The Witteveen Lecture: Klaas Knot on the case for fiscal stabilisation in a low interest rate environment

'In ways that economists seek equilibrium, Witteveen sought harmony'

Witteveen was a very important economist. He was former managing director of the IMF, a politician, a Professor from the age of 28 and he wrote multiple books. Middendorp talked about Witteveen's leadership, his economic thinking and why it still matters today. In doing so, he emphasized Witteveen's three main beliefs: 1) analysis and signs based on facts, 2) open exchange of ideas and 3) innovativeness and open-mindedness. Witteveen based his policy recommendations based on thorough analysis based on facts, while remaining open-minded. He also believed that an open exchange of ideas, also from outsiders, contributes to a stronger democracy. 

'What would Witteveen have adviced on today events?', Middendorp asked himself. We will never know exactly but what we do know is that his answer would be based on thorough analysis and an open mind. Middendorp ended his speech with a beautiful note on Witteveen's view on life. 'In ways that economists seek equilibrium, Witteveen sought harmony.' 

Knot's case for a more active role of fiscal policy 

Knot started his keynote with explaining the theory of how monetary and fiscal policy interact in normal times. 'Monetary policy affects fiscal policy by influencing the cost of funding for the government, and the sustainability of debt.' He explained that monetary policy not only influences the cost, but also the effectiveness of fiscal policy. However, fiscal policy also affects monetary policy. For example, changes in taxes, government spending and public wages affect the demand for goods and services, which in turn drives inflation. When looking at monetary-fiscal interactions in times when interst rates are persistently low, a problem arises for central banks. This is because of the natural interest rate at which the demand for and supply of capital are in equilibrium. When the central bank wants to stimulate the economy and raise inflation, this may not be feasible with a very low natural interest rate. 

Very low interest rates mean trouble for central banks but good news for governments, as low interest rates tend to increase the impact of fiscal policy on the economy. Raising public expenditure in a low interest rate environment leads to more private spending, as people expect that prices will increase in the future. Governments can therefore help the central bank by raising aggregate demand and inflation, and shortening the period of low interest rates. 

Knot does however introduce some economic and political objectives, like for example redistributing income and transmission lags. 'This simply means it takes time, for example, to design and implement a good subsidy policy for the purchase of electric cars. And then it takes time before people actually buy more electric cars. These time lags often prevent fiscal policy from providing the necessary stimulus at the time it is needed. So when I say that persistenly low interest rates strengthen the case for more countercyclical fiscal policy, I'm not saying this should be the new compass for the ship of state to sail by', Knot explains. 

'I think the response to the Covid crisis offers important lessons for the fiscal architecture in the euro area', Knot says. 'The successful coordination of fiscal and monetary policy was in great part due to the enormity of the economic threat. I think in order to make our monetary union more stable, we need a fiscal framework that enhances coordination between member states and allows for better alignment of moentary and fiscal policy over the entire economic cycle.'