Policies which have fiscal effects are not necessarily fiscal policy. To believe otherwise is a fallacy.

The distinction between fiscal and monetary policy is rarely, if ever, made clear by economists of any ilk. It has been taken for granted that we just know the difference. But in a post-QE world the distinction has become blurred – as the discussion of this astute essay from Simon Wren-Lewis also reveals.

Milton Friedman is a rare exception. Although I cannot find an explicit outline of the distinction between monetary and fiscal policy in his writings, it is implicit and clear. Monetary policy involves changes in the provision of the monetary base.[1] Fiscal policy, in contrast, involves changes in taxation and government expenditure.

Now all economists have been aware that fiscal and monetary policy affect each other. The most direct area of overlap is in financing budget deficits – the centrepiece of the classic 1981 paper by Sargent and Wallace, and emphasised by John Cochrane, Stephanie Kelton and Scott Fullwiler.[2] This tradition assumes that central banks are fully subservient to national treasuries, in which case budget deficits can derail monetary policy if the government at some point has to print money to pay its bills. This does not undermine our distinction – it just asserts that at some point the treasury takes control of monetary policy. In practice, the institutional primacy of government is only ever partial, and in the Eurozone the opposite is true – monetary policy has primacy.[3]

The Eurozone is very important to this discussion because it reveals that the institutional framework assumed in much of economics is not set in stone. In the Eurozone the need to fulfil monetary policy can dominate fiscal policy effects on government debt dynamics. This in fact is a direct opposite to what Sargent & Wallace describe.

In the Eurozone the ECB is required by law to create and distribute as much base money as is required to generate price stability. And if the ECB needs more bonds to carry out open market operations, it can in fact command that governments provide them.

This should all be clear:

1. Monetary policy involves changes in the availability of base money implemented by the central bank.[4]

2. Fiscal policy involves changes in government taxation and expenditure policies.

3. The outstanding stock of government bonds is under the direct control of neither the central bank nor the Treasury (assuming the CB uses government bonds to do open-market-operations). Central Banks, if they want to, can entirely control the demand and supply of base money using IOR and reserve requirements, particularly if they introduce tiered reserves.

This third point requires clarification, and it shows why QE, helicopter drops, and talk of the central bank’s balance sheet have all cause widespread confusion.

The textbook way a central bank alters interest rates and the supply of base money is through open-market-operations (OMO) – ie buying and selling government bonds. QE is really not exceptional – central banks have just bought government bonds of longer duration and more recently they have bought private sector bonds too.

There has been a lot of confusion about central banks ‘cancelling’ the bonds they buy. It’s worth thinking about this. In jurisdictions where the central bank is an arm of the government, the balance sheet effects of QE are identical to the central bank cancelling debt when it buys it, and issuing new debt when it sells back to the market. To this extent, Mervyn King had a point when discussing whether or not we should just net the bonds at the Bank off against the gross debt of the Treasury – there remains a contingent liability, if QE needs to be reversed.

So QE is no more ‘fiscal policy’ than OMO are. Depending on the institutional regime, the profits and losses of central banks accrue to the national treasury (or treasuries, in the Eurozone). And large scale QE has big effects on the central bank’s profits, so it has fiscal consequences – but this is no way undermines the distinction between policies.

Ok, so monetary policy (always) has fiscal effects.[5]. That, of course, does not render our distinction invalid. Almost every economic decision has a fiscal consequence. For example, private sector decision-making is the principal determinant of the budget deficit – as we see when deficits rise during recessions. If everything is ‘fiscal policy’ the term has no meaning.

So what about helicopter drops? Helicopter drops involve the central bank transferring money to the private sector financed with base money. Friedman used them as an example of the efficacy of monetary policy in a liquidity trap. Cash transfers are different to QE because the net assets (financial wealth) of the private sector rise (under QE the private sector had a bond and now has cash) – there are also distributional differences, because everyone would receive the new deposits. That is precisely why the effects of helicopter drops are likely far greater than QE.

At the same time, the central bank no longer has a new bond on its balance sheet. The long term fiscal consequences of this are uncertain, and may differ from doing QE. They will depend on many things – primarily on what happens to growth, where interest rates are over the medium term, and how the assets it would have purchased performed. None of this is unique to helicopter drops, nor does it render monetary policy ‘fiscal’.

In summary, we have a new logical fallacy. Simply put, all monetary policy has fiscal effects, but a fiscal effect is not a fiscal policy. To believe otherwise is logical error.

All errors are mine, (and all of Dario’s are his!). Thanks to @sjwrenlewis @darioperkins @Shireblogger and @dvespinosa for twitter discussion.

For chapter & verse on the implications of helicopter drops on the central bank’s balance sheet and why it does and doesn’t matter see this.

[1]The monetary base is defined as notes and coins and bank reserves – the electronic equivalent to notes and coins used by banks. The monetary base is under the direct control of the central bank – unlike broader measures of ‘money’.

[2]Scott Fullwiler provides a clear distinction between fiscal and monetary policy, in this excellent article. But as is often the case with MMT, the definition is idiosyncratic: “fiscal policy is about managing the net financial assets of the non-government sector relative to the state of the economy, and monetary policy is about managing interest rates (and through it, to the best of its abilities, bank lending and deposit creation) relative to the state of the economy.”

[3]Even in countries where the legal independence of central banks is weak, the resignation of central bank governors has political and economic consequences. ‘Independence’ is a continuum.

[4]Targeting interest rates involves a commitment to supply or contract reserves.

[5]Now that central banks are also buying private sector bonds, the fiscal effects are slightly different. When the central bank buys a government bond, the balance sheet effect is equivalent to cancelling the bond – the government is paying interest to itself. When the CB buys a private sector bond, the private sector is paying interest to the government. So if the CB sells the private sector bond back to the market this is a loss of government revenue.

About The Author

Eric Lonergan is a macro fund manager, economist, and writer. His most recent book is Money (2nd ed) published by Routledge. He is also a supporter of Big Issue Invest (BII), the investment arm of The Big Issue, and is one of the initial limited partners in BII’s Social Enterprise Investment Fund LP. In a personal capacity, he makes direct investments in social enterprises. He also supports and advises The Empathy Museum.

10 Responses

  1. jh@rogers.com'

    Good post, although it tapers to a weak argument IMO.

    In general, this subject can easily become a game of constructing definitions and meanings to suit one’s preferred conclusions.

    But I do think there is a logical hierarchy of policy authority and influence in either direction.

    To the degree that the central bank has a mandate to manage its balance sheet, that mandate is monetary policy, with the effect on the monetary base being one particular balance sheet effect, as you point out. This policy result and separation is normally fairly clear cut, since the fiscal authority has no institutional interest in duplicating functions like open market operations and setting the policy interest rate.

    And a mandate to manage the central bank balance sheet means a mandate to cause an income statement effect. If net income is distributed back to the fiscal authority, then monetary policy has an effect on the fiscal position. But as you point out, that does not mean the monetary authority is implementing fiscal policy. Although I think you blur that issue slightly in unnecessarily differentiating between non-QE and QE income statement effects in this regard. There is always a fiscal effect. QE is just a matter of degree.

    But I think your argument fades with regard to “helicopter drops” for the same reason Wren-Lewis’ does. You have both missed the critical question, IMO.

    Which is – do you believe that a central bank can do “helicopter drops” without first obtaining an extraordinary mandate from the fiscal authority to do so – including most importantly, quantity parameters. (Such a quantity guideline would not be imposed from outside on central bank QE.)

    My answer is no way. In this particular case, the desired policy separation is not at all clear cut, since the fiscal authority must voluntarily forgo its normal course possibility of effecting exactly the same direct money effect (for the recipients) by distributing its own cheques. This is not the delegation of a unique open market operation authority to a unique institution designed for those operations. It’s the delegation of an implementation channel for fiscal policy – because there is already an existing fiscal authority and channel in place that can achieve exactly the same first order effect of money distributed to selected recipients on a net (deficit at the margin) basis. And the fact that the fiscal authority will normally issue bonds or collect taxes to finance that distribution – thereby achieving a different monetary base effect than “helicopter drops” – is secondary to this fact and this normal course authority and distribution channel.

    And if the central bank does obtain such an extraordinary authority, it is an authority to implement a component of fiscal policy – not to formulate that policy.

    Wren Lewis makes the point that the great advantage in using “helicopter drops” is that the monetary authority can implement them very quickly. He should be reminded or be asked the question how long it can take for the monetary authority to obtain its HD authority and where it gets it from. Pretty slow going so far.

  2. superpoincare@gmail.com'

    “Monetary policy involves changes to the stock of base money implemented by the central bank.”


    Not true. Think of pre 2007 days. The central bank raises or lowers interest rates without any change to the monetary base. It’s an announcement effect.

    Hadn’t noticed Scott Fullwiler’s point “fiscal policy is about managing the net financial assets of the non-government sector” when I first read it.

    That’s wrong! Fiscal policy is mainly expenditure and taxation decisions. The budget balance and public debt are endogenous. So the “government” is not managing the net financial assets of the economy.

    • Eric Lonergan

      It is true that CBs can just change interest rates directly (for example raiding IOR) – but implicitly there is a commitment to supply (or shrink) stock of reserves to ensure the rate prevails. I will add a footnote with this clarification – thanks Ramanan!

    • scott.fullwiler@gmail.com'
      Scott Fullwiler

      I don’t disagree with your point, and never have (as my posts on the SFB model from 2009 show, btw). If I’m being (more) precise, I’ll say the govt attempts to manage the nfa of the non-govt sector within the context of at least partial endogeneity of these nfa.

      The point I was making in the post Eric’s alluding to here was simply saying that fiscal policy was about nfa and CB policy was about interest rate–it was not intended to suggest (as you interpreted here) that the govt has 100% exogenous control. I was simply re-explaining the point of my 2010 post that helicopter drops are fiscal ops.

      I would also agree w/ Eric that monetary policy clearly has fiscal effects.

      On the other hand, I’m not in complete agreement with his view that monetary policy is about base money. Prior to 2008, as JKH noted–and in general, if the target rate is set > IOR–base money is 100% endogenous in response to the demands of the pvt sector. With target rate = IOR, “base money” can be exogenous, but it will earn IOR = target rate aside from the currency portion of “base money” the pvt sector decides to hold.

      • Eric Lonergan

        I am inclined to change my definition of monetary policy to “changes in the *availability* of base money”. An interest rate-targeting regime is really a commitment to supply reserves in order to keep interest rates at a given level. The key point is that reserve management is monetary policy – that’s the definition – it could even be called “base money policy”. Fiscal policy is something else. And management of the outstanding stock of public sector liabilities is something different again.

  3. jh@rogers.com'

    Distilling my comment further, the issue is the difference between responsibilities for the formulation of policy and the implementation of policy. For example, we know who both formulates and implements QE policy – it’s the central bank. But the central bank will not have independent responsibility in the same way for the formulation of HD policy. That’s what makes it primarily fiscal policy. For example, the CB can have the full authority to formulate a plan/strategy/policy for what ends up being $ 3 trillion of QE. But it won’t have that same level of authority in the case of $ 3 trillion of HD. The fiscal authority will approve and delegate that parameter – because it is a direct alternative to normal fiscal policy. Even if that implementation authority is classified under a bigger umbrella called monetary policy, it is still subservient to a higher order fiscal policy responsibility in a way that QE is not, and in that material context the monetary policy labeling ends up being an exercise in semantics only.

    • Eric Lonergan

      Thanks for the comment JKH. I think it depends on the jurisdiction. The ECB would be breaking the law if it sought national governments’ approval for a certain quantity of helicopter drop. See this for chapter & verse.

      IMO heli drop is not legal in US – there would have to be coordination between treasury & Fed, so probably subject to Congressional approval. Tbh, they woul just slash taxes first, and the Fed wld do massive QE. So no real need.

      In UK Treasury would probably approve any request by BoE – because held in high esteem, and legislation is easily approved.

      Elsewhere, depends.

  4. bculkin@gmail.com'
    Brad culkin

    At the risk of be beclowning myself let me say what I think Steve Keen would say:
    Central banks do not control a nations money supply. The banking system writ large (including shadow banks) creates new credit money by lending same into existence. The counter claim that capital ratios and reserve ratios give CBs ultimate control over this is wrong. When banks lend as part of a Minsky credit expansion, the very act of lending creates new money, some of which accrues to bank profits thus augmenting bank capital. So capital ratios are not fixed constraints on lending but functions of total lending. Meanwhile reserve constraints are never allowed to crimp lending as a practical matter of CB policy. Indeed some countries have dispensed with any reserve requirements. The doubling time of the Minsky instability mechanism whereby banks lend credit money into existence thus pumping asset (collateral) prices justifying more lending in a positive feedback loop is partly determined by bank capital ratio limits but that is all.
    Thus “liquidity trap” is not a good discription of where we are. We are at the end point of a Minsky bank credit money expansion cycle, an endpoint characterized by saturated total private debt levels. The debate should therefore turn to asking how do we reduce total private debt?

  5. marcosabait@gmail.com'
    Marco Saba (@marcosabait)

    I think that the Author don’t understand the fiscal effect of creating new money by pretending it is a (fake) liability in the central bank balance sheet. A fake – or unresolved – liability is an old trick to hide profits. In this case, we are speaking about profits foregone by the Treasury.


Leave a Reply

Your email address will not be published.