WHEN A MONETARY SOLUTION IS A ROAD TO PERDITION / THE FINANCIAL TIMES COMMENT & ANALYSIS ( A MUST READ )

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May 17, 2012 7:42 pm

When a monetary solution is a road to perdition

By Charles Plosser

Governments can finance expenditure in only three ways: taxation, debt (future taxes), or printing money. In this sense, monetary and fiscal policy are intertwined. Yet there are good reasons for separating the functions and responsibilities of central banks and fiscal authorities.



History teaches us that unless governments are constrained institutionally or constitutionally, they often resort to the printing press to avoid making tough fiscal decisions. But history also teaches us that this can create high inflation and, in the extreme, hyperinflation. Thus it is wise policy to maintain a healthy separation between those responsible for tax and spending and those responsible for money creation.


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Independent central banks must be responsible and accountable, but also constrained in the use of their powers. Otherwise, they risk their legitimacy, credibility and ultimately their independence.


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What steps can be taken to draw clear boundaries between monetary and fiscal policy? One, give the central bank a narrow mandate – such as making price stability its sole or primary objective.

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Mandates that are too broad or vague invite excessive discretion and reduce accountability. Two, restrict the types of assets a central bank can hold on its balance sheet. This limits its ability to allocate credit to specific markets, a decision that rightfully belongs to fiscal authorities or the private sector. Three, conduct monetary policy in a more systematic manner, limiting the scope for discretionary actions that might blur boundaries between monetary and fiscal policy.


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Unfortunately, the financial crisis and unsustainable fiscal policies have led to a breakdown of these barriers. Governments are pushing central banks to exceed monetary boundaries, and independent central banks are stepping into areas previously viewed as outside the scope of accepted practice.


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For example, despite the known benefits of maintaining stable prices, there are calls in Europe and the US for central banks to abandon this commitment and create higher inflation. Such an inflation tax would devalue outstanding nominal government and private debt, and thus transfer wealth from those who have lent money in good faith to borrowers.


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Inflation is a blunt instrument for assigning winners and losers from excessive borrowing. Forced redistributions of this kind, if undertaken at all, should be done by the fiscal authorities, not through the backdoor by central banks.


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In some circles, it has become fashionable to invoke “lender of last resort” arguments as a rationale for central banks to lend to failing businesses or, in some cases, failing governments. Yet this breaches the accepted principle outlined by Walter Bagehot in 1873, that central bankers can limit systemic risk in a banking crisis by “lending freely at a penalty rate against good collateral”. Efforts to subvert this traditional role of central banking will encourage excessive risk-taking, sowing the seeds of the next crisis.


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The Federal Reserve and other central banks have also taken actions that blur the lines between monetary, credit and fiscal policy. They did so in the belief that these actions were essential during the financial crisis. For example, the Fed announced in November 2008 that it would purchase housing agency mortgage-backed securities and agency debt to increase the availability and reduce the cost of credit in the housing sector.


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Yet when the Fed engages in targeted credit programmes that seek to alter the allocation of credit across markets, it is engaging in fiscal policy. While it is popular to view such blurring of the boundaries as “co-operation” or “co-ordination” between the monetary and fiscal authorities during a crisis, ignoring the boundaries puts an economy’s longer-term performance at risk.


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Once a central bank ventures into fiscal policy, it is likely to face pressure from the private sector, financial markets or the government to use its balance sheet to intervene in markets or substitute for other fiscal decisions. Such demands undermine the fiscal authorities’ discipline and the central bank’s independence.


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Central banks and monetary policy cannot resolve unsustainable fiscal policies. The only real solution lies in the fiscal authorities’ ability to make credible commitments to long-term fiscal sustainability. It is a difficult task. But a monetary solution is a bridge to nowhere at best; at worst a road to perdition – a world of rising and costly inflation and weakening fiscal discipline.


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The writer is president and chief executive of the Federal Reserve Bank of Philadelphia


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Copyright The Financial Times Limited 2012.