exchange of moves since last delayed can become first and first hurried can become last, but I would agree.

[Min]

In the Long Run nobody moves last. Or, rather who moves last is determined randomly, right? By such things as the eruption of the Yellowstone supervolcano, which would affect Canada as well as the US.

[Nick Rowe]

Lord and Min: yep. When time is continuous, and each player makes multiple moves, talking about "who moves last" doesn't make sense, if interpreted literally. It's ultimately about who takes (or is assigned) responsibility for what. But when we model it as a game, it comes out as an assumption about who moves last.

[Min]

Nick Rowe: "But when we model it as a game, it comes out as an assumption about who moves last."

Well, if you are going to say who moves last, then the thing to do is to make an iterated game, or in this case, two iterated games. Start with one move by each player, then two moves by each, etc., and see how the iteration changes things, if at all. Trying to reason as though the long term were not a series of short terms is fraught with danger.

[Min]

I see I misspoke. You can lengthen the games without iteration. Iteration implies multiple payoffs.

[Nick Rowe]

Min: yes. But it's too hard. And infinitely-repeated games often have more than one equilibrium. One of which will look like the equilibrium under my assumptions, and others which won't.

[Kevin Donoghue]

Nick,
To be honest I'm stretching things a bit in saying that Bénassy's policy prescriptions vary according to the assumptions about who moves last. It would be more exact to say that it depends on whether fiscal or monetary policy react equally quickly to shocks. If fiscal policy is just as quick as monetary policy then Friedman's zero-nominal-interest-rate rule is best for monetary policy, with fiscal policy doing all the serious work. But if fiscal policy is too sluggish to be useful then monetary policy comes into its own.

So I shouldn't give the impression that he's exploring the same issue that you are, though I do think they're related.

The papers which eventually became Bénassy's book used to be freely available online, but no longer AFAICT, which is a pity. Maybe now that French economists are in fashion he's hoping people will buy the book?

[Ralph Musgrave]

Why have two different systems or organisations that influence aggregate demand? Why not have three, or twenty three?

I go along with the Tinbergen principle which is something like “for each policy objective, one policy instrument is needed, and only one”.

[Nick Rowe]

Kevin: yes, that's different, but I too think it's related. In a game of Chicken, I would choose a car that was known to have bad cornering, so the other driver would know I could not swerve at the last second, so he moves last.

Ralph: me too!

[Left Coast Bernard]

Dr. Rowe,

What is the long-run government budget constraint that will lead to the Canadian government authorities to adjust taxes or expenditures to satisfy?

The usual meaning of the word constraint is something imposed externally that limits ones actions. That nothing can move faster than the speed of light is a constraint.

It seems to me, an amateur economist, that perhaps you have in mind a target or goal, a long-run government budget goal. But what is the goal? Is the government goal to not have to borrow money? Is the government goal to stabilize its cumulative debt at some fraction of Canada's GDP?

A highway speed limit is not a constraint as it is not the result of natural law. The government attempts to impose a speed limit, but drivers can freely chose to drive faster or slower than the limit. The constraint on an automobile's speed arises from mechanical and energetic factors, and traffic and road conditions. It is higher than the speed limit on any given road.

Thus, what is the constraint of the Canadian government's budget? It can't run out of Canadian money, so the budget constraint doesn't seem to lie in how much money it shows on its accounts.

Of course, this is different than my personal case. I have a budget constraint. So does any business, or non-currency issuing government.

[Nick Rowe]

Bernard: "Of course, this is different than my personal case. I have a budget constraint. So does any business, or non-currency issuing government."

It's just the same for a currency issuing government, except we have to add in the (inflation-adjusted) revenue (profits) it gets from the central bank from printing currency. It's not a big deal. Less than 1% of GDP, for any reasonable inflation target. And there's a maximum amount it can earn, in inflation-adjusted terms, as Zimbabwe discovered.

[Min]

Nick Rowe: "And infinitely-repeated games often have more than one equilibrium. One of which will look like the equilibrium under my assumptions, and others which won't."

Free yourself from the straitjacket of a unique equilibrium! :)

[Min]

Nick Rowe: "It's just the same for a currency issuing government, except we have to add in the (inflation-adjusted) revenue it gets from the central bank from printing currency."

That's why Nick invoked the assumption of a truly independent central bank. Like the current Eurozone. Like the good old days, when the Rothschilds lent money to European royalty. ;)

[sherparick]

1. I took a look at Canadian CPI over the past year before commenting. After a little uptick at mid-year, it appears to be getting caught up in the global trend to more disinflation, dipping below the 2% target. http://www.inflation.eu/inflation-rates/canada/historic-inflation/cpi-inflation-canada-2014.aspx It appears that the Central Bank of Canada is having a hard time meeting this target under current circumstances. (A problem it shares with most Central Banks around the world.)

2. Since Canada has really bet the farm (and factory) on being a resource extractive/petro state under the Harper Government, I wonder how the global bust in commodities, particularly oil price decline, a "demand shock" so to speak, will effect Canada's Fiscal situation, current account situation, and the overall Canadian economy?

3. One argument that at least one Keynesian (Robert Waldman) and Neo-Fischerite (Edward Lambert at Angry Bear) has made against Monetarism (old and new) is that Central Banks don't have the means to reach their inflation and nominal GDP targets when a disinflation/deflationary liquidity trap grabs hold of the economy (or in the current circumstances, global economy) and the labor share of GDP versus capital experiences a secular decline. Central banks don't have means, and not just the will, to reach their goals under current circumstances in the face of flat or declining demand (counting Europe, North America, Latin America, East Asia, South Asia, and parts of Africa that have integrated into the global economy, there is an estimated 250 million unemployed or underemployed workers. That is a lot of surplus supply of labor where the price of labor would have to fall to clear that market. And there are demand and debt default issues if labor's price falls low enough to clear such a market.

[Min]

sherparick: "Central banks don't have means, and not just the will, to reach their goals under current circumstances in the face of flat or declining demand"

IIUC, the US Fed, by law, can only put money into the hands of creditors. What if central banks put money into the hands of debtors?

[Nick Rowe]

sherparick: until the latest data points on CPI and employment, I too was worried about low inflation and slow recovery. The Bank of Canada raised interest rates a little too much a little too early. But I'm a bit more optimistic now. (Though the Eurozone and maybe China don't look so hot). But if my optimism turns out to be premature, the Bank can always loosen.

Min: that's a new one on me. Governments are debtors, and so are banks.

[Min]

Nick, the Fed does not directly lend to the US gov't. It does buy gov't bonds from those who do, thus putting money into the hands of those creditors. Maybe that is a distinction without a difference. {shrug} The Fed does share its profits with the Treasury, something I overlooked. ;)

As for commercial banks, their deposits are liabilities, but not considered debts in common parlance. But even if we consider all bank deposits as debts, are banks net debtors? OTOH, we certainly have a large portion of the population who are net debtors. That means that there are net creditors. If the net creditors are not the banks, who are they?

But my question remains. What if the central bank put money into the hands of (net) debtors?

[Nick Rowe]

Min: nobody would rationally lend to anyone with negative net worth. But when I say that, I am including expected future income on the asset side of the balance sheet.

I'm a net creditor. I lend more to others than others lend to me. Older people are like that.

[Majromax]

@Min:

It would make little difference as long as the recipients of the loans did not default. However, ensuring that is tricky.

Simple macroeconomic models of this sort assume a no-default premise, where all debts are made good on schedule. This is reasonable as a first approximation, but it's a limitation we have to keep in mind.

In the real world, no agent is truly free of default risk, and the markets adjust by offering loans with some risk premium built in. Generally, for the sovereign government/central bank interaction we care about here, that risk premium is infinitesimal. However, it does become more apparent when alternate instruments are considered: the Fed obviously had to consider risk when purchasing mortgage-backed securities.

The risk of getting default risk wrong is that a monetary policy may not quite do what was intended. If default risk is assumed lower than it actually is, the CB will take a loss on its assets; it will then be left with the choice of monetizing those losses (printing money in an unplanned manner) or making good via withholding seigniorage payments (socializing the losses).

If the default risk was assumed higher than reality, then the CB will find itself with anomalous profits. This isn't as possibly-bad, but on the other hand that means that the initial actions were not as effective as they should have been. (The CB purchases a corporate bond at $85 rather than $90 because of an incorrect assumption about default risk; that means that the monetary base has increased by less than the CB intended.)

Far simpler, both theoretically and practically in ordinary times, for the CB to deal in essentially default-free instruments.

[Min]

Thanks, Nick and Majromax. :)

Nick, I wasn't suggesting that the Fed make payday loans or any such. ;) The net debtors I had in mind were like middle or higher income people who cut back spending because of their debt overhang.

For instance, suppose that someone gets a loan of $5,000 from the CB at 2% (the inflation target) and uses it to pay off $5,000 of credit card debt at 20%. There is no net increase in the money supply, as one loan has just been swapped for another. However, with lower loan payments, it is plausible that the person will spend more money. OC, the lending bank takes an income hit, but all things considered, it is plausible that both aggregate demand and the velocity of money will increase. No?

BTW, I am not suggesting that such loans be available at all times, just in times of sluggish recovery or balance sheet recessions, or depressions. None of this "responsibly irresponsible" BS.

[Majromax]

In a sense, you're advocating an Old-Keynesian approach, suggesting that different people have differing marginal propensities to consume based on their credit situation. This isn't entirely unreasonable, since lifetime income hypotheses end up assuming that credit is generally available; that may not be true in reality. However, you run into a few problems:

*) First, it's unclear that the markets inefficiently allocate credit as-is. A substantial part of that 20% credit card rate corresponds to a default risk, so a CB loan at 2% acts as a substantial subsidy.
*) Second, it's unclear that debt retrenchment is irrational, from an economy-wide standpoint. Are people paying back their debts because they must, or are they doing so because their expectations of future income have lowered? If it's the latter, then direct credit relief is the tail that wags the dog, since it would be unnecessary if the CB stabilized demand in the first place.
*) Third, it's unclear that you need direct-to-consumer actions to effect this sort of change. The non-default portion of the credit card rate reflects the opportunity cost of funding consumer purchases (in aggregate by the issuing bank). Reducing the banks' funding costs via traditional actions will generally effect change throughout the credit market. This is why home mortgages are currently available for 3-4%.
*) Fourth, distributional considerations are generally considered a proper matter for the government instead of the central bank. As a very broad guideline to the separation, the CB gets to say how much money is in the economy, while the government gets to say who has what share of money.

[Min]

Majromax: "Fourth, distributional considerations are generally considered a proper matter for the government instead of the central bank"

But do the actions of the CB have no distributional effect? Isn't the differential recovery of the US economy a case in point? The heroic efforts of the Fed (which I do not disparage) have mainly benefited the top tier of the economy, no? They are not neutral with regard to distribution, are they?