For the last thirty years, around the world, the changing relationship between monetary authorities and fiscal authorities has been at the center of economic and financial developments: the course of growth and inflation and the path of asset prices. At the beginning of the period, virulent inflation demanded robust monetary authority independence, so as to pursue draconianly tight monetary policy, including disciplining fiscal authorities when their loose policies contradicted the overriding goal of winning the war against inflation. Victory was achieved a decade ago.
And ever since, a more cooperative and collaborative relationship between monetary and fiscal authorities has been required, so as to cut off the fat tail of deflation risk, notably in recessions. Some bemoan this development as a loss of central bank independence. And indeed it is. But central bank independence, by definition, is all about cutting off the fat tail of inflation risk. When the fat tail becomes deflation, a stubbornly independent central bank becomes much less of a virtue, and potentially a deflation-abetting vice.
In my view, the ECB needs to come to this conclusion. Following such a course will, of course, be fraught with risks, notably an unmooring of long-term inflation expectations. The ECB should not have ever been put in this place. But the inherent design flaws of monetary union have come home to roost. Call it some unpleasant Keynesian-Minsky logic...
Paul McCulley, PIMCO, June 2, 2010