by Central banks and fiscal policies Suppose a UK government became extremely irresponsible, and enacted large tax cuts during an economic boom. The Bank would, following its remit, attempt to put the lid on inflationary pressure by raising interest rates. Suppose further that the markets panicked, and refused to buy UK government debt except at ridiculously high interest rates. In that situation I think it is extremely unlikely that the Bank would intervene and buy government debt, because it would believe that economic stability was best served by the government cutting its deficit. Academics have sometimes speculated about such a standoff. In this game of chicken would the government give in and raise taxes or cut spending, or would the Bank give in and
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Central banks and fiscal policies
Suppose a UK government became extremely irresponsible, and enacted large tax cuts during an economic boom. The Bank would, following its remit, attempt to put the lid on inflationary pressure by raising interest rates. Suppose further that the markets panicked, and refused to buy UK government debt except at ridiculously high interest rates. In that situation I think it is extremely unlikely that the Bank would intervene and buy government debt, because it would believe that economic stability was best served by the government cutting its deficit.
Academics have sometimes speculated about such a standoff. In this game of chicken would the government give in and raise taxes or cut spending, or would the Bank give in and “monetise” the deficit by buying government debt? I think this debate is a little academic, because a government so intent on creating an inflationary boom would also think nothing about telling the Bank what to do. The governor would be ordered to monetise the deficit and if he refused he would be replaced by someone who would.
No governor of a central bank wants to be put in that situation. It is for this reason that Mervyn King said: “Central banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.” Obsession can breed irrationality. Which brings us back to 2010, which is much more like recent events than our hypothetical economic boom. Perhaps this irrational fear of deficits may help explain why during the largest recession since the war King ignored standard macroeconomic theory and practice and encouraged the austerity that proved so disastrous. A lesson may be that while you can trust central bankers to deal with a short-term panic in the government debt market during a recession, you should never trust them to be objective when talking about fiscal policy.