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September 1, 1997

Federal Reserve Bank of Cleveland

Money, Fiscal Discipline, and Growth
by Jerry L. Jordan


istory will regard the last quarter
of the twentieth century as a time when
the world reawakened to one of Adam
Smith’s most important observations—
that the specialization and trade fostered
by market economies are ultimately the
source of the wealth of nations. At no
time in history have markets spread so
rapidly, and with such promising prospects, as in the last 15 years. Europe’s
move to a single market for capital,
goods, and labor is part of a worldwide
trend toward greater reliance on unfettered markets for the allocation of productive resources.

perity and will end with some challenges
faced by every monetary authority attempting to maintain a sound currency,
placing particular emphasis on the hazards emanating from fiscal policies. My
views stem from a belief that as central
bankers pursue their obligation to maintain their currency’s purchasing power,
there are clear implications for the array
of options available to fiscal authorities.
In the context of EMU, separation of
monetary policy from the conduct of fiscal policies will place stringent constraints on individual member countries.

Economists do not question the merits of
Europe’s single-market initiative on efficiency grounds. Integration allows producers to specialize more fully in goods
for which they have a comparative advantage, and permits factors of production to seek their highest return. However, economists are still debating the
challenges associated with the European
Monetary Union (EMU). Although a
common currency reduces transaction
costs involved in cross-border exchange,
it also eliminates exchange rate changes
as an adjustment mechanism to blunt the
effects of asymmetric economic shocks.
The debate does not revolve around
whether monetary union is achievable,
or even sustainable; it centers on whether
people understand the potential economic consequences of monetary union and
whether they are prepared to meet its
challenges. The cost–benefit calculation
becomes particularly difficult because,
ultimately, European political integration
is a necessary condition for a successful
monetary union.

The act of undertaking economic
exchange involves information and
transaction costs that are only indirectly
reflected in the relative prices of goods
and services. These real resource costs,
which influence the extent of trade, the
degree of specialization, and the economic benefit derived therefrom, stem
primarily from the difficulty of acquiring
information about the quality of the
goods, their true current values, and the
trustworthiness of the counterparty. The
lower the costs of information, the more
opportunities there are for individuals to
undertake exchanges that maximize
mutual welfare. When we find ways to
conserve productive resources devoted
to information gathering and conducting
exchange, we have more resources available for creating consumable output.

European Monetary Union’s full
potential will be realized only if the
supra-national monetary authority
ensures a stable currency and safeguards the financial system’s integrity. Uncoupling monetary from fiscal
policymaking will impose severe constraints on member nations’ fiscal
policies. Collectively unsound fiscal
policies may compromise the ability to
maintain a stable currency and erode
prospects for economic growth.

s Transaction Costs and Money

Rather than debating the relative merits
of monetary union, I will focus on the
role of sound money in promoting prosISSN 0428-1276

Ironically, the costs of exchange increase
with the extent of specialization and the
scope of markets, since specialization
implies that people who are experts in
specific economic activities lack complete information about other endeavors.
Societies have always sought ways to reduce the costs associated with exchange.
Governments can make a positive
contribution in the form of binding

standards. For example, harmonization
of European conventions, rules, and
laws—as part of the single-market initiative—is welfare enhancing because
the economic infrastructure essential to
markets is being strengthened. Reforms
that strengthen property rights and
remove political boundaries to resource
utilization will raise standards of living.
Also prominent among the institutional
arrangements traditionally provided by
governments are the forms of money
used to facilitate payments. The word
“money” means different things to different people; it cannot be used without
some ambiguity. Most important, money
is the means of final payment that best
reduces the costs of economic exchange.
We tend to take for granted the resources
that sound money frees for alternative
uses, but they are enormous. Indeed, the
greater the specialization and more complex our economies become, the more
essential it is to provide stable monetary
and payments systems. There can be no
doubt about the importance of sound
money—but achieving and maintaining
it can be a challenge.

s Inside and Outside Money
Many assets can serve some of the functions of money. Historically, a great number of financial instruments have been
used to facilitate exchange. The evolution of money appears to reflect a balance of convenience in use against the
risk that a particular form of money
might depreciate unexpectedly. Fully
convertible paper currencies, or “bank
notes,” came into use because they were
more convenient than coins, particularly
in large transactions, and were inherently
less expensive to produce. But they
involved more risk than commodity
money, since they relied on a faith that
the issuing institutions would indeed
redeem them for commodity money at
par. These early instruments were initially claims to commodity money. Eventually, however, as the public gained confidence in the stability of their purchasing
power, these paper instruments came to
be regarded as money in their own right.
In fact, up to this time, all new forms of
money were initially defined in terms of
a pre-existing, familiar, monetary standard. As Milton Friedman and Anna
Schwartz explained, there has never been
a “phoenix-like” currency.
Today, economists generally recognize
both fiat currencies and highly liquid
bank deposits as money, but of distinct
types. Fiat money is called outside
money, since it is imposed on the economy as a direct liability of government;
outside money is typically legal tender.
Commercial bank liabilities are termed
inside money, because these instruments
are generated by market forces within the
financial system. People usually do not
distinguish between the two forms, especially when the inside money is denominated in the government’s monetary unit
of account. However, inside money is a
direct liability of the issuing institution
and is only a claim to outside money.
Even though most of the world’s money
balances consist of inside money, outside money provides an economy’s ultimate monetary standard. Monetary
authorities can enhance the quality of
inside money both by ensuring that the
outside money which backs it is stable
and sound, and by ensuring that the systems which clear and settle payments
can efficiently and reliably exchange the
economic values carried by the various
monetary forms. A central bank has to
be concerned not only about the integrity

of its own liabilities, but also about the
stability and reliability of the financial
system issuing claims to its liabilities. If
it is inattentive, the monetary authority
may witness financial-sector disruptions
that induce real economic loss.
The condition of a nation’s financial
intermediaries and financial (asset) markets may influence the monetary authority’s policies, but need not compromise
its objectives. Unsound financial institutions and inefficient financial markets
may render more arduous, but do not
preclude, the achievement and maintenance of a stable currency. Nevertheless,
if ex ante concerns about, or ex post
responses to, the condition of financial
intermediaries or markets cause monetary authorities to deviate from a disciplined, sound policy stance, then overall
financial instability can result.
The adverse real economic effects of
shocks to the financial sector are minimized when the monetary authorities
continue to provide a stable monetary
unit (currency) despite the existence of
unsound financial intermediary institutions or unstable financial (assets) markets. This means protecting the currency
from deflation as well as inflation.

s The Quality of
Monetary Services
Economists are accustomed to talking
about the quantity of money; I would
like to suggest thinking more deeply
about its quality. A society will choose
to use as money that form which enables
people to gather information and conduct transactions with the minimum use
of resources. Indeed, the worldwide use
of the U.S. dollar alongside local currencies illustrates the point that monies do
compete along a quality dimension.
Financial efficiency depends primarily
on the stability of money’s purchasing
power—that is, on its exchange value in
terms of goods and services. Stable purchasing power does not mean that all
prices are constant. Rather, it implies
that while some money prices will increase and others will fall, on balance,
people feel safe in assuming that the
monetary unit will continue to buy
essentially the same bundle of goods
over time. It means that concerns about
the average value of money will not
influence their economic decisions.

When the purchasing power of money
is unstable, price changes do not efficiently serve their function of providing
information about the relative scarcities
of goods, services, and assets. When
the public observes that the money
prices of virtually everything are continually rising—a condition referred to
as inflation—they will project this
trend to the future and alter their behavior. They will reduce their holdings of
money balances, look for alternative
transaction vehicles, and devise alternative methods of exchange. The quality
of the services provided by the initial
forms of money then decays, transaction
costs rise, and the benefits of specialization and trade diminish. The substitutes
become more efficient only because the
“first-best” money has been debased.

s Fiat Money
Today’s national currencies are fiat. The
stability of fiat currencies is anchored
only by the public’s faith that their central banks will not issue too much—
more than the public wishes to hold at
current prices—and undermine their
purchasing power. Since fiat monies
have no intrinsic value, the public’s
choice among alternatives rests on the
relative abilities of central banks to invest them with some guarantee of quality. In this process, both the public and
the central bank may become locked in
a peculiar type of strategic game—a
game that now encompasses broader
political forces.
For their part, central banks understand
the long-term efficiencies that stable
money can provide, but they are also
part of a fiscal regime that includes
strong incentives to violate the public’s
trust by generating unanticipated inflation. Through unanticipated expansions
of fiat money, central banks can levy an
unlegislated tax, reduce the real value of
the government’s outstanding debts, or
attempt to exploit a short-term trade-off
between growth and inflation. Governments—particularly those that heavily
discount the future benefits of monetary
stability in favor of near-term tradeoffs—sometimes instruct or pressure
their central banks to issue excessive
amounts of outside money.
Such short-sighted government policies
have at most a transitory effect on economic growth. People respond to these
policies by adjusting their money holdings, altering their price-setting behavior (favoring current consumption over

investment), and purchasing nonproductive assets rather than saving. As
people alter their behavior, the daily
costs of conducting exchanges denominated in a particular monetary standard
rise. The additional resources expended
on information gathering and on protecting the real value of wealth would
otherwise have been available for
growth-enhancing activities.
Research findings confirm the public’s
ability to respond in this manner: Countries with higher inflation rates do not enjoy faster rates of economic growth. To
the contrary, there is mounting evidence
that higher inflation actually reduces
long-term growth. For one thing, high
and variable inflation makes it difficult
for investors to commit to long-term
projects. Instead, people in high-inflation
countries tend to channel resources toward hedging and speculating against the
uncertain purchasing power of money.
Governments with a long view typically
attempt to insure the quality of their
monetary unit by adopting institutional
arrangements—independent central
banks, fixed exchange rates, free international capital movements—that restrict
their own monetary discretion. While
some combinations of these can enhance
monetary stability, none is sufficient,
since the government that establishes
them may alter them at will. Even under
a gold standard, which theoretically
eliminates all opportunities for monetary
policy discretion, governments maintain
the option of altering the gold price of
the monetary unit.
The public will ultimately hold that
quantity of its officially established
money (both inside and outside) which
minimizes information and transaction
costs only if the central bank develops a
reputation for repeatedly defending the
purchasing power of its currency. Certain
types of rules, however, can enhance a
central bank’s reputation by providing a
signal that they—and the governments
that establish them—intend to maintain
the quality of the currency. Examples
include explicit price-level targets, or—
as in the case of the EMU—legal imperatives to place price stability above other
objectives. Such arrangements may be
particularly important because reputations for price stability build very slowly.
Rules that limit discretion enhance price
stability while the central bank’s reputation builds.

s The Fiscal Connection
The performance of national fiat currencies in the twentieth century has been
strongly influenced by the fiscal regime
in which the monetary authorities operated. The reason is that monetary policies have often been used as an alternative fiscal instrument—a means of
financing government spending.
The prospect of a multicountry monetary
union presents some interesting implications for the fiscal authorities of the
member nations. For the first time, there
will be a central bank and a fiat currency
that are not associated with a single
country—at least until complete political union occurs. Monetary policy decisions will be made at a supra-national
level, while fiscal decisions will remain
at national levels.
This arrangement could help promote
central bank independence and foster the
primary objective of monetary stability,
because it eliminates money creation as a
means of raising revenue at the national
level. At the same time, this separation
will exert enormous fiscal discipline on
participating national governments.
Although seigniorage will continue to be
paid to national governments, its level
will no longer be a national decision.
Moreover, national governments will no
longer be able to issue their own legal
tender and erode the real value of outstanding nominal debts through inflation.
To the extent that labor and capital are
mobile across a single market, more discipline will be imposed on fiscal authorities by the new monetary arrangements.
Absent the ability to create money, high
levels of national debt can be serviced
only by higher future tax receipts. Within
the single market, however, the prospect
of higher taxes would cause the factors of
production to migrate. Higher tax rates
could, eventually, shrink the tax base.
Although the deficit/output ratios of the
potential EMU participants have converged, the inherited ratios of debt to
GDP still vary widely. The diversity of
these fiscal positions, together with many
well-publicized structural economic
problems in Europe—such as costly
welfare programs and unfunded pensions—suggest that the market will not
view debt instruments of various participating countries as perfect substitutes.

This potential divergence creates a
unique situation for the central bank in
a monetary union. Once the member
countries no longer have a sovereign
currency, the debts of member governments become merely claims to future
tax receipts, and there is no longer the
potential for resorting to inflation to ease
an individual government’s debt burden.
If the supra-national central bank discriminates among the quality of debt
instruments—for example, by buying
only the highest-rated ones—the fiscal
discipline imposed on certain countries
will intensify.
To the extent that market participants
assign different risk premiums to the
obligations of member countries, the
national authorities will be in a position
similar to that of state fiscal authorities
in the United States. An examination of
the U.S. state and local bond markets
suggests that the risk premium rises
sharply with the ratio of state debt to
state product. States with high debt-tooutput ratios can become effectively
rationed out of the market. To an outsider, it is not clear how a supra-national
monetary authority would discriminate
among the debt obligations of individual
member nations. The debt monetization
operations of a prudent monetary authority would heighten interest rate differentials among countries with dissimilar fiscal positions. This, however, could feed
back onto the fiscal position of individual countries; that is, divergent debtservicing costs would worsen the relative
fiscal positions of the high-debt nations.
The risk for the fiscal authorities of any
member country is that the “dismal arithmetic” of the budget constraint leaves
few palatable alternatives. If the yield on
government securities demanded by
markets exceeds a country’s nominal
income growth, then interest expense on
the outstanding debt must become a
relatively larger burden. Nominal income growth has only two components,
real growth and inflation, the latter of
which is no longer under the control of a
national central bank. So, if a nation’s
real growth, plus any inflation within the
monetary union, is less than the average
interest rate on the existing debt, one or
some combination of three things must
happen: 1) fiscal deficits can increase,
2) tax rates can be raised in an attempt to
match rising total expenditures, or 3) the
fraction of the government’s non-interest
outlays (including pensions and other

wealth redistributions) must permanently trend downward.1 It may be that
none of these adjustments is sustainable.
Furthermore, the political stresses involved in securing a sustainable outcome cannot be assessed in advance.
Ultimately, the consolidated fiscal positions of all the member countries will
affect confidence in the soundness of the
currency. The monetary authority will be
issuing non-interest-bearing liabilities on
itself in exchange for the interest-bearing
obligations of member countries. If the
collective fiscal position of the individual
countries is questioned in the market, the
commitment by the monetary authorities
to maintain a stable currency will also be
questioned. In the end, the sustainability
of any monetary regime depends on the
fiscal regime in which it operates.

s Summary
Central banks are successful when
households and businesses make decisions based on the assumption that all
observed changes in money prices accurately reflect the relative scarcities of

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goods and services in the economy.
When this occurs, money is serving its
purpose of reducing the costs of engaging in economic exchange. First and
foremost, a successful central bank must
maintain a stable purchasing power for
its currency. That does not ensure prosperity, but it is a necessary condition for
efficient resource utilization.
The success achieved by the European
economies in meeting the convergence
criteria set forth in the Maastricht treaty,
along with the strong emphasis on price
stability, provides a promising beginning. The unavoidable discipline required of fiscal authorities, however,
poses unique challenges to the central
bank’s operations and ultimately will
determine the stability of the currency.
How remaining questions about this
unprecedented effort are resolved will
have a direct bearing on the standards of
living in Europe in the early decades of
the twenty-first century.

s Footnote
1. The necessary conditions for a rising
national debt–income ratio are that the real
rate of interest exceeds the economy’s
growth rate and that a “primary” deficit
exists. A primary deficit occurs when
receipts and outlays, net of interest income
and payments, are in deficit.

Jerry L. Jordan is president and chief
executive officer of the Federal Reserve
Bank of Cleveland. These remarks are excerpted from a speech he presented at the
Institute of Economic Affair’s Ninth Annual
State of the International Economy Conference, held in London on October 30,
1997. (Editor’s note: This article went to
press on November 5, 1997.)
The views stated herein are those of the
author and not necessarily those of the Board
of Governors of the Federal Reserve System.
Economic Commentary is available electronically through the Cleveland Fed’s site on the
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