The title of this hearing, “Monetary vs. Fiscal Policy,” frames the issue in an unfortunate way. That title harks back to the unproductive Keynesian-monetarist debates of the 1960s and 1970s. As I hope my comments make clear, a more constructive way to think about this is as “monetary and fiscal policy.” This is not merely a semantic point–it is fundamental economics. I commend the subcommittee for delving into this underappreciated topic.
1 Policy Interaction Basics
Research over the past 25 years emphasizes that monetary and fiscal policy jointly determine the economy-wide level of prices and the rate of inflation. n1 Out of that literature has emerged the understanding that two distinct combinations of monetary and fiscal policy behavior– policy regimes–can determine the price level and stabilize the level of government debt.
Leeper Written Testimony: Policy Interactions
1.1 Policy Regimes
Table 1 summarizes the policy mixes that determine inflation and stabilize debt.
The first regime reflects the conventional view that monetary policy actively adjusts the policy interest rate to lean against inflation, while fiscal policy passively adjusts primary budget surpluses–revenues less expenditures, not including interest payments on government debt–to stabilize the long-run debt-GDP ratio. Taylor’s famous rule falls into this regime: the central bank raises the policy interest rate more than one-for-one with the inflation rate and raises the interest rate more modestly when the output gap increases [Taylor (1993)]. Because monetary policy focuses on stabilizing inflation and the real economy, fiscal policy must ensure that government debt remains well behaved. When fiscal policy makes taxes rise with the level of real government debt by more than enough to cover interest payments and some of the principal, the debt-GDP ratio will be stable in the long run. Many economists believe this regime prevails during “normal” economic times.
Policy Authority Monetary-Fiscal Policy Regimes that Determine Inflation and Stabilize Debt
Conventional View Alternative View
Monetary Aggressively raises interest rate with inflation Weakly raises interest rate with inflation
Fiscal Raises primary surplus with real debt Pursues other objectives besides debt stabilization
Table 1: Monetary-Fiscal Policy Mixes
A second, alternative, regime can also determine inflation and stabilize debt. In this regime, fiscal policy pursues other objectives by setting primary surpluses independently of debt and the price level. Monetary policy chooses the interest rate so that it responds only weakly–or not at all–to inflation, which permits expansions in government debt to raise the price level. Higher price levels reduce the real value of debt to make the debt-GDP ratio stable. Since
1.2 Fiscal Consequences of Monetary Policy
To keep this discussion focused, in what follows I consider only the conventional mix of monetary and fiscal policy behavior. That policy combination embeds the Taylor rule as one example of monetary policy behavior.
Basic economic reasoning tells us that monetary policy actions have fiscal consequences. Let’s start with something routine: the
Now fiscal policy comes into play. Those higher interest payments require higher taxes or lower expenditures in the future to service the debt. The message is: to successfully reduce inflation, tighter monetary policy necessarily requires tighter fiscal policy at some point. That fiscal response is essential for the Fed to be able to control inflation.
What happens if the fiscal response is not forthcoming because the fiscal authority never adjusts taxes or spending? The dollar value of government debt grows to finance interest payments. Bond holders see their interest receipts rise, but don’t anticipate higher offsetting taxes. They feel wealthier and demand more goods and services. Higher demand raises prices, counteracting the Fed’s original intention to lower inflation.
Appropriate fiscal backing for monetary policy is critical for the Fed to achieve price stability.
2 U.S. and International Examples
It is helpful to consider actual instances when policy behavior departed from the conventional monetary-fiscal regime.
2.1 An Important
Recovery from the Great Depression illustrates that the alternative monetary-fiscal policy mix has been an explicit policy choice. n4 President
Abandoning convertibility of the dollar to gold, which included abrogating the gold clause on all future and past public and private contracts, changed the nature of government debt. Under convertibility, even though government bonds paid in dollars, the
Roosevelt used three strategies to convince the public that higher debt would not necessitate higher future taxes. First, he made policy state-dependent, saying he would run bond-financed deficits until the economy recovered. Second, he emphasized the temporary nature of the policy by distinguishing between the “regular budget,” which he balanced, and the “emergency budget,” whose deficits were driven by relief spending. Finally, Roosevelt raised the political stakes by pitching economic recovery as a “war for the survival of democracy” [Roosevelt (1936)]. The strategies appeared to work because expected inflation began to rise by spring 1933 [Jalil and Rua (2016)].
Monetary policy behaved passively through the recovery. After
Economic recovery was rapid. Real GNP returned to its pre-depression level in 1937. Price levels–consumer and wholesale price indexes and the GNP deflator–rose but fell short of regaining their levels in the 1920s. Historians like Friedman and
Remarkably, this expansion in nominal debt did not raise the debt-GNP ratio. Figure 1 plots the par and market values of gross federal debt as percentages of GNP from 1920 to 1940. The vertical line marks departure from gold in
In this alternative policy mix, the
2.2 Recent International Cases
Countries have not always provided appropriate fiscal backing. n6 In recent years,
It is tempting to infer that
Two European countries have had fiscal rules for some years and take those rules seriously. By “seriously” I mean the governments actually follow the rules. n7
Since a nationwide referendum in 2001,
The top panel of figure 3 suggests that Swedish and Swiss fiscal rules have worked to limit debt growth. In both countries, debt has steadily fallen over the past 15 years and now is about 35 percent of GDP. Remarkably–and these two countries may be the sole exceptions– debt either continued to fall or was flat during the financial crisis. This stunning outcome is a testament to the effectiveness of fiscal rules that are followed.
But this prudent fiscal policy may have come at a cost in terms of inflation targeting. Both countries have 2 percent inflation targets that have been missed. In
The Swedish and Swiss cases illustrate that fiscal backing for monetary policy must be symmetric. When monetary policy reduces interest rates and interest payments on government debt, fiscal policy needs to reduce taxes. Fiscal rules designed primarily to reduce government debt may interfere with the symmetry of fiscal backing.
These international examples offer suggestive evidence of how monetary and fiscal policies that are inconsistent with each other can produce undesirable economic outcomes. Each is a case in which monetary and fiscal authorities independently pursue their objectives and fiscal authorities fail to provide the fiscal backing needed for the central banks to control inflation.
Economic developments in
3.1 Recent Data
For almost a decade,
* Short-term interest rates have been below 1 percent for the past nine years.
* Over that period, bank reserves increased by a factor of 52.
* Inflation, by any measure, has averaged less than 2 percent since 2008.
Average Annual Rate 2008Q1-2017Q1 Ratio of Value in 2017Q1 to Value in 2008Q1
Federal funds rate 0.37 —
Core CPI 1.82 —
Core PCE 1.57 —
GDP Deflator 1.53 —
Bank reserves — 51.7
Gross debt — 2.0
Table 2: Core CPI is less food and energy; Core PCE is personal consumption expenditures excluding food and energy; GDP deflator is implicit price deflator; Bank reserves are total reserves of depository institutions; Gross debt is the market value of gross federal debt. Sources:
How can this happen?
Massive growth in bank reserves hasn’t created inflation because banks happily hold idle and safe reserves whose yield exceeds those in the federal funds and short-term
There is another fact with which this committee is familiar:
* Gross federal debt has doubled since 2008 [figure 5].
Why hasn’t this been inflationary?
In a phrase: bond-market pessimism.
During the financial crisis, there was a worldwide flight to safety: investors had an insatiable appetite for Treasuries. This demand, perhaps more than monetary policy actions, has kept bond yields low. That appetite continues today, ensuring demand more than absorbs the expanding supply of bonds. As long as people expect future surpluses will adjust to finance the growing debt, the expansion in debt will not significantly raise aggregate demand and the price level.
The question for monetary policy is: what happens to inflation–and the Fed’s ability to control it–when the thirst for safety is quenched? The answer hinges very much on the fiscal response.
3.2 An Accounting Exercise
What I’ve described arises naturally from a fiscal policy that aims to stabilize the government debt-GDP ratio. What’s important is that the private sector understands and believes that the fiscal response will eventually take place. Of course, when debt levels are low, the changes in debt service and, therefore, taxes, are modest. Debt service has also been modest during the past decade because interest rates have been exceptionally low.
The fortuitous fiscal effects of low interest rates may be coming to an end.
This committee has heard previous testimony about the process of monetary policy “normalization.” But there is an important fiscal component to normalization that I want to highlight. Here is a little accounting exercise. The market value of gross federal debt is now a bit higher than nominal GDP. If interest rates on government bonds rise from current levels to 6 percent, roughly the post-World War II average, interest payments will rise over time by about 5 percent of GDP or close to
Debt service now consumes about 10 percent of federal expenditures. In the late 1980s and early 1990s, at its post-war peak, debt service was 20 percent of expenditures–and then the debt-GDP ratio was under 60 percent. Evidently, interest-rate normalization carries substantial fiscal implications.
4 Policy Rules
Formal economic models posit algebraic rules that govern policy behavior. These rules are necessarily extreme simplifications of actual policy behavior, designed to highlight how specific components of systematic policy behavior affect the economy’s operation. They are not intended to be a complete description of how policy behaves in every possible situation.
Policy rules may be descriptive or prescriptive. Moving from describing behavior to prescribing behavior is, to me, a very large leap. At this point, the most we can ever say is that a particular simple rule seems to deliver good economic welfare across some set of formal models. But those models embed a great many stated and unstated assumptions that may or may not apply to the actual economy. Assumptions include formulations of private economic behavior, particularly private-sector expectations, and a range of shocks that may hit the economy.
The studies do have a common thread: All analyses that conclude beneficial outcomes from Taylor-type rules for monetary policy maintain the assumption that fiscal policy also obeys a rule that appropriately backs the monetary policy behavior.
Of course, I do not advocate completely discretionary policy untethered by guiding principles. Both monetary and fiscal policy must be guided by broad economic objectives. And both monetary and fiscal policy authorities must be held accountable for achieving those objectives.
Underlying the discussion in this testimony is the need for systematic fiscal backing for monetary policy. Whether the
n1 Early contributorsincludeLeeper(1991),
n2 See Taylor (1999), Clarida, Gall, and Gertler (2000), Lubik and Schorfheide (2004), and Davig and
n3 See Davig and
n4 This draws on Jacobson,
n5 Today all but the 10 percent of
n7 This draws on
n8 See Danninger (2002) and Bodmer (2006) for additional details and analyses.
Read this original document at: https://financialservices.house.gov/UploadedFiles/HHRG-115-BA19-WState-ELeeper-20170720.pdf