Fiscal policy cannot save the ECB
Given persistently low inflation, sluggish growth, and global uncertainties, the ECB needs to provide even more monetary stimulus. However, with interest rates already negative and strong opposition to further asset purchases (Financial Times 2019), it seems to have run out of ammunition. This is why the parting ECB President, Mario Draghi, called for fiscal policy “to do its part” in the latest press conference (Draghi 2019).
A further argument in favour of fiscal stimulus concerns the loud complaint of German savers about negative rates (Bindseil et al. 2015). An expansionary fiscal policy path would presumably drive interest rates higher. According to this line of argument, ‘the Germans’ should thus favour a fiscal stimulus package in their own interest.
Evaluating the impact of fiscal expansion on inflation and interest rates
To understand whether an expansionary fiscal policy can provide significant support to the ECB (and relief for German savers), a quantitative model is needed. There exist many different macroeconomic models for studying the effect of fiscal policies. We use the mainstream models used by central banks and international institutions. This allows us to test the proposition, made by ECB representatives, that a fiscal expansion would materially help to achieve the inflation target of the type of models used by the ECB itself.
We perform our analysis using the Macroeconomic Model Database (MMD), which is an archive of macroeconomic models based on a common computational platform that provides a way to implement a systematic model comparison (Volker et al. 2006, Volker et al. 2012). For our purposes, we selected all the models estimated or calibrated for the euro area economy that allow us to study the impact of a fiscal policy shock (resulting in 10 models to be used). Among them, there are also two two-country (US and euro area) models, which are two versions of the old model used by the ECB, the New Area Wide Model (see Table 1 part 3). For each model we accept the model-specific monetary policy rule.
Table 1 List of models used in the analysis, available in Macro Model Database Version 3.0
The MMD allows us to compute the impact of a standard fiscal shock, namely, a 1% increase in discretionary government expenditures (as a percentage of GDP). A shock of 1% of GDP would be substantial, given that the average fiscal deficit in the euro area is already running at about 1% of GDP. Such a shock would thus bring the overall deficit, temporarily, to 2% of GDP. In these model evaluations the approach used is to assume that the increase in expenditure is temporary, i.e. it is undone after one period (usually assumed to be a quarter).
The message from standard models is of a small temporary impact
Figure 1 below reports the average of the models’ impulse response functions for inflation and interest rates1 to a unit fiscal shock. The grey shaded area represents the dispersion among the responses of the different models. A first result is that that the grey area extends also into negative territory. In other words, a zero or even negative impact is always possible, at least according to some models. There is thus considerable model uncertainty.
Figure 1 Average impulse response functions to a unit fiscal shock of ten euro area models
Note: The black solid line is the average of the impulse response functions of ten different models calibrated or estimated for the euro area (listed in Table 1), and obtained using the Macro Model Data Base. The grey shaded area represents the 95% confidence interval. The horizon period is 20 quarters.
The highest impact of a fiscal policy shock on both the interest rate and inflation is obtained by using the European Commission QUEST III model, which is designed to include a detailed government sector. The smallest impact on inflation and the interest rate is found by using two recent models mainly built for analysing the unconventional monetary policy instrument, i.e. Christoffel et al. (2009) and Gelain (2010).
As our purpose is to obtain a view of the mainstream, we concentrate on the average of the different results. The ‘average model’ result suggests that the magnitude of the (temporary) boost to inflation and interest rate coming from a fiscal expansion is positive, but quite limited.
Figure 1 shows that, one period after the fiscal shock, the average peak impact on inflation is only about 4 basis points (bps). A fiscal expansion would thus have essentially no significant impact on inflation. Fiscal policy ‘doing its part’ cannot bring inflation closer to 2%.
For the interest rate, the average impact would be 14 bps, thus, somewhat higher than inflation, but even this is rather modest. If the aim of the operation were to allow the ECB to exit its negative rates, one would thus need a fiscal expansion of 3-4% of GDP just to lift the interest rates, for a short period of time, above zero (the deposit rate is now 50 bps – four times the peak impact of 14 bps would be 56 bps).
Concentrating only on the two versions of the New Area Wide Model, which is the one used by the ECB, we get broadly similar results, as shown in Figure 2 below. In particular, the impact on inflation is again negligible and for the interest rate, one quarter after the shock the impact is similar for both models and, at about 10 bps, close to the average response of Figure 1.
Figure 2 Impulse response functions to a unit fiscal shock of two NAWM models
Note: The figure represents the impulse response functions of inflation and interest rate to a unit fiscal shock of two versions of the New Area Wide model. The dashed line is the response of the model by Coenen et al. (2008), and the solid line is the response of the model by Cogan et al. (2013). The impulse responses are obtained using the Macro Model Data Base. The horizon period is 20 quarters.
Moreover, the small effects mentioned above refer to peak, i.e. temporary impacts. Not surprisingly, given the temporary nature of the assumed fiscal shock, the impact is also temporary. On average, the interest rate increases in the same quarter of the shock and then starts decreasing. Similarly, inflation stays above baseline for one year and then it falls back.
This should have been self-evident from the outset. A temporary boost from fiscal policy cannot solve the fundamental problem of the ECB, namely that longer term inflation expectations are so low. The inflation expectations over the next ten years incorporated in so-called inflation swaps are now below 1%. And the inflation expected in five years, for the following five years, are below 1.2%. The problem is thus not a temporary boost to inflation, but a sustained one. A temporary fiscal expansion cannot provide this.
It is an open question whether a permanent fiscal expansion could also provide a permanent boost to inflation. The government of Japan has run deficits of 4-5% of GDP for the last decades. But inflation has remained close to zero for most of that time. Moreover, running higher fiscal deficits for a decade would lead to higher debt level and thus present a host of other negative side effects. At any rate, it would be highly inappropriate for the ECB to call for a policy that is clearly incompatible with the overarching fiscal rules of the euro area.
We have concentrated on the results from standard macroeconomic models, of the type used by the ECB itself to calibrate its own policy. The overall trust of our results is confirmed by a comparative study made by seventeen authors (Coenen et al. 2012) simulating a fiscal shock in seven models that are heavily used by policymaking institutions, i.e. the IMF, the Federal Reserve, the ECB, the Bank of Canada, the OECD, and the European Commission. Figure 3 reports the findings of these authors concerning the response of inflation in Europe to a two-year increase in government consumption of 1% of GDP if there is no monetary accommodation, i.e. if the ECB were to keep interest rates constant. The highest increase on impact, among the four models designed for the European economy, is slightly lower than 0.2% for the IMF model. This would mean that a very large fiscal expansion (of 4% of GDP) would be needed in order to lift inflation temporarily from the present 1% to 1.8%.
Figure 3 Effect on inflation of two-year increase in government expenditure in Europe
Source: Coenen et al. (2012).
The result that a fiscal expansion is unlikely to have a strong impact on inflation should not be a surprise, given the large body of research finding that the Phillips curve has flattened (e.g. Blanchard et al. 2015). Lane (2019) also finds estimates of the Philips curve across various measures of economic slack of between 0.10 to 0.15, which is just slightly above the average peak impact of 0.08 found here if we assume that the average multiplier (reaction of output to a fiscal expansion) is close to unity.
The overall conclusion is clear. One would need a very large fiscal deficit to have even a modest impact on inflation or interest rates. Fiscal policy cannot save the ECB.
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 The fiscal expansion would also increase output, but we are interested here only in the question how much a fiscal impulse could help the ECB achieving its inflation target and give German savers higher interest rates.