WORD ON THE STREET: In the wake of the financial crisis and the ensuing recession, many countries around the world responded with a significant increase in government spending. Some of this increase came about through what economists call automatic stabilizers.
But there has also been a dramatic expansion in budget deficits attributable to deliberate efforts to apply fiscal stimulus to improve economic outcomes. This expansion in government spending has been very significant in the U.S., but it has also occurred in other countries.
So what does this have to do with monetary policy? Well, it turns out, a great deal. It is widely understood that governments can finance expenditures through taxation, debt – that is, future taxes – or printing money. In this sense, monetary policy and fiscal policy are intertwined through the government budget constraint.
For good reasons, though, societies have converged toward arrangements that provide a fair degree of separation between the functions of central banks and those of their fiscal authorities. For example, in a world of fiat currency, central banks are generally assigned the responsibility for establishing and maintaining the value or purchasing power of the nation's unit of account.
Yet, that task can be undermined, or completely subverted, if fiscal authorities set their budgets in a manner that ultimately requires the central bank to finance government expenditures with significant amounts of seigniorage in lieu of current or future tax revenue.
The ability of a central bank to maintain price stability can also be undermined when the central bank itself ventures into the realm of fiscal policy. History teaches us that unless governments are constrained institutionally or constitutionally, they often resort to the printing press to try to escape what appear to be intractable budget problems. And the budget problems faced by many governments today are, indeed, challenging. But history also teaches us that resorting to the printing press in lieu of making tough fiscal choices is a recipe for creating substantial inflation and, in some cases, hyperinflation.
Awareness of these long-term consequences of excessive money creation is the reason that over the past 60 years, country after country has moved to establish and maintain independent central banks – that is, central banks that have the ability to make monetary policy decisions free from short-run political interference. Without the protections afforded by independence, the temptation of governments to exploit the printing press to avoid fiscal discipline is often just too great. Thus, it is simply good governance and wise economic policy to maintain a healthy separation between those responsible for tax and spending policy and those responsible for money creation.
It is equally important for central banks that have been granted independence to be constrained from using their own authority to engage in activities that more appropriately belong to the fiscal authorities or the private sector. In other words, with independence comes responsibility and accountability. Central banks that breach their boundaries risk their legitimacy, credibility and, ultimately, their independence. Given the benefits of central-bank independence, that decision could prove costly to society in the long run.
There are a number of approaches to placing limits on independent central banks so that the boundaries between monetary policy and fiscal policy remain clear.
First, the central bank can be given a narrow mandate, such as price stability. In fact, this has been a prominent trend during the last 25 years. Many major central banks now have price stability as their sole or primary mandate.
Second, the central bank can be restricted as to the type of assets it can hold on its balance sheet. This limits its ability to engage in credit policies or resource allocations that rightfully belong under the purview of the fiscal authorities or the private marketplace. And third, the central bank can conduct monetary policy in a systematic or rule-like manner, which limits the scope of discretionary actions that might cross the boundaries between monetary and fiscal policies. Milton Friedman's famous k-percent money growth rule is one example, as are Taylor-type rules for the setting of the interest-rate instrument.
Unfortunately, over the past few years, the combination of a financial crisis and sustained fiscal imbalances has led to a breakdown in the institutional framework and the previously accepted barriers between monetary and fiscal policies. The pressure has come from both sides. Governments are pushing central banks to exceed their monetary boundaries, and central banks are stepping into areas not previously viewed as appropriate for an independent central bank.
Let me offer a couple of examples to illustrate these pressures. First, despite the well-known benefits of price stability, there are calls in many countries to abandon this commitment and to create higher inflation to devalue outstanding nominal government and private debt. That is, some suggest that we should attempt to use inflation to solve the debt-overhang problem. Such policies are intended to redistribute losses on nominal debt from the borrowers to the lenders. Using inflation as a backdoor to such fiscal choices is bad policy, in my view.
Pressure on central banks is also showing up through other channels. In some circles, it has become fashionable to invoke lender-of-last-resort arguments as a rationale for central banks to lend to ‘insolvent’ organizations – either failing businesses or, in some cases, failing governments.
I believe that central banks need to think hard about how and when they exercise this important role. We need to have a well-articulated and systematic approach to such actions. Otherwise, our actions will exacerbate moral hazard and encourage excessive risk-taking, thus sowing the seeds for the next crisis. Unfortunately, neither financial reform nor central banks have adequately addressed this dilemma.
Breaching the boundaries is not confined to the fiscal authorities asking central banks to do their heavy lifting. The Fed and other central banks have undertaken other actions that have blurred the distinction between monetary policy and fiscal policy, such as adopting credit policies that favor some industries or asset classes over others. Such steps were taken with the sincere belief that they were absolutely necessary to address the challenges posed by the financial crisis.
The clearest examples can be seen when the Federal Reserve established credit facilities to support markets for commercial paper and asset-backed securities. Most notable has been the effort by the Fed to support the housing market through its purchases of mortgage-backed securities. These credit allocations have not only breached the traditional boundaries between fiscal and monetary policy, but also generated pointed public criticisms of the Fed.
Once a central bank ventures into fiscal policy, it is likely to find itself under increasing pressure from the private sector, financial markets, or the government to use its balance sheet to substitute for other fiscal decisions. Such actions by a central bank can create their own form of moral hazard, as markets and governments come to see central banks as instruments of fiscal policy, thus undermining incentives for fiscal discipline. This pressure can threaten the central bank's independence in conducting monetary policy and thereby undermine monetary policy's effectiveness in achieving its mandate.
In my view, this blurring of the boundaries between monetary and fiscal policies is fraught with risks. As I said, these boundaries arose for good reason, and we ignore their breach at our own peril. I believe we must seek ways to restore the boundaries.
The central bank's balance-sheet policy
Another related issue facing central banks arises from the degree to which central banks have expanded their balance sheets. There are two dimensions to this issue. One is the composition of the balance sheet. In the U.S., for example, the balance sheet of the Federal Reserve has changed from one made up almost entirely of short-term U.S. Treasury securities to one that is mostly long-term Treasuries, plus significant quantities of long-term mortgage-backed securities. This concentration of housing-related securities is problematic because it is a form of credit allocation and thus violates the monetary/fiscal policy boundaries I just mentioned.
The second aspect is the overall size of the balance sheet. Many central banks expanded their balance sheets in an effort to ease monetary policy after their usual policy instrument – an interest rate – had reached the zero lower bound.
Do central bankers anticipate that their balance sheets will shrink to more normal levels as they move away from the zero lower bound? Is it desirable to do so? Or should monetary policy now be seen as having another tool, even in normal times?
Some have suggested that central banks adopt a regime in which the monetary policy rate is the interest rate on reserves rather than a market interest rate, such as the federal funds rate. This would then permit the central bank to manage its balance sheet separately from its monetary instrument, freeing it to respond to liquidity demands of the financial system without altering the stance of monetary policy. In principle, this would take pressure off central banks to shrink their balance sheets from the current high levels and simply rely on raising the interest rate on reserves to tighten monetary policy.
The alternative is to return to a more traditional operating regime in which the central bank sets a target for a market interest rate, such as the federal funds rate in the U.S., above the interest rate on reserves. Implementing this regime would require a smaller balance sheet.
I am very skeptical of an operating regime that gives central banks a new tool without boundaries or constraints. Without an understanding, or even a theory, as to how the balance sheet should or can be manipulated, we open the door to giving vast new discretionary abilities to our central banks. This violates the principle of drawing clear boundaries between monetary policy and fiscal policy.
When markets or governments come to believe that a central bank can freely expand its balance sheet without directly impacting the stance of monetary policy, I believe that various political and private interests will come forward with a long list of good causes, or rescues, for which such funds could or should be used.
Economic theory and practice teach us that monetary policy works best when it is clear about its objectives and systematic in its approach to achieving those objectives. Granting vast amounts of discretion to our central banks in the expectation that they can cure our economic ills or substitute for our lack of fiscal discipline is a dangerous road to follow.
Charles I. Plosser is president and CEO of the Federal Reserve Bank of Philadelphia. This article is adapted and edited from a presentation given before the Global Society of Fellows of the Global Interdependence Center at Banque de France in Paris on March 26. The original text is online.
(Illustration of Edward Hicks' ‘The Peaceable Kingdom’ courtesy of the National Gallery of Art)
