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Public debt and inflation are related on account of monetary policy’s power to accommodate high levels of public debt. Thus, the higher public debt becomes, the greater the pressure that can be put upon monetary policy to respond accordingly. Suddenly it might be fiscal policy that calls the shots – monetary policy no longer follows the objective of price stability but rather the concerns of fiscal policy. A state of fiscal dominance has been reached.
The logic of the fiscal theory can be described as follows: Let us assume additional expenditure, for instance higher transfers, which are not financed by additional taxes but by issuing additional bonds. Consequently the value of real debt is now higher than the present value of future tax payments. Households feel richer and thus consume more, causing output and inflation to increase. Monetary policy has to stabilise real debt to avoid an inflation spiral, with the result that it responds at a rate of less than 1 to 1 to inflation, thereby violating the Taylor principle. Thus, higher inflation reduces debt in real terms and lower real interest rates reduce the real debt service burden of existing government debt.
Even if fiscal policy has not yet reached its limit, the economic mechanisms attached to the fiscal theory of the price level might already swing into action. To be specific: let us assume that agents expect, with some probability, that monetary policy will bear the burden of adjustment and stabilise real government debt through higher inflation. Once inflation expectations start rising, the same might happen with inflation as well. Thus, even if the fiscal limit has not been reached, it may still affect inflation. In other words, how policy makers are expected to cope with the fiscal limit, including their efforts to consolidate, not only affects expectations concerning future policy regimes but can also affect today’s welfare. Against the backdrop of this theoretical analysis, one thing should be made clear from a monetary policy perspective: policymakers should not assume that they are on safe ground just because inflation expectations are firmly anchored. Only if agents expect deviations from a “virtuous regime” of monetary dominance to be short-lived – say, because policymakers still enjoy high credibility – will inflation expectations remain well anchored. However, if agents learn that the deviation is going to last for longer than initially expected, their inflation expectations will change. And this might happen very suddenly.
What conclusion can we draw from this theoretical analysis? Well, the right conclusion is that fiscal consolidation is crucially important to keep inflation expectations anchored. On this basis, one could make a solid case for consolidation. For it is incumbent on governments to reduce the level of public debt. Indeed, they have to do this to promote economic growth and to ensure price stability. Now that market pressure has eased somewhat, so has the political will to consolidate. Many argue that consolidation has gone too far and that it will impede growth given the current state of the economy. But is that a tenable argument against the need to reduce public debt, to get out of the danger zone? Let us take a closer look at the relationship between consolidation and growth.
High levels of public debt are one of the major economic policy challenges of our times – especially from a central banker’s point of view. Sustainable public finances are a necessary prerequisite for a stable currency – a prerequisite that monetary policy itself cannot create. Given that high levels of public debt also hurt economic growth, there is a solid case for consolidation. True, in the short run, consolidation can dampen growth; that is undisputed. Nevertheless, a credible commitment to sound public finances will also inspire confidence. And confidence is what is lacking in the euro area.