Navigating Fiscal-Monetary Tensions: The Role of Fiscal R-Star in Ensuring Economic Stability

The IMF's study introduces "fiscal r-star" to highlight growing fiscal-monetary tensions in advanced economies, emphasizing the need for coordinated policy to ensure long-term macroeconomic stability. The paper warns that current tensions are at historic highs, posing significant risks of future financial crises.

The International Monetary Fund's report authored by Marijn A. Bolhuis, Jakree Koosakul, and Neil Shenai, delves into the growing complexities of fiscal and monetary policy interactions in advanced economies. The study is particularly relevant in the context of the post-Global Financial Crisis (GFC) period, where fiscal policies have become increasingly "active," meaning they are less responsive to rising debt levels. This shift has been further amplified by the economic disruptions caused by the COVID-19 pandemic.

Defining Fiscal R-Star and Its Importance

The authors introduce the concept of "fiscal r-star" to better capture the dynamics of fiscal sustainability in such an environment. Fiscal r-star is defined as the real interest rate required to stabilize a country's debt-to-GDP ratio when the primary balance—the difference between government revenues and expenditures excluding interest payments is set exogenously, and when the economy is growing at its potential with inflation at the central bank's target. This concept contrasts with the more traditional "monetary r-star," which refers to the neutral real interest rate used by central banks to stabilize inflation. The difference between these two rates is termed the "fiscal-monetary gap," which the authors propose as a measure of the tensions between fiscal and monetary policies.

The Impact of a Widening Fiscal-Monetary Gap

The paper's central argument is that the fiscal-monetary gap has become a critical indicator of macroeconomic stability in advanced economies. When this gap is large, it signals significant tensions between fiscal and monetary authorities, which can manifest in various adverse economic outcomes. For instance, a large fiscal-monetary gap is associated with rising debt levels, higher inflation, financial repression, and lower real returns on bonds and cash. These conditions, in turn, elevate the risks of future financial crises, including debt, currency, and systemic crises. The paper's empirical analysis draws on over 140 years of data from 16 advanced economies, covering periods of significant economic upheaval, including the World Wars, the Great Depression, the Cold War, the Great Moderation, the GFC, and the COVID-19 pandemic. The findings reveal that fiscal-monetary tensions are currently at historic highs, levels last seen in the early 1950s when advanced economies were grappling with the debt overhang from World War II. This historical perspective underscores the gravity of the current fiscal-monetary landscape and the potential risks it poses to global economic stability.

Theoretical Underpinnings and Policy Implications

The study also explores the theoretical underpinnings of the fiscal-monetary gap and its implications for policy. Under a passive fiscal policy regime, where fiscal authorities adjust the primary balance in response to rising debt levels or real interest rates, the fiscal r-star aligns closely with the monetary r-star, minimizing the fiscal-monetary gap and thus reducing tensions. However, in an active fiscal policy regime, where the primary balance does not adjust in response to debt levels, the fiscal r-star diverges from the monetary r-star, creating a fiscal-monetary gap. This divergence can force monetary authorities into difficult trade-offs. For instance, if the monetary authority raises interest rates to stabilize inflation (aligning with the monetary r-star), it could exacerbate public debt dynamics, leading to a potentially unsustainable fiscal situation. Conversely, if the monetary authority keeps interest rates lower than the monetary r-star to accommodate fiscal policy, it may help stabilize debt in the short term but could also fuel inflationary pressures and undermine price stability.

Navigating Future Fiscal-Monetary Challenges

The paper's findings suggest that addressing these fiscal-monetary tensions will require a combination of policy adjustments. Growth-enhancing reforms and fiscal consolidation are highlighted as necessary steps to attenuate these tensions over time. However, the authors also acknowledge the political and economic challenges of implementing such measures, particularly in an environment of low growth and high public debt. The paper also touches on the potential role of financial repression measures that result in negative real interest rates through controlled inflation and other mechanisms as a tool for reducing public debt burdens. While financial repression can provide temporary relief for fiscal authorities by reducing the real value of debt, it also carries significant risks, including distorting financial markets and undermining long-term economic growth.

The IMF study provides a comprehensive analysis of the evolving fiscal-monetary landscape in advanced economies. By introducing the concept of fiscal r-star and the fiscal-monetary gap, the authors offer new insights into the complexities of fiscal and monetary policy interactions in an increasingly uncertain economic environment. Their findings underscore the importance of coherent and coordinated policy approaches to ensure long-term macroeconomic stability and prevent future financial crises.