How Blurry is the Line between Monetary and Fiscal Policy?

Economists have traditionally drawn a sharp distinction between monetary and fiscal policy. Monetary policy should try to promote growth and limit inflation by setting short-term interest rates, managing the money supply, and providing liquidity during times of financial stress. Fiscal policy should also encourage growth and, more broadly, promote the general welfare through careful choices about spending, taxes, and borrowing. The Federal Reserve has responsibility for monetary policy, while Congress and the President handle fiscal policy.

That clean distinction was one of many casualties of the financial crisis. As credit markets froze, the Fed pursued unconventional policies that blurred the line between fiscal and monetary policy. For example, it purchased more than $1 trillion in mortgage-backed securities (MBS) issued by Fannie Mae and Freddie Mac, created new lending facilities for commercial paper and asset-backed securities, and provided special support for such key financial institutions as AIG, Bank of America, and Citigroup.

Those actions differed from conventional monetary policy in two ways. First, they exposed the Fed to more financial risk. Short-term Treasury securities, the Fed’s usual fare, carry no credit risk and almost no interest rate risk. In contrast, the Fed’s new portfolio has healthy doses of both. Second, in several cases the Fed offered to purchase financial assets at above-market prices or, equivalently, to make loans at below-market interest rates. In effect, the Fed chose to subsidize some specific financial activities.

Both changes increased the Fed’s fiscal importance.

Most visibly, Fed profits have jumped as its portfolio expanded and it acquired higher-yielding assets. Indeed, the Congressional Budget Office (CBO) projects that Fed profits will hit $77 billion in 2010, up from $32 billion in 2008. That makes them the fourth largest source of federal revenues, after personal income, social insurance, and corporate income taxes, but ahead of estate and excise taxes. Actual returns could be higher or lower, however, depending on how well its investments perform.

Also important, though less visible, are subsidies implicit in some of the Fed’s financing programs. The Term Asset-Backed Securities Loan Facility (TALF), for example, offered favorable long-term funding to investors who wanted to finance investments in securities backed by auto loans, student loans, and certain other types of debt. Similar programs provided favorable funding to support commercial paper markets and to assist AIG, Bank of America, and Citigroup. CBO recently pegged the initial cost of the resulting subsidies at $21 billion.

Not all programs created subsidies, however. CBO concluded, for example, that the MBS purchase program did not involve subsidies because the Fed made its purchases at market prices.

To be sure, the Fed’s fiscal initiatives were dwarfed by the explicitly fiscal actions taken by Congress and Presidents Bush and Obama. The Troubled Asset Relief Program (TARP), for example, was originally estimated to involve subsidies of $189 billion (a figure that has fallen as financial markets have healed), and support to Fannie Mae and Freddie Mac has added tens of billions more. Still, CBO’s estimates do highlight the Fed’s move into fiscal territory as it battled the financial crisis.

Those steps were appropriate given the severity and suddenness of the crisis, but have fueled concerns about the Fed’s scope of authority. Some members of Congress, for example, have questioned whether the Fed should be able to engage in even moderate amounts of fiscal policy without congressional oversight. Their increased interest in Fed oversight, in turn, has raised concerns about defending the Fed’s traditional independence in making monetary policy.

As Chairman Ben Bernanke argued in a speech last week, maintaining the Fed’s independence in monetary policy would be easier if policymakers would “further clarify the dividing line between monetary and fiscal responsibilities.” Let’s hope such guidance comes along before the next financial crisis strikes.

This post first appeared on TaxVox, the blog of the Urban-Brookings Tax Policy Center.

8 thoughts on “How Blurry is the Line between Monetary and Fiscal Policy?”

  1. My understanding of the Chicago Plan of 1933 is that the Govt Borrowing ( Stimulus ) is meant to reinforce the Monetary Policy. It is, in fact, the borrowing itself that accomplishes this through Inflation Expectations.

    What to spend the borrowed money on is a separate issue, but it should also reinforce the Monetary Policy’s goals. Most people agree with some kind of Social Safety Net Spending, including Milton Friedman and Hayek, as well as the Chicago Plan Economists.

    After that, the spending becomes more contentious. I prefer actions like Tax Breaks for Investing, or even Hiring in a bad situation such as the one we’re in now. I also like Sales Tax Holidays and Dated Coupons. Infrastructure is fine too, but, since it’s mainly useful as another Inflation Expectation Booster and Placebo Effect for Confidence, it should be limited and spent efficiently.

    The best way to guarantee Monetary and Fiscal Policy work together is a plan such as the following:

    Milton Friedman A Monetary and Fiscal Framework for Economic Stability

  2. It’s interesting that you posted this– I was just talking with one of my IPA coworkers about virtual economies (eg Second Life, Farmville), and what fun it would be to play around with them. We were trying to work out how fiscal policy would be implemented in these games, and how it would be different from monetary policy interventions. We ended up deciding that fiscal policy might require users to exchange virtual goods to get more money. Not sure if that’s the best answer, or what the implications of the distinction are, but it certainly made me think about the fundamental differences between monetary and fiscal policy tools.

  3. Blurring the lines between fiscal (the administration) and monetary (the “Fed”) policy is not an encouraging development for our economy — I suppose the separation of fiscal and monetary policy is “too hard” for journalists and the public to understand — “simplifying” the economy through integration of fiscal and monetary policy-making is a recipe for economic catastrophe.

    Assuming that neither fiscal nor monetary policy can obtain a clear referendum from the public to enact either austerity measures or partial defaults, the only remaining course of action (which ironically does not require a public referendum to implement) is to “print” money and inflate our way into austerity and debt reductions. More at:

    Thank you for the opportunity to comment…

  4. Donald Marron a Professor of what?

    What part of “To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures;” do you not understand? It is crystal clear that Congress alone has full responsibility for all aspects of ‘money’.

    Mr. Marron should appologize for his ignorance to the public and retort his less than accurate information.

    End the Fed immediately.

    1. Eric Nordstrom,

      Your understanding of Constitutional law is extremely limited. While Congress may be given the powers you mention in the Constitution, it is very clear that Congress has the ability to delegate certain powers. In this instance, it was Congress itself that created the Federal Reserve in 1913. While some rather fanciful folks take the view that Congress exceeded its powers to delegate by creating the Federal Reserve, those people are apparently ignorant of the fact that the very authors of the Constitution (principally Alexander Hamilton) delegated powers to the First Bank in 1791. Since they wrote the Constitution, I think it is safe to assume they knew what it meant. Also, the Supreme Court fairly clearly dealt with this issue in McCulloch v. Maryland, a 1819 case in which they approved the establishment of the Second Bank by Congress.

      If you want to make an intelligent contribution to this discussion, I suggest that you focus your attention on the issue of whether the Congress should have greater control over the Federal Reserve and not whether the Fed is unconstitutional.

  5. I am not an economist, but wouldn’t be more exact to write ‘The line between who does what is blurry’? I mean, yes, FED made some fiscal steps, but the monetary actions are distinctive from fiscal, just the actor is the same.

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