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. 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. 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.
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.
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.. 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.
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.
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’.
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.”
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.
Targeting interest rates involves a commitment to supply or contract reserves.
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.