Charles I Plosser: Fiscal policy and monetary policy - restoring the
boundaries
Speech by Mr Charles I Plosser, President and Chief Executive Officer of the Federal
Reserve Bank of Philadelphia, at the US Monetary Policy Forum, sponsored by The Initiative
on Global Markets, University of Chicago Booth School of Business, New York City,
24 February 2012.
* * *
The views expressed today are my own and not necessarily those of the Federal Reserve System or the FOMC.
Introduction
I am pleased to participate in this important forum once again. I am particularly delighted to
be a part of such a distinguished panel. This conference has rapidly become one of the
premier venues for serious discussions of monetary policy and I am honored to be a part of
it.
Fiscal imbalances
During the past year, we have witnessed the ongoing saga of governments, both in Europe
and in the U.S., struggling with large deficits and soaring public debt. For the most part,
these challenges are self-inflicted. They are the result of governments choosing fiscal
policies that they knew would be unsustainable in the long run. Financial market participants
remain skeptical about whether the political process can come to grips with the problems. So
far, this skepticism appears to be wholly justified. Neither the European nor the American
political process has developed credible and sustainable plans to finance public spending.
Instead, 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 impede economic growth, in part, due to the uncertainty they
impose on consumers and businesses. Moreover, the longer the delay in developing credible
plans, the more costly it becomes for the respective economies.
Given the magnitude of the fiscal shortfalls, the way in which the political process restores
fiscal discipline will have profound implications for years to come. Will there be higher taxes
on investments by the private sector that risk reducing productive capacity and output in the
future? Will there be higher taxes on labor that discourage work effort or hiring? Will there be
cutbacks in government expenditures on defense or basic research that might force
significant resource reallocations and affect a wide array of industry sectors? Will there be
cutbacks on entitlements that could affect health care, social insurance, and other aspects of
our safety net? Or will a viable fiscal plan combine various types of tax increases and
spending cuts?
These are important questions that involve hard choices and trade-offs between efficiency
and equity. Yet, until fiscal authorities choose a path, uncertainty encourages firms to defer
hiring and investment decisions and complicates the financial planning of individuals and
businesses. The longer it takes to reach a resolution on a credible, sustainable plan to
reduce future deficits and limit the ratio of public debt to gross domestic product, or GDP, the
more damage is done to the economy in the near term.
Some observers say cyclical factors and the magnitude of the recent global recession
caused the current fiscal crisis. It is certainly true that the policy choices made by
governments to deal with the financial crisis and ensuing recession have caused a significant
deterioration in fiscal balances and debt levels in many countries. 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. In the U.S., for example, the major
long-run drivers of the structural deficit at the federal level are entitlements such as health
care and Social Security.1
Thus, even after cyclical effects play out, many countries will continue to 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. In light of these realities, market participants
have begun to question the solvency of governments and their ability to honor their sovereign
debt obligations in the absence of deep structural reforms. 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. While some have argued that preventing Greek default would keep the crisis from
spreading, that argument has proven false.
The interaction of monetary policy and fiscal policy
The fiscal challenges alone are daunting. Yet, they can also have profound implications for
monetary policy and the role of central banks. Today, I want to focus my remarks on that
interaction between monetary policy and fiscal policy. Of course, the appropriate relationship
between the two is not a new topic. Yet, it has taken on new relevance and importance as a
result of the recent crisis and the actions undertaken by policymakers. Let me elaborate.
It is widely understood that governments can finance expenditures through taxation, debt, or
printing money. In this sense, monetary and fiscal policy are intertwined through the
government budget constraint. Nevertheless, there are good reasons to prefer an
arrangement that provides a fair degree of separation between the functions and
responsibilities of central banks and those of the 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 monetary unit of account. Yet, that
task can be undermined or completely subverted if fiscal authorities independently set their
budgets in a manner that ultimately requires the central bank to finance government
expenditures with significant amounts of seigniorage in lieu of tax revenues or debt.2 The
ability of the central bank to maintain price stability can also be undermined when the central
bank itself ventures into the realm of fiscal policy.
Imagine a situation in which public debt levels are high and rising. Now stretch your mind
even more and imagine that fiscal policymakers are reluctant to make the hard choices of
cutting expenditures or increasing taxes. Of course, neither of these assumptions requires
much imagination. Indeed, history and our daily newspapers provide numerous examples.
Unless governments are constrained institutionally or constitutionally, they 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.3 Indeed, history shows that it is often a path
toward hyperinflation.4
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. Without the protections afforded by independence, the
temptation of governments to exploit the printing press in the absence of fiscal discipline is
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.
But it is equally important that independent central banks be constrained from using their
own authority to engage in activities that enter the realm of fiscal policy or distort private
markets.5
There are several ways to place limits on central banks so that the boundaries between
monetary and fiscal policy remain clear:6
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.
Third, the central bank can conduct its monetary policy in a more systematic or rule-like
manner, which limits the scope for discretionary actions that might violate the boundaries
between monetary and fiscal policy. Milton Friedman's famous k-percent money growth rule
is one example, as are Taylor-type rules. Such approaches to systematic policy can be a
commitment device that limits discretionary behavior and thus helps to solve
time-consistency problems.
The breakdown of the accepted boundaries
Unfortunately, over the past few years, the combination of a financial crisis and sustained
fiscal imbalances has led to a substantial breakdown in the institutional framework and the
accepted barriers between monetary and fiscal policy. 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 acceptable for an
independent central bank. Let me give you some examples.
I will start with what I see as a not-so-subtle undermining of the commitment to price stability.
Despite the well-known benefits of maintaining stable prices, there are calls in both Europe
and the U.S. to abandon this commitment and create higher inflation to devalue outstanding
nominal government and private debt. Such an inflation tax would transfer wealth from those
who have lent money, in good faith, to the borrowers. 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 or excessive borrowing by private individuals and
firms. Forced redistributions of this kind, if undertaken at all, should be done through the
political process and by the fiscal authorities, not through the backdoor by the central bank
by way of inflationist policies. As a monetary policymaker, I do not want to be complicit in
such a strategy. 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 price stability. Thus, proposals to use inflation to
fix the debt overhang problem are nothing more than a call for debt monetization to solve a
problem that is fundamentally fiscal in nature.
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 reason for central banks
to engage in fiscal actions. This is a strained argument at best. The basic role of a lender of
last resort is to provide liquidity to financial institutions that are solvent but facing temporary
liquidity problems. Yet recently, some have used the concept to argue that the central bank
should be the lender of last resort to governments. This is a perversion of one of central
banking's core concepts. It is a fig leaf to conceal the process of monetizing the sovereign
debt of those countries that are insolvent due to their inability to manage their fiscal affairs.
Monetary policy should not be used to solve a fiscal crisis.
Unfortunately, from my perspective, 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 also undertaken actions that have blurred the distinction between monetary policy,
credit 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. 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. When the Fed
engages in targeted credit programs that seek to alter the allocation of credit across markets,
I believe it is engaging in fiscal policy and has breached the traditional boundaries
established between the fiscal authorities and the central bank. Indeed, some of these
actions have generated pointed criticisms of the Fed.
I view the breakdown of the traditional institutional arrangements as dangerous and fraught
with longer-term risks. While it is popular to view such blurring of the boundaries as
appropriate "cooperation" or "coordination" between the monetary and fiscal authorities, the
boundaries were established for good reasons and we ignore them at our own peril.
Restoring the boundaries
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.
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. I have also stressed the importance of a systematic approach to monetary policy
that serves to limit discretionary actions by the central bank. At this conference three years
ago, I argued for a new accord between the Treasury and the central bank that would
severely limit, if not eliminate, the ability of the central bank to lend to private individuals and
firms outside of the discount window mechanisms.7 I argued that 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. Thus, I
proposed that the new accord limit the Fed to an all-Treasuries portfolio, except for those
assets held as collateral for traditional discount window operations. Should the fiscal
authority ask the central bank to engage in lending outside of its normal operations, the fiscal
authority should 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 and the Fed's balance sheet remained essentially all Treasuries.
Congress has mandated the goals of monetary policy to promote price stability, maximum
employment, and moderate long-term interest rates. Asking monetary policy to take on ever
more fiscal responsibilities undermines the discipline of the fiscal authorities and the
independence of the central bank. Central banks and monetary policy are not and cannot be
real solutions to the unsustainable fiscal paths many countries currently face. The only real
answer rests with the fiscal authorities' ability to develop credible commitments to
sustainable fiscal paths. It is 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 and a weakening of fiscal discipline.
References
Plosser, Charles I., "Credible Commitments and Monetary Policy After the Crisis," speech
presented at the Swiss National Bank Monetary Policy Conference, Zurich, Switzerland,
September 24, 2010.
Plosser, Charles I., "Ensuring Sound Monetary Policy in the Aftermath of Crisis," speech
presented at the U.S. Monetary Policy Forum: The Initiative on Global Markets, New York
City, February 27, 2009.
Sargent, Thomas, "Where to Draw Lines: Stability versus Efficiency," New York University
Working Paper (September 6, 2010).
Sargent, Thomas, and Neil Wallace, "Some Unpleasant Monetarist Arithmetic," Federal
Reserve Bank of Minneapolis Quarterly Review, 5 (Fall 1981), pp. 1-17.