Active and Passive Policies

There is classsic paper by Eric M. Leeper, Rudy Professor Ph.D., University of Minnesota, 1989 Macroeconomics, Money, Applied Time Series, distinguished between active and passive monetary and fiscal policies, within the context of simple policy rules, I consider this paper of great importance though  paper cost some $30. In every country we find monetary policy to be active (interest rates ) and fiscal to be passive but this paper assignment was to be vice-verse . Normally when the inflation is high the rates are raised to deflate the demand and put pressure on inflation. A passive fiscal policy is where, following an increase in debt, taxes rise or spending falls by enough to bring debt back to some target level. If neither taxes nor spending respond to excess debt, debt would gradually explode as the government borrowed to pay the interest on the extra debt. This is the extreme case of what Leeper calls an active fiscal policy.

Well all the economist and strategist known to the world in tough situation go for an active monetary policy and passive fiscal policy. This would correspond to what Simon Weiss called the consensus assignment. Lets talk about the paper now Leeper defines situation when fiscal policy determines inflation and monetary policy decides debt (i known its interesting) because debt becomes sustainable if controlled by inflation. This idea, which became known as the Fiscal Theory of the Price Level (FTPL)[1], is very controversial. (For once, divisions cut across ‘party’ lines, with John Cochrane and Mike Woodford both contributing to the FTPL.) However for current purposes you can think of the FTPL policy combination as being a form of fiscal dominance

So why did Cœuré invoke Leeper’s definitions of active and passive in his speech? To quote:

“central bank independence and a clear focus on price stability are necessary but not sufficient to ensure that the central bank can provide a regime of low and stable inflation under all circumstances – in the economic jargon, ensuring “monetary dominance”. Maintaining price stability also requires appropriate fiscal policy. To borrow from Leeper’s terminology, this means that an “active” monetary policy – namely a monetary policy that actively engages in the setting of its policy interest rate instrument independently and in the exclusive pursuit of its objective of price stability – must be accompanied by “passive” fiscal policy.”

Now OMT (Outright Monetary Transactions) involves the ECB being prepared to buy government debt in order to force down interest rates so that fiscal policy becomes sustainable. To some that seems like fiscal dominance: monetary policy is being used in a similar way to the FTPL, in order to make debt sustainable. Cœuré wants to argue that with OMT we can get back to the consensus assignment, because OMT will allow fiscal policy to become passive again.
  

The current fiscal policy in the Eurozone is not at al ignorning the debt .However the fiscal policy to turn passive its has to counter the debt interest payments so that the debt do not explode. The rates that is quoted right now are too high with the default risk too high its almost impossible.To be true its indeed the high risk of default which keeps the fiscal policy active. OMT is necessary to allow fiscal policy to become passive in countries subject to significant default risk, and therefore for monetary policy to ensure price stability. The argument, like the FTPL, is controversial: many of those who dislike the FTPL would argue that an active monetary policy is sufficient to ensure price stability. This analysis also ignores the problem of the Zero Lower Bound (ZLB) for nominal rates, which one could reasonably argue forces monetary policy to become passive.

I want to make two final points which Cœuré does not.The current Eurozone fiscal rules also probably imply adjustment that is faster than necessary. As a result, no additional conditionality is required before the ECB invokes OMT. Second, this analysis ignores the problem of the ZLB, which is as acute for the Eurozone as it is elsewhere. Cœuré says that OMT is not Quantitative Easing (QE), but does not explain why the ECB is not pursuing QE. It has taken the ECB about two years too long to recognise the need for OMT – let’s hope that it does not take another two before it realises that for monetary policy to stay active in the sense described above, it also needs QE.