Charles I Plosser: Some observations on fiscal imbalances and monetary
policy
Speech by Mr Charles I Plosser, President and Chief Executive Officer of the Federal
Reserve Bank of Philadelphia, at The Philadelphia Fed Policy Forum: "Budgets on the brink:
perspectives on debt and monetary policy", Philadelphia, 2 December 2011.
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The views expressed today are my own and not necessarily those of the Federal Reserve System or the FOMC.
Introduction
Good morning and welcome to the Philadelphia Fed Policy Forum. We are delighted you
could join us today. The topic for our conference is both important and timely: "Budgets on
the Brink: Perspectives on Debt and Monetary Policy". I look forward to today's presentations
and discussion, but as the host for today's program, I am going to take the opportunity to
share some of my thoughts on the fiscal situation facing many countries, including our own.
Of course, these are my views and do not necessarily represent those of the Federal
Reserve Board or my colleagues on the Federal Open Market Committee.
The challenge of fiscal imbalances for the economy
During the past year, we have witnessed the ongoing saga of governments, both in Europe
and in the U.S., as they struggle with large deficits and soaring public debt, which are the
result of unsustainable fiscal policies. Financial markets have become increasingly skeptical
about whether the political process can come to grips with the problems. And so far, this
skepticism appears to be wholly justified. Politicians continue to engage in protracted
debates over who will bear the burden of the substantial adjustments needed to put fiscal
policies back on a sustainable path. In my view, these prolonged debates have detrimental
effects on economic growth, in part, because of the uncertainty they impose on consumers
and businesses.
Given the magnitude of the fiscal shortfalls in many countries, the way in which fiscal
discipline is restored will have profound implications for some time to come. Will there be
higher taxes on productive investments by the private sector and higher taxes on wage
earners - which would discourage both investment and work effort? Or will there be cutbacks
on government purchases of goods and services from certain industries, such as aerospace
and defense, or cutbacks on entitlements that would affect health care and social insurance?
Or will a viable fiscal plan combine various types of tax increases and spending cuts? Until
the path is chosen, uncertainty encourages firms to defer hiring and investment decisions
and complicates the financial planning of both individuals and firms. The longer it takes to
reach a resolution on a credible plan to reduce future deficits, the more damage is done to
the economy in the near term.
The cause of the current fiscal crisis is sometimes attributed to cyclical factors and the
magnitude of the recent global recession. It is certainly true that the financial crisis and the
policy choices made by governments to deal with the ensuing recession have caused a
significant deterioration in fiscal balances and debt levels in many countries. For example, in
the U.S., the federal budget deficit is now about 9 percent of gross domestic product, up from
less than 2 percent in 2007. However, the underlying trends that are at the root of
unsustainable fiscal deficits in many countries, including the U.S., have been in place and
known for some time. Even after cyclical effects play out, many countries will have large
structural budget deficits. In this sense, the financial crisis and recession have simply
exacerbated the underlying problems and perhaps moved up the day of reckoning. In some
cases, such as Greece, that day has come. Market participants have begun to question the
solvency of governments and their ability to honor their sovereign debt obligations. In
Europe, the doubts have greatly complicated the political problems as various countries
debate the question of "who pays" for the anticipated bad debts of individual countries. Here
too, the protracted nature of the political debate creates uncertainty, which undermines
economic growth and exacerbates the crisis. Indeed, the argument offered by many that
preventing Greek default would prevent the crisis from spreading has proven false.
The interaction of monetary policy and fiscal policy
The fiscal challenges are daunting, yet they also have implications for monetary policy. The
policy choices made during the recent global recession have made these implications even
more complex and potentially dangerous. But the appropriate relationship between monetary
and fiscal policy is not a new topic. Indeed, our very first Policy Forum in 2001 was organized
around three questions for monetary policymakers, one of which was how should monetary
and fiscal policy interact?
It is widely understood that governments can finance expenditures through taxation, debt, or
printing money. If public debt levels are high and rising, and fiscal policymakers are reluctant
to make the hard choices of cutting expenditures or increasing taxes, history suggests that
governments often resort to the printing press to try to escape their budget problems. Yet we
all understand that this option is a recipe for creating substantial inflation. Indeed, it is often a
path toward hyperinflation. Failure to resolve underlying fiscal imbalances combined with
rising inflation means nominal funding requirements to close the budget gap keep growing,
requiring ever more money to be created, and causing inflation to rise even further. It is a
cycle any nation should seek to avoid.
In addition, inflation is a hidden tax on holding nominal assets, and when it is unanticipated, it
can have significant consequences that redistribute wealth from creditors to debtors. The
near-term effects of money creation often appear to be positive, while the undesirable
consequences only become apparent over time. While money creation results in lower
nominal interest rates and perhaps a modest boost to real activity in the short run, over time,
it results in higher inflation and higher nominal interest rates and ultimately requires painful
efforts to restore price stability. Awareness of these long-term consequences of succumbing
to the temptation of excessive money creation is the basic reason that over the last half of
the 20th century, there has been a strong movement to establish and maintain independent
central banks in country after country. 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.
Another widely acknowledged basic tenet of sound central banking is the wisdom of
maintaining a low and stable inflation rate. Price stability contributes to the economy's growth
and employment prospects in the longer term and helps to moderate the variability of output
and employment in the short to medium term. Price stability allows the economy to function
in a more efficient and more productive manner by giving individuals and businesses more
confidence that the purchasing power of their money will be maintained over time. Central
banks are uniquely positioned to achieve price stability. The economic costs of failing to do
so can be quite high.
Despite the well-known benefits of maintaining price stability, there are increasing calls to
abandon this commitment in both Europe and the U.S. Central banks are under increasing
pressure to act, both because fiscal authorities have been unable to make credible
commitments to maintain fiscal discipline and because central banks have been willing to
engage in actions that stray into the realm of fiscal policy - for example, purchasing assets of
the housing sector. This is a disturbing trend that risks undermining the independence of the
central bank to control monetary policy and its ability to preserve a credible commitment to
price stability.
Why monetary policy and fiscal policy should remain separate
As I mentioned, governments can finance expenditures through only three options: taxes,
debt - which is really just a euphemism for future taxes - or money creation, which leads to
the hidden tax of inflation. Central bank independence allows monetary policymakers to
pursue price stability without the political pressures to finance government expenditures or
otherwise engage in fiscal actions constitutionally reserved for the fiscal authorities. In a
classic paper1, recent Nobel Prize winner Thomas Sargent and his co-author Neil Wallace
showed that when the fiscal authority chooses an unsustainable fiscal policy path, in which
debt to GDP ratios are rising and proposed budgets don't generate enough future surplus to
offset current deficits, seigniorage is the only way for the government to achieve
intertemporal budget balance. In other words, the central bank must eventually monetize the
debt - whereby high rates of inflation devalue longer-term government debt. Today, one of
our speakers, Eric Leeper, will discuss his work on how long-run fiscal stress can undermine
monetary control of inflation. In such an environment, monetary policy is no longer
independent but becomes subservient to unsustainable fiscal policy.
There are those who argue that this is exactly what monetary policy should be doing today:
creating higher inflation to solve the fiscal failures by devaluing the outstanding government
debt. The inflation tax would transfer wealth from those that have lent money to the
government in good faith - the investors in sovereign debt - to the government itself. I am
deeply skeptical of such a strategy. In my view, inflation is a blunt and inappropriate
instrument for assigning winners and losers from profligate fiscal policy. Moreover, history
has shown that once inflation is unleashed, it is not always easy to bring it back down,
especially if the central bank loses the public's confidence and damages the credibility of its
commitment to return to price stability. The continuing fiscal disarray may also lead the public
to believe that the government's only near-term strategy is to monetize the debt. Even if the
central bank resists, expectations of future inflation could become unanchored and inflation
could rise through no fault or consequence of central bank action or intent.
Unfortunately, from my perspective, the Fed and other central banks have already embarked
on a path that has blurred the distinction between monetary policy and fiscal policy. These
steps were undertaken with the sincere belief that they were absolutely necessary to address
the challenges posed by the financial crisis. For example, the Fed established credit facilities
to support particular asset classes, such as commercial paper and asset-backed securities,
and in November 2008, the Fed announced it would begin purchasing housing agency
mortgage-backed securities and agency debt to increase the availability and reduce the cost
of credit in the housing sector. These types of credit programs target particular market
sectors and thereby alter the allocation of credit across markets, reducing funding costs for
some sectors and likely raising costs for others. These programs departed from the usual
way the Fed implements monetary policy through buying and selling U.S. Treasury
securities, an activity that is generally neutral across markets. When the Fed engages in
targeted credit programs that seek to change the allocation of credit across markets, I
believe it is engaging in fiscal policy. Instead of the central bank engaging in this credit
policy, the federal government could carry out these transactions by issuing Treasury debt to
support lending to the targeted markets or firms. In fact, the fiscal authorities frequently
undertake such actions - think of "green energy" loans, small business loans, and subsidized
home mortgages. Such credit allocation decisions belong with the fiscal authorities, not the
central bank. Even the recent maturity extension program, or "Operation Twist" as it is
sometimes called, involves selling short-term Treasuries and buying longer-term Treasuries
- an action that could just as well have been conducted by the U.S. Treasury.
Once a central bank ventures into conducting fiscal policy, it may 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. This pressure can threaten the central bank's
independence in conducting monetary policy and thereby undermine monetary policy's
effectiveness in achieving price stability.
I have long argued for a bright line between monetary policy and fiscal policy, for the
independence of the central bank, and for the central bank to have clear and transparent
objectives. Decisions to grant subsidies to particular market segments should rest with the
fiscal authorities - in the U.S., this means the Congress and the Treasury Department - and
not with the central bank. Should the fiscal authority ask the central bank to engage in
lending outside of its normal operations, the fiscal authority should be willing to exchange
government securities for the nongovernment assets that would accumulate on the central
bank's balance sheet as a result. This type of swap would ensure that the full authority and
responsibility for fiscal matters remained with the Treasury and Congress.
Congress has mandated the goals of monetary policy to promote long-run price stability,
maximum employment, and moderate long-term interest rates. Asking monetary policy to
take on the role of fiscal policy undermines the ability to achieve this congressional mandate.
Central banks and monetary policy are not and cannot be real solutions to the unsustainable
fiscal paths many countries currently face. Proponents who believe otherwise are skating on
thin ice. The only real answer rests with the fiscal authorities and their ability to develop
credible commitments to sustainable fiscal paths. It's a difficult and painful task to be sure,
but a monetary solution is a bridge to nowhere at best, and the road to perdition at worst - a
world of rising and costly inflation.
Once again, I want to thank everyone for coming today. I am confident that it will be a
fascinating program. So now that I've told you what I think, let's get stared and hear from the
real experts.