Nobel economist Sims on fiscal stimulus, Eurozone loss sharing and role of central banks

The Nobel laureate speaks with Christopher Jeffery about his scepticism regarding secular stagnation, the eurozone’s failings and the need for inflationary fiscal stimulus at the zero lower bound
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Christopher Albert Sims is a professor of economics at Princeton University. He spent the longest portion of his career at the University of Minnesota, teaching there from 1970 to 1990. He has also taught at Harvard University and Yale University. Sims, together with Thomas J Sargent, was awarded the Nobel Memorial Prize in Economic Sciences in 2011, for their empirical research on cause and effect in the macroeconomy. His work offers a technique to assess the direction of causality in central bank monetary policy.

Sims is also a fellow of the Econometric Society, a member of the American Academy of Arts and Sciences and a member of the National Academy of Sciences. In 1995, he was president of the Econometric Society and, in 2012, president of the American Economic Association. Sims graduated in mathematics from Harvard University magna cum laude in 1963 and secured his PhD in economics from the same university in 1968.

How much of a role have central banks played in creating or exacerbating the causes of the global financial crisis?

The blame for the financial crisis does not lie with central banks – certainly not with their monetary policy and interest rate policies aimed at controlling inflation. The crisis emerged from financial instability, with private incentives for profit not being aligned with public interests in stability. Regulators were not aware of or ready to pay the political price for trying to stop unstable investment patterns. In the US, the big push towards deregulation with the confidence that markets by themselves would take care of any instability problems – central banks had some blame for that, as they did have a regulatory role and responsibility for banks. But they were not the main source of the instability. 

Some people argue that the low interest rate policy before the crash that was aimed at warding off a Japan-style deflation increased instability. But I do not take that view. The danger of deflation was real and we did avoid it. The problem was the invention of instruments for investments in housing. Nobody was keeping track of them. Also, unusually for a financial crisis, the vast majority of market participants just did not see it coming, even after the price of housing started to come down in 2007 and 2008.

I remember speaking to some of my colleagues about what would happen if a 30% decrease in house prices occurred. They thought it was a ridiculous notion. They all knew prices in aggregate in the US had never gone down at all before, and although they had trended down a little bit, most people felt they could not fall substantially across the board. Even people doing stress tests then probably would not have included a 30% decline in house prices. Following a trend and not thinking about the true downside risks is a common pattern in financial crises. And that is not something that the Fed could do a lot about. There were people saying that house prices were a bubble, including Robert Shiller. Some people took it seriously but not the average investor – and I do not attribute it to low interest rates. There are countries with house price booms and busts where interest rates were not near zero, such as Spain.

Is damage now being done by persistently low rates in the US since the advent of the crisis?

I don’t think there has been damage done by the low interest rates. There has been damage that has been done by the long recession, which low interest rates are hoping to mitigate. In fact, one of the disturbing things about policy is that a lot of it predicated on the notion that we are going to go back to ‘normal’ and inflation will hit a target level. But right now, in Japan, the US, the UK and the eurozone, interest rates are close to the zero lower bound (ZLB). There is no reason to indicate that monetary policy can easily get inflation back up to those levels and the assumption that low interest rates cannot last is complacent. Japan has shown us that it can last for a very long time.

Do you believe low rates are here to stay for many years?

I am agnostic. The results from a simple model that I use when thinking about policy are indeterminate when we are near the ZLB and fiscal policy is incoherent. If for some reason inflation expectations rise and the prevailing psychology in the US in that there will be inflation, it is possible that the US will recover. But this is less likely to happen in Europe and that is another reason to worry that it might not work here. Japan has similar problems. It cannot really co-ordinate its fiscal policy and monetary policy with the introduction of higher levels of value-added tax, leading to a contradictory fiscal policy.

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Do you believe that the model of an operationally independent central bank pursuing inflation targets is the optimal approach?

It is usually the right approach. But we are in unusual times right now. The question is: what does independence of the central bank actually mean? In my view, it means that in normal times, the fiscal impacts of monetary policy are not reacted on. Seignorage goes up or down and it is not news. It does not result in Congress or the Treasury calling in the chairman of the Federal Reserve. That has happened in other countries, but not in the US. But when you get to very low levels of inflation, seignorage can be negative and then – even though in principle that is not a problem – someone in the legislature will have to send some money over to the central bank instead of the other way around, and we do not worry about that. In the US, this would be an issue. It would require legislation to send that money over to the central bank. I have written a paper recently with Marco del Negro [assistant vice-president in the macroeconomics and monetary studies function of the research and statistics group at the Federal Reserve Bank of New York], on central bank balance sheets [‘When does a central bank’s balance sheet  require fiscal support?’, Journal of Monetary Economics 73 (2015) 1–19]. Our calculation suggests that it would take a very unusual disturbance or financial innovation to cause any balance sheet problems with the Fed that would actually require Federal intervention.

But in Europe, monetary policy action is generating fiscal shifts – capital gains and losses across countries. This is inevitable in a monetary union – debtor countries benefit when interest rates go down and countries with relatively less debt are transferring resources. The way the Economic and Monetary Union (Emu) was set up, however, meant this was never and is still not acknowledged.

So in the current situation, where it has become very clear that there are potential system implications for the European Central Bank’s (ECB) balance sheet, it is tying the hands of policy-makers. You may want to have an institution that monitors the transfers, but you cannot tell the central bank never to take a policy that presents a risk it will have a fiscal impact. Monetary policy does that, necessarily. Right now, for example, buying sovereign debt of some countries creates a balance sheet risk for the ECB, which in remote circumstances may require the stronger countries to fund it. If the aim is to preserve Europe’s monetary union, people have just got to get used to it.

Do you have Germany in mind in particular?

The Germans were sold the Emu on the notion that this could be done without any fiscal integration or fiscal transfers. Now they do not even seem to have realised that inflation rates will inevitably differ, and it is for the central bank to set policy based on the average. In the current situation, if the ECB could hit a 2% average it is likely that Germany’s inflation would be above that and there should be no objection. The ECB’s task is not to keep inflation below 2% in Germany, it is to keep it at 2% on average for the whole union. And that means inflation in some countries will be above 2%, maybe even by quite a bit.

You have suggested replacing MV=PY with a new equation whereby the market value of outstanding public debt, divided by the price level, is equal to the discounted present value of primary fiscal surpluses – calculated as revenues less expenditures, not including interest payments on debt. Would you please explain your thinking?

That the real value of public debt is the discounted present value of future primary surpluses is an equilibrium condition. It holds in nearly any model, and the math that delivers it is the same as the math that tells us the price of a company’s stock is the discounted present value of its future dividends. This is not controversial, and it doesn’t really replace MV=PT. Both equations hold true in equilibrium. But when public debt is deonominated in the country’s currency, and if primary surpluses don’t respond to increases in the amount of nominal debt, this equation tells us inflation must result. And, of course, the reverse is also true: maintenance of high future primary surpluses while current fiscal policy contracts must create deflationary pressure. 

Standard models assume that policy automatically increases future primary surpluses when the real value of public debt increases, so that the real value of public debt is guaranteed to be stable, regardless of the path of inflation. With that assumption, plus a Taylor-rule monetary policy, there is only one ‘stable’ time path for inflation.

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But there are other equilibrium time paths that involve inflation feeding on itself – high inflation generating high interest rates, high deficits, shrinking real balances and high private sector spending.  Standard models have simply assumed these are impossible. John Cochrane’s paper, Determinacy and identification with Taylor rules 2011, in the Journal of the Political Economy, explains there is nothing in the model or in the way the real world works that makes rapid inflation or deflation inconsistent with competitive equilibrium. The only way to eliminate the explosive paths for inflation in equilibrium is to bring in the effects of fiscal policy on inflation. I agreed with him on that. If primary surpluses respond positively – even by a small co-efficient – to high levels of inflation, then you can get rid of these explosive paths and return to what people think of as the standard models of monetary policy that determine inflation.

In normal times, that is a natural assumption and you can forget about these unstable paths and use your standard model. But we are not in normal times. We are at the ZLB and the argument that monetary policy by itself can control the price level doesn’t work anymore. It only works if you have a fiscal policy in place that expands vigorously as you approach the ZLB – and everybody knows that is going to happen, so it never approaches the ZLB. Once you are there, monetary policy is basically impotent. Interest rates are zero; they cannot really do much. If you want to get away from very low inflation, you need a fiscal intervention and it has to be in the form of issuing nominal debt and convincing people that it is not backed by future tax hikes. It will be paid by the inflation created, and inflation will eat away the value. That is so far away from the thinking of policy-makers in Europe, the US and the UK now, that it is hard to see how it can actually happen.

Is it complicated if you are a major reserve currency?

Being a major reserve currency has been useful for the US as people are willing to hold a lot of US government debt. In a way, this is a problem if you want to generate inflation. If there is a limited market for that debt, then inflation will pick up right away. If everybody is scared to death that there will be another financial crisis and are prepared to hold US Treasury securities at practically no interest, you can issue a lot of debt without creating much domestic demand pressure. So a thorough analysis really has to take into account who holds the debt. The simpler models assume all the debt is held domestically. You would certainly get additional complications if you build in external debtholders, such as the debt held in Chinese reserves.

Where does this ring true in the historical context?

It could be seen in the Great Depression. There is a paper by Federal Reserve Board economist Gisela Rua and economist Andrew Jalil called Inflation expectations and recovery from the Depression in 1933: evidence from the narrative record, part of the finance and economics discussion series published by the Fed, which looks at the period around the time the US said it would abandon the gold standard. They analysed news reports at the time and show that shortly after President Franklin D Roosevelt’s election nobody thought he would do anything drastic. Then, in 1933, the US left the gold standard and passed the ‘Thomas inflation amendment’, which authorised the Treasury to issue a lot of debt and the Fed to buy it. Within a week or two the business press said, “inflation is on the way”, and it changed expectations. Eight or nine months later, Roosevelt backed off it. But growth suddenly spurted. The US grew at a tremendous rate after that until 1937. It was a surprise to people that Roosevelt turned out to be as expansionary as he was. It had an impact on the markets and on real activity. It would take that kind of intervention to quickly reverse the effect of the ZLB.

Is there a need to have a credible inflation policy beforehand – there are plenty of countries that generate inflation and it does not work out too well?

This is not a prescription that inflation is a good thing. It is for a situation when part of a country’s problem is that it has zero interest rates and very low inflation. We do get people who are concerned there may be runaway inflation at some point because central bank balance sheets are so big. But in the US, UK and Japan, these concerns are unfounded. With interest on reserves, the central bank can be contractionary very easily, quickly and more powerfully than in the old days of open market operations. In the eurozone, raising interest on reserves has balance sheet implications and the northern countries may get worried they would have to recapitalise.

I have asked Alan Meltzer why he is so worried about big Fed balance sheets and he said it is because he is afraid that the Fed would not raise interest rates as much as it needed to if inflation increased. But I find this pretty implausible. At least as long as the Fed is influenced by academic economists, as it is, they understand that you have to raise interest rates. Of course, the process will not be popular, but raising interest rates has always been politically unpopular, and central banks – at least in the advanced countries – nonetheless have done it. So there is no particular problem in tackling inflation, at least in the US and countries with their own currencies. In the euro area, this is one of many ways where the institutional set-up makes it problematic.

Do you believe inflation targeting is the correct policy mandate for central banks or could other benchmarks be used?

The advantage of inflation is that is minimises time inconsistencies. Of course, any kind of policy rule is that is understood by the public and modelled without many frictions could work. But the public find it easiest to understand if the central bank says, our policy is going to be in the neighbourhood of 2% and it is not going to vary very much. You don’t need to worry about how we manage this. If inflation goes up, the monetary authority explains why inflation went up and how it plans to bring it back down. If the plan is plausible, the public will support the effort to get back to 2%.

If you have a money supply target instead of inflation and suppose M1 grows above target but you are in a recession, which can easily happen as interest rates go down in recession and demand for money goes up, the public is going to have a hard time understanding why you are doing monetary contraction in a recession because you are committed to a money growth target. They know you do not really care about money growth you care about recession and inflation. If you say, ‘I care about inflation’, usually caring about inflation does not conflict much with caring about GDP. People believe you are going to do that and, over time, if you get excessively high or low inflation you do not have a credibility problem when you try to get back to your target. If you get a money growth target, there would be constant questions about whether the central bank is really going to stick to policy actions that nobody wants on inflation and output.

But what about at the ZLB?

What central banks have done that was useful was to announce that they were committed to low interest rates and raising them is contingent on getting inflation back up close to target. But that by itself does not work unless you get some fiscal expansion to go with it. In the US our fiscal policy is almost random. So we did get usual counter-cyclical stimulus although, given the size of the depression, the fiscal stimulus was not unexpectedly large. Then we had the sequester tightening, which seems to have relaxed a little bit. Who knows what is going to happen with budget negotiations as this Congress goes on. But you would at least hope there would not be the systematic powerful contractions as took place in the southern countries in Europe. We kind of ‘lucked out’ by having some fiscal policy that was in line with economic needs, but it has been random rather than systematically implemented. 

But have all austerity countries been that badly affected – what about Ireland?

Ireland had a very severe depression and is now returning to growth. But, like all the eurozone countries, Ireland is basically on the gold standard in that debt is offered with payment in something that the country cannot print. The real debt is a big burden. Ireland certainly would have been better off if it had not taken on all the bank debt that it did. You could argue that Ireland could have ended up like Iceland, which is doing better than they are.

In general, there is no such thing as non-defaultable real debt. With sovereign debt, we have relied on a situation when things get bad enough that a country does not think reputational issues are a constraint on default, it chooses to default and nobody can tell it not to. So that is a kind of implicit bankruptcy mechanism in sovereign default. In the euro area, officials seem to operate on the assumption that, except for Greece, no sovereign will default. What is needed is a systematic mechanism for the treatment of default. There have to be incentives that encourage countries to not want to do it but, for the same reason we have abolished debtor’s prison, we should change the way we treat sovereign default. It does not do any good to put countries in debtor’s prison to punish them when they cannot pay off the debts.

Bank of Portugal governor Carlos Costa has called for the creation of a European Monetary Fund capable of providing ‘technical and financial support to countries facing unsustainable situations’. This is not an especially popular proposal. To what extent would this help fill the gaps in the institutional structure of the euro area you have identified?

Any movement for Europe-wide institutions that account for the interdependencies and recognises them is positive. So the common bank supervision policy is a positive development. But it really was depressing to see that as soon as it was recognised the mechanism could develop into a major financial burden in common across the euro area, there was resistance. European supervisors have not really been funded well enough to bail out banks that are bigger than the countries they reside in. I would like to see a European institution that could issue euro-denominated bonds that are in one way or another backed across the Emu. An institution that could buy European sovereign bonds and issue common bonds would be inherently political and it would need some political legitimacy. But until there is a real ‘euro bond’ the ECB’s situation is difficult as it has no instrument such as US Treasury bills that can be used in open market operations that are politically neutral. The ECB can buy sovereign debt but if there is an interest rate difference, it is making decisions about what the differentials should be – and that is a political problem.

The German chancellor Angela Merkel is the only leader of a Western nation still in power since the start of the crisis. She has said ‘no’ to a Eurobond. So does your proposal sound likely?

That is the disturbing thing. One often sees that people often oppose even modest, easily implementable steps at the time of reform because they see the direction the reforms are going in. They say, “No, no, not that, never – it is off the table”. So modest proposals for reform where people can see there is some common fiscal risk-sharing get labelled as absolutely off the table.

What do you make of the ECB’s performance?

The ECB is doing what it can. It understands the limitations due to the lack of a common fiscal institution and struggles to do the best it can. One very disturbing thing is its recent policy – and it is not because the ECB leadership wants it but countries, especially Germany, insist on it – is this notion that purchases of government debt that has led to an expansion of the ECB’s balance sheets are going to be on the balance sheets of the individual country’s central bank. And that is a big step back from the original visions of the ECB and the European system of central banks. Most people, including me, thought that what they were creating was a system where a country’s central banks were much like regional Federal Reserve banks. They are really an accounting fiction where nobody really cares about the balance sheet of the Federal Reserve Bank of Kansas City. They are part of the Federal Reserve System. We thought that was the way the euro would work. But they are making policy contingent on the idea that under some circumstances, the balance sheet of a country’s central bank matters.

It is possible to imagine, for example, that the Bank of Italy could go bankrupt as it is without the full support of the ECB. That would be a major setback, in effect, an unravelling of Emu. It has emerged that in an emergency situation where the ECB has wanted to intervene and buy debt that does not meet the standards for liquidity provision, they have negotiated a deal that it can be done by the national central banks (NCBs). But it still needs ECB approval even though it stays on the NCBs’ balance sheets. My only hope is that if, say, the Bank of Italy got into balance sheet difficulty, the ECB and rest of the European Union would prevent it from defaulting. It just seems like everything would be coming apart if NCBs can default without assistance from the rest of Europe.

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Is there any solution in sight for the eurozone?

So long as Europe changes incrementally step by step without accepting that having a common currency requires some fiscal risk-sharing, things are going to remain sporadic. What I would like to see is leadership emerging in some of the large countries that recognises “we are in this together”. Part of the problem is that these losses have not been allocated. If southern countries default, it is going to fall substantially on northern nations, but the question of who should bear the losses remains unresolved.

It is always better to buy fire insurance before the fire. Unfortunately, because the eurozone did not do that, is it quite late to be talking about how to buy fire insurance.

What do you make of the deployment of data-dependent forward guidance?

Central banks have done a pretty good job at communicating the idea that their policies going forward are contingent. The Fed says it is probably going to raise interest rates before too long, but at the same time says this is dependent on the situation with inflation and the labour market – and everybody understands that. What I am suggesting is that at the ZLB we need a similar commitment for fiscal policy that says, “we are not going to introduce any new contractionary measures even if it means running conventional deficits and we are not going to do anything about it until inflation gets back up”. At the ZLB, fiscal policy needs to take responsibility for inflation as the central bank cannot do it by itself. But, as I said, this is so far away from the thinking of people making fiscal policy. Certainly with Germany having the most influence in Europe, it is unlikely they will be happy saying people can run deficits at a certain percentage of GDP until inflation comes back up. The Germans seem to be happy even with low inflation, even if it is below the target.

What is your view on the secular stagnation and savings glut debates?

It is very hard to know. Secular stagnation-like theory tends to emerge when there has been a long recession. But you can never be sure they are not right. I am not sure what to make about the savings glut theory. We are in a low growth phase because of a bad combination of monetary and fiscal policy. There is plenty of room for growth and we will find ourselves growing again if we can get out of it.

Is there a role for trade agreements?

The trade agreements that are now being talked about are generally not about tariffs, so there is an argument that these are not important. I am not sure that is a big issue. The international capital flows and the fact capital flows around trying to arbitrage regulation – that is a big problem on the regulatory side.

Do you think central banks have all the tools they need, including macro-prudential powers?

We need better monitoring of financial stability and nobody knows how to do it in exactly the right way. People have said we need to move in the direction of collecting more data and have less leverage in one way or another. Moving in that direction makes sense. But of course, these regulations have costs. There are some people that have gotten so wary of financial instability that they are proposing counterproductive policies.

For example, some are proposing monetary policy rules that respond to the ratio of credit-to-GDP. But the ratio of credit-to-GDP rises in anticipation of growth. Of course its increase can also lead to instability, sometimes. But to take the position to try to prevent instability by limiting credit-to-GDP because in itself this is a problem I would say a big mistake.

Are you in favour of more volatile growth?

Not so much volatility. But growth involves taking risks and will occasionally result in an ‘internet boom’ where people get overly optimistic. That is the way things are. But we do not want to make growth impossible as we try to stop financial instability.

Do we have an optimal international monetary system?

The easy answer is no. The IMF is basically a good institution that has been criticised unfairly. The US position that has prevented China and other emerging countries from having a say that is consistent with the size of their economies may be causing fragmentation of the monetary system in a way that is counter-productive.

But I do not have any simple suggestions for an ideal monetary system. There are a lot of problems of co-ordinating financial regulation across countries. I don’t see an immediate prospect of creating an international institution that would do that. It is too political, but that means there is a lot of negotiation that is probably more important than trade agreements, to avoid creating an unstable arbitrage across different regulatory regimes and keep the regimes from interfering with each other.

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