Euro Area Economics: When Central Bank Surprises Meet Government Wallets

Hey there! So, you know how sometimes it feels like the economy is a giant, complicated machine with levers labeled ‘monetary policy’ (that’s the central bank stuff, like interest rates) and ‘fiscal policy’ (that’s the government spending and taxing)? Well, we’ve been digging into how those levers interact, especially in the Euro Area, and let me tell you, it’s pretty fascinating – and maybe a little surprising!

For ages, the thinking went: the central bank handles prices and money, and governments handle their budgets and debt, and they should mostly stay in their own lanes. Especially in the Euro Area, with one central bank (the ECB) and lots of different national governments, this separation seemed super important for keeping things stable. But lately, with big crises like the 2008 financial meltdown, the pandemic, and even recent geopolitical wobbles, those lines have gotten a bit blurry. Governments spent *a lot*, and the ECB did some pretty unconventional things to help keep the economy afloat. This got us wondering: does how well a government manages its money (its ‘fiscal sustainability’) affect how effective the central bank’s actions are?

Why This Matters Now

Think about the last few years. We had massive fiscal packages during the pandemic, coupled with really easy monetary policy. Then, boom, inflation hit hard. Some folks argue that all that government spending, combined with central banks being super accommodative, is a big reason why inflation stuck around, especially in places like the US. The Euro Area is a bit different, though. Sometimes fiscal moves seemed to help calm inflation, sometimes not so much. This mixed picture really screams that the interaction between national governments and the ECB is key.

The traditional view, often called the ‘monetary-dominant regime,’ says the central bank is in charge of prices, and governments adjust their budgets to make sure their debt is sustainable without forcing the central bank’s hand. This is the ‘Ricardian’ fiscal regime. But there’s another idea, the ‘fiscal-dominant regime,’ where the government spends what it wants, and prices (or the central bank) have to adjust to make the government’s debt add up. This is where the government’s budget constraint basically calls the shots on the price level. Big names in economics like Sargent, Wallace, Leeper, Sims, Woodford, and Cochrane have explored these ideas for years. The core message? One policy’s effectiveness often depends on what the *other* policy is doing.

Diving into the Theory

At the heart of this is the Fiscal Theory of the Price Level (FTPL). It suggests that if a government isn’t seen as committed to paying back its debt through future surpluses (being passive or Ricardian), then people might expect future inflation to erode the real value of that debt. In this scenario, if the central bank tries to tighten monetary policy (raise interest rates), it might not work as expected, or could even make things worse! Why? Because raising rates can increase the government’s debt servicing costs, potentially making the fiscal situation *less* sustainable in the eyes of the public, which then fuels expectations of higher future inflation. It’s a bit like trying to put out a fire with gasoline if the underlying fiscal situation isn’t stable.

There’s been a lot of debate and research on whether countries are in a monetary-dominant or fiscal-dominant regime, or if they switch between them. Some studies look at whether governments raise taxes or cut spending when debt goes up (the backward-looking Bohn rule approach). Others look at whether budget surpluses react to shocks in a way that reduces debt (the forward-looking approach). The empirical evidence for the Euro Area is mixed – some find sustainability, some don’t, and some find it changes over time. This time-varying nature is super important, and it’s something we really wanted to dig into.

How We Looked at It

So, our main goal was to see how effective the ECB’s unexpected monetary policy moves (we used these clever ‘monetary surprises’ identified by Jarociński and Karadi, based on market reactions around ECB announcements) are, *depending* on how fiscally sustainable a country is at that moment.

First off, we needed a way to measure fiscal sustainability over time. We used a method developed by Schlicht to estimate a time-varying version of Bohn’s rule. This basically tells us how much a country’s primary budget balance (revenue minus non-interest spending) reacts to changes in its debt-to-GDP ratio. If it reacts strongly by improving the surplus when debt rises, that’s a sign of higher sustainability (more Ricardian). If it doesn’t react much, or even worsens, that’s lower sustainability (less Ricardian). We looked at the Euro Area as a whole, plus Germany, Italy, and Portugal. Why these three? Because they represent different fiscal flavors within the Euro Area – Germany often seen as a ‘core’ stable country, Italy with significant debt challenges, and Portugal representing the ‘periphery’ which has gone through big adjustments.

Once we had our measure of time-varying sustainability, we used a technique called Local Projections (LPs). This is a neat way to estimate how variables like output and prices respond to a shock over time. We ran three types of LP models:

• A standard linear model (not considering fiscal sustainability).
• A threshold model (splitting the data into two groups: high and low sustainability, based on whether our sustainability measure was above or below its average).
• A smooth transition model (which allows for a more gradual shift between regimes, using a logistic function based on the sustainability measure).

We used quarterly data from around the early 2000s up to late 2021.

What We Found (The Big Reveal)

Okay, here’s where it gets interesting.

1. The Standard Picture: When we just looked at the linear model, ignoring fiscal regimes, we saw what you’d expect from standard economic theory. A surprise monetary tightening (like an unexpected interest rate hike) led to a drop in both output and prices. This is the central bank doing its job to cool the economy and fight inflation.

2. Enter Fiscal Sustainability: But when we brought in the fiscal regimes, the picture changed dramatically!
* In the *more* sustainable (more Ricardian) regime, monetary tightening had a stronger contractionary effect on both output and prices. The central bank’s actions worked as intended, perhaps even better.
* In the *less* sustainable (less Ricardian) regime, the response was often insignificant, or even *perverse*. For the Euro Area aggregate, Germany, and Portugal, we saw prices *rise* or show no significant drop after a monetary tightening shock in the less sustainable periods! This is a big deal. Output responses were also weaker or different.

3. Italy’s Story: Italy’s results were particularly telling. In the less sustainable regime, the monetary shock didn’t have a significant effect on output or prices in the threshold model. But in the smooth transition model (which is often better at capturing these nuances), we *did* find that prices increased in the unsustainable regime. This really hammers home the point.

4. The “Stepping on a Rake” Effect: This finding – prices rising or not falling when the central bank tightens in a less sustainable fiscal environment – is exactly what the FTPL and folks like Sims and Cochrane talk about. It’s the “stepping on a rake” effect. If people expect future fiscal problems to lead to inflation, raising interest rates can increase the government’s debt burden (especially the nominal value of floating-rate debt), which reinforces those expectations of future inflation, leading to higher prices *now*. It’s a nasty feedback loop.

5. Robustness: We checked this in several ways. We used an alternative measure of sustainability based on the relationship between government revenues and expenditures (the cointegration rule). While this rule captures a slightly different aspect of sustainability, our main finding held: monetary policy effectiveness depends on the fiscal regime. We also tried different model specifications, and the results were broadly consistent.

6. Core vs. Periphery: Interestingly, this pattern held across the Euro Area aggregate, Germany (often seen as fiscally strong), Italy (facing debt challenges), and Portugal (which underwent significant adjustments). This suggests that it’s not just about whether a country is ‘core’ or ‘periphery,’ but about its *own* fiscal behavior and sustainability *over time*.

The smooth transition model generally gave us the clearest results, likely because it uses all the data and captures the gradual changes in fiscal stance better than just splitting the sample in two.

So, What’s the Takeaway?

This isn’t just academic navel-gazing. Our findings have some pretty important implications, especially for the European Central Bank. It suggests that the ECB’s ability to control inflation and steer the Euro Area economy isn’t solely in its hands. It depends significantly on the fiscal behavior of *each* member state.

If national governments aren’t seen as being on a sustainable fiscal path – meaning they aren’t expected to generate enough future surpluses to cover their debt – then the ECB might find its tools less effective. Trying to fight inflation with higher interest rates could, in the worst-case scenario, contribute to the very inflation it’s trying to combat, or at least be much less potent.

This echoes what economists like Cochrane have been saying: monetary policy is crucial, yes, but fiscal policy isn’t just a side show. Fiscal health is fundamental to making monetary policy work properly. In an incomplete monetary union like the Euro Area, where the ECB sets policy for everyone but national governments control their own budgets, this interaction is perhaps even more critical. It means that achieving macroeconomic stability in the Euro Area requires not just a strong central bank, but also continued commitment from member states to fiscal responsibility. It’s a team effort, and if one part of the team isn’t playing ball on sustainability, the whole strategy can be undermined.

Source: Springer