Monetary and Fiscal Interaction:

1. Monetary and Fiscal Interaction: Understanding of Economic Crisis, Foreign Exchange Crisis, and Policy Responses December, 2012 Byung Han Seo (徐 秉 翰)

2. Ⅰ. Two eq’m conditions in DSGE economy MtVt (i, .)=Ptyt Money demand Or (1) Pt/Pt-1 = EPt+1/Pt + f(yt-yt*) Phillips curve And Gov’t debt valuation (2) + = Foreign(indexed) debt+Nominal debt/price level=PV of future primary surpluses Monetary-dominant: (1) drives P(=eP*), (2) follows along. Fiscal-dominant: (2) can drive P, (1) follows along. Especially for developing countries.

3. Fiscal-dominant (Non-Ricardian) regime (2) • Debt + # shares x price per share = E pv of future earnings • Nominal debt (including currency) is like corporate equity. • Real (foreign, indexed) debt is like corporate debt. • (2) is a valuation equation, can determine P(=eP*) from B,M,s, just like stock value. • If s(=τ -g) or β decreases: • Nominal debt (=equity): P rises (=Implicit default) • Real debt (=debt): Explicit default • OMOs, QE, and Credit Easing(=private asset purchase, guarantee, etc) policies are ineffective unless E pv of future earnings is changed. + =

4. Non-Ricardian(fiscal-dominant) regime (2) • Very different implications from conventional monetary economics: • Price level is determined even in a cashless, frictionless economy (M=0)! • Only government M, B matter. • Private M(checks), foreign M(dollarized), private B(“liquidity”) do not matter for P or e. • Exchange rate reflects “faith in government,” not money stocks, • and is volatile due to stochastic discount factor. • Passive M↔B (real bills), interest rate targets ok! • Inflation still feels like excess “aggregate demand” or • “money chasing goods.” + =

5. Ⅱ. Fiscal roots of inflation/devaluation 1) Empirical example: 1997 Asia. Large prospective (not current) deficits led to crashes. Bad loans, governments will bail out banks. Can’t (won’t) raise taxes. →“Default’’ (via devaluation/inflation) on outstanding nominal debt. + = Source: Burnside, Eichenbaum, Rebelo JPE 2001 Fiscal roots: Could any open market operation (exchange money for nominal debt) have saved East Asia 1997, Russia 1998, Argentina 2002? Note: danger of conventional accounting. Inflation tax not on books. Korea “paid” for bank crisis by devaluing won salaries. (BER 2002).

6. Ⅱ. Fiscal roots of inflation/devaluation 2) Net present value of impact on fiscal deficit of aging-related spending, in percent of GDP Source: IMF(2009)

7. Ⅲ. Monetary and Exchange Rate regimes 1) Exchange Rate Peg, Currency Board Peg: reserve crises, “speculative attack”? Currency board: all MB 100% backed by dollar assets. What could be safer? (2) + = Foreign reserves do not matter! The ability to borrow reserves (against future taxes) is all that matters! Good s Can borrow reserves Bad s Must eventually “Default” on M, B, grab reserves, even if 100% Absent primary surpluses s, board/peg must collapse sooner or later! Argentina: Explicit default on Bf, abrogate board to “default” on B, M.

8. * BOK B/S, in percent of nominal GDP, end of year

9. ** Sterilized FX mkt intervention is ineffective in the long run • BOK has issued interest-bearing central bank bonds(MSB) as a major instrument for sterilized FX mkt intervention. This implies fiscal abuse of central bank due to unsound fiscal policy, distorts fiscal deficits and gov’t debt, undermines fiscal discipline. → Fiscal-dominant regime This violates the basic principle of democracy that there is "no taxation without representative"(Magna Carta 1215). • "Inflation and the Government Budget Constraint in Korea"(Seo, 1996) "Sterilized Intervention and Monetary Controls”(Seo, 2005) • Governor Robertson(Board of Governors 1961) argued that sterilized foreign exchange intervention by the Fed was bad law, bad politics, and bad economics (Hetzel 1996).

10. *** Impossible Trinity Trade-off between free capital mobility, exchange rate stability andindependent monetary policy

11. Ⅲ. Monetary and Exchange Rate regimes 2) Dollarization, Monetary Union Pro: 1. Hard to go back. 2. No money or nominal debt to devalue. → Solves commitment problem and fiscal temptation to inflate! 3. Uses global standard units. Makes trade, capital much easier. Con: 1. (Traditional) Can’t offset real shocks. But…How many hyperinflations/crashes is this ability worth? “If depreciating the currency were the key to prosperity, Brazil and Argentina would be the richest country in the world.” 2. (Sims) No shock absorber. In trouble, must explicitly default. Like a debt-only firm. Stock (nominal debt) is good! Optimal currency area depends on fiscal transfers. - US states. EU? Solution: Dollarize transactions (including clearing). “Government equity.” Reserve currency, or variable coupon debt. “Stock” advantages, dollarization advantages.

12. Ⅲ. Monetary and Exchange Rate regimes 3) Interest rate rules (Taylor) regime Characteristics: Fiat currency, floating exchange rate, large or closed economy. Advantage: 1. Can smooth real shocks in Ricardian(monetary-dominant) policy regime. Difficulties: 1. Must raise interest rate more than 1-1 with inflation. -Even in bad times – tempted to “fight recession” →Time consistency, rules, central bank independence, inflation targets,… 2. Does it really stabilize inflation (business cycle)? → multiple equilibria 3. Needs lots of fiscal slack. - Fiscal equation is still there, tax/spend (s) must adjust to follow P. - Suppose central bank deflates. Treasury must raise taxes to pay off outstanding nominal debt! - Will not solve fiscal temptation to inflate (“default” on debt). - Not an option for countries with intractable fiscal problems (Sims) Even if commitment problem is solved

13. Ⅲ. Monetary and Exchange Rate regimes 2) Dollarization, Monetary Union Pro: 1. Hard to go back. 2. No money or nominal debt to devalue. → Solves commitment problem and fiscal temptation to inflate! 3. Uses global standard units. Makes trade, capital much easier. Con: 1. (Traditional) Can’t offset real shocks. But…How many hyperinflations/crashes is this ability worth? “If depreciating the currency were the key to prosperity, Brazil and Argentina would be the richest country in the world.” 2. (Sims) No shock absorber. In trouble, must explicitly default. Like a debt-only firm. Stock (nominal debt) is good! Optimal currency area depends on fiscal transfers. - US states. EU? Solution: Dollarize transactions (including clearing). “Government equity.” Reserve currency, or variable coupon debt. “Stock” advantages, dollarization advantages.

14. Ⅲ. Monetary and Exchange Rate regimes 2) Dollarization, Monetary Union Pro: 1. Hard to go back. 2. No money or nominal debt to devalue. → Solves commitment problem and fiscal temptation to inflate! 3. Uses global standard units. Makes trade, capital much easier. Con: 1. (Traditional) Can’t offset real shocks. But…How many hyperinflations/crashes is this ability worth? “If depreciating the currency were the key to prosperity, Brazil and Argentina would be the richest country in the world.” 2. (Sims) No shock absorber. In trouble, must explicitly default. Like a debt-only firm. Stock (nominal debt) is good! Optimal currency area depends on fiscal transfers. - US states. EU? Solution: Dollarize transactions (including clearing). “Government equity.” Reserve currency, or variable coupon debt. “Stock” advantages, dollarization advantages.

15. Ⅲ. Monetary and Exchange Rate regimes 3) Interest rate rules (Taylor) regime Characteristics: Fiat currency, floating exchange rate, large or closed economy. Advantage: 1. Can smooth real shocks in Ricardian(monetary-dominant) policy regime. Difficulties: 1. Must raise interest rate more than 1-1 with inflation. -Even in bad times – tempted to “fight recession” → Time consistency, rules, central bank independence, inflation targets,… 2. Does it really stabilize inflation (business cycle)? → Multiple equilibria 3. Needs lots of fiscal slack. - Fiscal equation is still there, tax/spend (s) must adjust to follow P. - Suppose central bank deflates. Treasury must raise taxes to pay off outstanding nominal debt! - Will not solve fiscal temptation to inflate (“default” on debt). - Not an option for countries with intractable fiscal problems (Sims) Even if commitment problem is solved

16. Ⅲ. Monetary and Exchange Rate regimes 4) Inflation-tax maximizing regime Primarysurplus s = tax – spending + nominal interest x monetary base • Characteristics: • Own country fiat money (not dollarize, peg, gold standard, etc.) • Chronic high inflation • Legal restrictions to boost demand for base money • Currency controls, then trade controls (Hold M, not $) • Banking, finance, interest rate controls (Hold M, not bank deposits, stocks) • Anti- “hoarding”, “speculation” measures. (Hold M instead!) • Price controls, then quantity allocation Occurs when tax < spending a) Wars. (US too.) b) Communist countries. c) Developing countries. “Bad” (huge distortions) Must solve underlying fiscal problem to get away from it.

17. Ⅳ. Summary and conclusion • Money and nominal debt are like corporate equity. Foreign or real debt are like corporate debt. • 2. “Stock value” can drive inflation. Composition effects (money vs. nominal debt) under central bank control can be secondary. • Fiscal considerations and “debt/equity” drive choice and structure of monetary regime! • Any monetary or exchange rate regime can not stabilize economy w/o the sound and sustainable fiscal policy and financial system. ●결론적으로, 나라가 잘 되려면 논어에서처럼 “君君 臣臣 父父子子” 해야 합니다. 저는 이를 “정정 시시(政政 市市)”라고 말하는데, 정부가 정부답고 시장(국민)이 시장다워야 합니다. 정부가 과도한 국방과 복지(butter and guns), 비행기도 뜨지않는 공항건설 등 쓸데 없는 곳에 국민의 혈세를 낭비할 뿐만 아니라, 재정통화정책을 정상적으로 운영하지 않고재화시장,노동시장,금융시장에 직접 개입하여 물가,임금,금리 및 환율을 규제 관리하는 등 “하지 말아야 할 일”을 하기 때문에 위기가 초래되는 것입니다.

18. Thanks for your attention Q & A