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November 28, 2005

Nouriel Roubini Says: Behave Like Cocks-of-the-Walk

Nouriel Roubini worries about the long-run economic destiny of the U.S. and Europe, and tells both Jean-Claude Trichet and Ben Bernanke to act like roosters: jump up on top of the fence and crow loudly:

RGE - The "Game of Chicken" (or Roosters?) between the ECB and the EU fiscal authorities..and how will Bernanke deal with the US fiscal time bomb? : There are different ways to interpret the decision by the ECB to make explicit that it will not accept bonds with a credit rating below A- as collateral.... Buiter and Sibert argue - in a very interesting paper - that the operating procedures of the ECB in its repo operations [have] impl[ied] an effective subsidy to the use of inferior collateral, i.e. the government debt of poorer credits with higher sovereign risk....

A complementary interpretation is that the ECB is now trying to restore a first-mover advantage in the classic "game of chicken" between a monetary and fiscal authority. The "fiscal theory of the price level" suggests that fiscal deficits may or may not lead to high inflation depending on whether there is "fiscal dominance" or "monetary dominance" in this game of chicken. If there is "fiscal dominance", reckless deficit policies... will eventually force the central bank to... use the inflation tax to finance an exogenous fiscal deficit path. If there is "monetary dominance", the... fiscal authority is forced to blink and adjust its budget policy (cut spending or raise taxes).... [If] neither authority blinks... default risk increases, interest rates go higher and the debt dynamics worsen.... [S]trong forms of the fiscal theory of the price level suggest strange cases... a[n immediate] jump of the initial price level (and high inflation)....

Is this EU game of any relevance for the U.S. and for the new Chairman of the Fed Ben Bernanke? Very much so, as a similar game of chicken is starting to take place between the Fed and the US fiscal authorities. The current US fiscal policy is on a train wreck path and the Fed is now tightening, in part, to signal that they will not monetize fiscal deficit.... Dallas Fed [President] Fisher.... "The FOMC has taken note of the fiscal situation, as shown by this pre-Katrina passage from the released minutes of the Aug. 9 meeting: 'Few signs were evident that greater fiscal discipline in the budget process would emerge any time soon.' In this environment, the markets, if left to their own devices, would produce higher interest rates to ration money and balance the demand and supply of capital. If the Federal Reserve were to resist the upward pressure on interest rates, it would in effect monetize the burgeoning fiscal deficits. The Federal Reserve has staunchly resisted monetizing deficits for more than a quarter century, and I feel strongly that it can ill afford to monetize them today."

That is the language of a true rooster in this game of chicken!... [B]oth Brad DeLong and Jagadeesh Gokhale have recommended to the Fed - in two FT oped pieces - to behave like a "monetary dominant" rooster to avoid the unpleasant monetary arithmetic of an unsustainable fiscal policy train wreck. Gokhale tells the Fed to play like a dominant rooster to defuse the "fiscal time bomb" while DeLong argues that "Fiscal Stability Should Be the New Fed Mantra".

So the final and most important question is whether Ben Bernanke will turn out to be a rooster or a chicken.... [S]ince Bernanke is smart and wise enough to know that fiscal deficits matter (even for the current account) and that fiscal dominance would be poison for the Fed, he may soon want to speak also about the importance of fiscal discipline.... [I]n spite of Milton Friedman, inflation is always a "fiscal" - not "monetary" - phenomenon when fiscal policy is on a train wreck path....

Posted by DeLong at November 28, 2005 12:24 PM