The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
I
¡I
-
l{O$KïNfî,
rÞ.vqis
{'lS,
vrr ùËltvttJ
G)
;)
FEDERAL
l2:30 p.m., E.S.T.
January 30, 1990
G)
RESERVE
GD
BANK oF
GD
CLEvELAND
G)
(D
l.l. Lee Hoskl ns ,
GD
Pres I dent
Federal Reserve Bank
of
Cleveland
of Business Economlsts
Columbus,Ohlo
.l990
January 30,
Columbus Assoclatlon
i'iiu,-"
-'- ' " '
Ü¡tY
'¡uK
0t' KAI'liAi¡
EB 0 2 1990 Po Box 6saz
gsttsfnr :;':ii:?
IS CURRENT FISCAL
POLICY AN OBSTACLI TO SOUND MONETARY POLICY?
Federal Budget Deficits and Zero Inflation
afternoon.
Good
a pleasure to be the kickoff speaker for this
It's
newly-founded chapter
of the Natlonal Association of
(NABE). As you know,
I
support
its
have been asiociated with
advancement and congratulate you on
Business Economists
NABE
for
some
time.
starting a chapter in
I
Columbus.
is the relationship between monetary policy and fiscal
policy. The debate is centered around two questions: what does fiscal poìicy
My
subject today
imply about the conduct
of
monetary
policy,
and what does monetary policy
imply about the conduct of fiscal polìcy?
of us, myself fncluded, learned economÌcs at a time when the answer
to thls question couìd be found in the textbook Keynesian demand-management
paradlgm. Central to this paradigm was a belief in the abtlity of
Many
policymakers
to fine-tune
complementary mix
economic
of flscal
activity
and monetary
through Judicious choices from
policy instruments.
a
The notion that
higher levels of real economic activity could be bought with higher inflation
was
it
part and parcel of thìs view of the world. As ìong as this idea prevalled
was reasonable
to presume that inflation
price to pay for sustained
was an
inevitable, and acceptable,
economic growth.
The high unemployment and
inflatlon of the
.l970s
effectively
destroyed
of a stable trade-off between inflatlon and unempìoyment. The
misfortunes of these years also led to growing skepticism about the ability of
discretionary changes in either fiscal or monetary policy to smooth the
this
ldea
short-run cycl i cal fl uctuations i n
busi ness acti vi
economists and policymakers now accept
ty.
An impressì ve number of
the idea that the proper goal of
both
fiscal and monetary poìicies is to maximize long-run economic growth, and that
price stabiìity, ìn particular, is the only contribution that monetary pollcy
can make
to this obJective.
-2Despite
this progress, I
am concerned because,
discussÌons that accept the goal
attainability which, in
my
of price stability
too often, policy
proceed
to question its
vietr, retards public acceptance. A common f.ear is
the threat of recession that is frequentìy associated wÍth the pursuit of
price
stability. Recentìy, I
have argued
that threats of recession should not
interfere with the ìong-run goal of price stabiìity,
because
price stability
actually reduces the risk of recession and is a pro-growth po]icy.
would
like to discuss another
price
stabiìity.
Today I
popular argument raised against the goal of
That argument states that we shou'ld postpone a commitment to
price stabi'lity until
fiscal house'in order. Those who hold this
view claim that we cannot commit to a poìÍcy of price stability because'large
deficits cause high interest rates, thereby limiting monetary policy's abiìity
to reduce inflatlon under conditions reasonably consistent with fulì
we have our
emp'loyment.
My message
compromise
is a simpìe one.
Federal budget
deficits should
not
either the Federal Reserve's goal of price stability or
the
of a specific timetable to achieve it. QuÍte the contrary. Poor
monetary policy, whlch I will equate with the failure to pursue a goa'l of
adoption
price stabfìity, interferes with the pursuit of a sensible long-term fiscal
po'l
icy. I
do not mean
to
suggest
olimpìy that current fiscal poìicy is
ideal, appropriate, or the result of
savings are too low,
measures
to
reduce the
address our savings
deficlt.
should recognìze
deficits;
at least partìy
it
because
monetar.y
of
policy. I
budget
believe that
deficits,
and that
shortfal'l probably must include measures to
However, while we
that
indeed,
bad monetary
strive for better fiscal polìcy,
we
policy cannot offset the harm caused by fiscal
can only add
to those costs.
-3-
The Elements
of
Sound Monetarv and
Fiscal Policles
Even policymakers who disagree on
have
details agree that
sound
policies
must
clear objectives, verifiable outcomes, and rules that are consistently
adhered
to.
Above al I
,
predi ctabl
individual economic decisions are
pol I cy obJecti ves and outcomes.
e, verl fi abl e pol i ci es ensure that
made
If
with a minimum of uncertainty about
thl s requi rement i s sati sfi ed, I ong-term
planning and resource allocation decisions
will not be foiled by poìicy
decisions that deviate from the expectations of reasonably ìnformed citizens.
Sound
policy thus requires a resolute focus on the long term and resistance to
poìicies that, while expedient in the short run, introduce even more
uncertai
nty i nto an al ready
hlhat
thls
means
for
unpredi ctabl
monetary
e worl d.
policy
is, I think, clear.
þle have learned
through disappointing experience that monetary policy cannot be used to
manipulate
real varlables for
any reasonable period
of time.
l,le have al so
that, ìn the'long run, inflatlon is the one economìc variable for
which monetary pol icy i s unambiguously responsible. Because inflation i s a
monetary phenomenon, inflation must a'lways be the prlmary concern of those who
learned
set monetary policy.
inflation, or, equlvalently, a price-leve1
target, Ìs a matter of record. Inflation can ultimateìy contribute to
My support
for
long-run zero
recession and has debilitating effects on economic performance. Equaì1y
of sound
policy: it's clear, it's verifiable, and lt has consistent rules. Unlike
other rates of inflation, zero inflatlon is a policy goal that has the
important, a zero inflation pollcy satisfies the key requirements
potential to be unambiguously understood by everyone.
-4-
In a similar fashion, a
prioritles
sound
fiscal poìicy is
for
and maps out a multl-year commitment
budget allocates resources between the public and
competing c'laims
within the public sector.
one
that clearly sets out
taxes and spending.
private sectors
and among
These budget considerations are
based upon
a political and social consensus about public expenditure
priorities
and the proper
sectors.
The
tax
system
The
division of functions
between the
private and pubìic
raises the revenue for governmental functions.
It
is
of such obJectives is accomplished within
important that the financing
long-term budget constraints and with a tax structure that enables citlzens to
can pìan accordingìy.
If
is
we can agree
appropriate,
cluttered with
pursue a zero
hovJ
many
that
my
of
descriptfon
do we get from here
sound monetary and
to there?
flscal pollcy
The road appears
to be
obstacles. For example, skepttcs ask, can policymakers
inflation policy in the current flscal policy
environment
without incurring unacceptable economic costs? And, hoYl should
authorities respond to the supposed
'l
i nabi i
monetary
ty of f i scal po'l ì cymakers to
fashìon sound policy decisions? These are familiar questions and doubts that
are frequently raised to thwart the pursuit
Does Current
Does
Flscal Poìicv
current fiscal
Make Zero
pol
icy
make
of
Inflation
sound monetary pollcy.
Too Costlv
price stabi
I
tty
to
Pursue?
too costly to pursue?
l^le
all familiar with the arguments of those who claim that the answer is
yes: large federal budget deflcits cause h'igh interest rates, forcing the Fed
are
to
ease monetary po'licy
in order to
keep
interest rates at levels consistent
full employment.
I think that this argument is weak for two reasons. First, both the
federal budget deficlt and more lmportantly, I believe, the growth rate of
with
federal government spending, at least
measured
relative to the
economy, have
-5-
falìing for the past several years and should continue to do so. Second,
even if fiscal policy choÍces were to put upward pressure on interest rates,
it is far from clear that the Fed can do anything to alleviate this pressure.
been
The Size
of the Government
about the
escape
has Decìined:
Gramm-Rudman-Hoì I i
ngs defi ci
Despi
te
some genera'l reservations
t reduction legislation, it is hard to
the conclusion that the process has exerted at least a moderating
influence on the growth of the federal government. In the two years
preceedi ng passage
close to 5 percent
of the Gramm-Rudman-Hol I i ngs bi I I , the defi ci t averaged
of GNP; as of the end of flscal year'1989 that number had
fallen to under 3 percent.
An
made
often heard objection to the deficit statistic involves the cìaim,
with
some
justificatÍon, that a good deal of the progress in deficit
reduction has been accomplished by strange accounting devices and various
forms
of
is some ground for those clafms.
deficÍt is, itself, based on somewhat arbitrary
budget chicanery. Certainly there
But, after
all,
the reported
accounting conventìons. Should contributions
to the social securlty trust
fund be regarded as tax collections or loans from the work'ing populatlon?
Should borrowing
to finance public infrastructure be offset on the government
books by the capìtaì acquired
with the borrowed funds?
which honest people can agree
to
Many would argue
issue
of
how much
that
These
are issues on
disagree.
more ìmportant than the
of the income generated
deficit question is
by the U.S. economy
is
the
appropriated
by the federal government and how has that percentage changed? In these terms
the answer
of
GNP
is unambiguous: net federal outlays,
fn the mld-ì980s,
Gramm-Rudman-Hollings
have
which rose
to about 24 percent
fallen every year slnce passage of
legislation, to about 20 percent in
1989.
the
-6Although important issues concerning the macroeconomic effects of
transfer policles, tax structures, and the composition of
expenditures remain unresolved,
government
ìt is hard to escape the conclusion that
is belng made toward alleviating concerns that are typically
progress
deficit expenditure. hlhile not ideal, the fiscal po'licy
environment has become more conducive to the pursuit of price stabiìity.
associated with
If Deficits Cause Hiqh Interest Rates. Can the Fed Do Anvthinq About It?:
There
is, of
course, legitÍmate concern that the progress in deficit
expendÍture reduction might cease
reasons.
How should such
or
even be reversed,
for
and
any number of
a reversal influence monetary poìicy?
I return to
if fiscal polÍcy choices were to put
upward pressure on ìnterest rates, and there ìs lìttle consensus among
economists that this is the case, it Ís far from clear that the Fed can do
the second issue
I
raised
earlier:
even
anything to ease that pressure.
It is important to emphasize the distinction
interest rates. Real rates of return are
capital,
and
between
based on
real
and nominal
the productivlty of ìabor,
other real assets in a society. In an inflationary environment,
of return lnclude an inflation premium to compensate lenders for
belng repaid ln money of reduced purchasìng povrer. Ultimately, Ít is real
nominal rates
interest rates that affect the consumption and production decisions of
indtviduals and businesses and the al location of resources over time.
Our economic experience since Norld hlar
II fails to reveal a firm
relationshìp between real interest rates and the growth rate of the
base,
or the various other
Again,
lt is
between monetary
monetary aggregates
that the
important to focus on real lnterest
monetary
Fed can control.
rates.
The correlation
polìcy and nominal interest rates that dominates discussÍon
in the fÍnanclal press tells
us next to nothing about the relationship between
7monetary growth and
resources over
the real interest rates that govern the a'llocation of
tlme.
in the federal funds rate does not
in real interest rates, in the productivity of
Every movement
produce equivalent changes
our
capital stock, or in any of the other Ímportant real variables that affect
economic
activity. The fact that monetary pol icy exerts relativeìy
direct
control over the federal funds rate does not impìy that real interest rates
can
,
s
i mi I ar1
y,
be control I ed by monetary pol i cy.
It is worth digressing for a moment to consider a relatlveìy new issue
that is making its way Ínto fiscal poìicy discussions, and is leading some
people
have
to argue that a zero inflation
monetary
ìn mfnd the so-called "peace dividend".
of tensions
policy
wou'ld be hazardous. I
The concern
is that the thawing
between the United States and the Soviet Union
will result 1n
in the miìitary area,
demand and forclng the Fed to ease in an effort to attaln
budget savings and lower government outìays, especiaìly
reducing aggregate
full
employment
in the economy.
I wÍlì lgnore the obvious lrony that both contractionary fiscal policy,
in the form of lower gou.rnr.nt expenditures,
and expansionary
fiscal policy,
as implìed fn the prevlous example by the contention that deflcits are
excessively 1arge, are being separately invoked to Justlfy expansionary
monetary
policy. I wlll
instead slmply re-emphasìze the points
I
have aìready
made.
The
first of those points is that government expenditures have been
falling as a share of total output for several years. As noted earlier,
federal outlays as a share of GNP have fallen by over three-and-a-half
percentage points since .l986
conti nued.
--
a period during which economic growth
has
net
-8The second
point ls that the ability of the
predictably control real variables
inappropriate
Fed
to consistently
is tenuous at best. Just as it
and
is
to infer that monetary policy can change real interest rates, it
ìs inappropriate to conclude that higher growth rates of money increase the
overall level of real economic activity.
The fal lacy of automaticaì ly drawing this conclusion is nicely
illustrated in a recent Economic
Bank
Commentarv
published by the Federal Reserve
of Cleveland's research staff. It is a well-known fact that
each
activity swelì. Is the increase in
the money supply responsible for the increase in economic actÍvity? Does the
December
both the money supply and real
Fed cause Christmas?
Certainly
not. The annual fourth quarter increase in
the money suppìy is the Fed's response to economic activity, not a cause
If it
were
of ft.
reaìly in our power to consistently lncrease output by the
of money, vrhy not increase the money supply without bound,
creating infin'ite wealth? The answer to this patently absurd question is
obvious to everyone. To create money without bound would result in lnfinite
inflation, not infinite wealth. But if a lot of new money wlll not deliver
mere creation
the goods, lvhy do we think a
little w'ill? Indeed the very suggestion that we
reliably control real activity wlth monetary pollcy, the old Keynesian
demand-management notion, suggests that we have yet to fu'lly assimilate the
can
lessons that recent economic history should have taught us.
Is
Sound Monetarv
I
Policv a Necessarv Condition for
have argued
appropriate
stabllÌty.
or
hlhlle we each may have our
fiscal policy is, fiscal policy is
direction. I
have the power
Fìscal Policv?
that fiscal policy is not currently a serious
the pursuit of price
what an appropriate
Sound
wl sdom
am
to
own
impedìment to
view about
moving in the
aìso high'ly skeptical that monetary authori ti
undo poor
fi scal
pol i cy chol ces.
es
-9-
that sound fiscal policy is not a necessary condition for
sound monetary policy, 'let me nolr shift the focus somewhat and pose the
Having claimed
fol'lowing question:
Is sound monetary policy a necessary condition for
sound
fi scal pol i cy?
this question, I will reiterate my notion of sound fiscal
policy. Sound fiscal poìicy clearly sets out priorities and maps out
Before
multi-year
I
answer
commitments
for
taxes and spendlng. Sound fiscal polìcy allocates
resources between the public and private sectors and within the public sector
of political and socìal consensus. And sound fiscal policy
communicates each of these objectives clearly within long-term budget
constraints so that private decisionmaking is consÍstent with efflcient
on the basis
resource aì ìocatìon.
The important question thus becomes, does the absence of a zero
inflation
fiscal pollcy or,
conversely, ls a zero inflation monetary policy conducive to the attainment of
sound fi scaì pol cy?
monetary
policy lnterfere with the attainment of
sound
1
Unpredictable Monetary Policy
I
is
have emphasized the necessity
an Impediment to Sound Fiscal Budget Pollcv:
of formulating fiscal policy on the basis of
objectives that are defined 1n the context of a long-term budget constraint.
In order to realize this goal, fiscal policymakers, like
decìsionmakers in
business, requlre an environment ìn whlch the constraints and condltions are
is impossible when monetary
pol icy results in variable and unpredictable inflation. By changing the reaì
value of government debt, unforeseen changes in the rate of ìnflation
as predictable as posslble. Such predictability
redistribute wealth
between
the private and pub'lic sectors and alter the
_l 0_
of the government. In response, fiscaì
'long-term planning
pol icymakers must either continual ly revi se their
assumptions or accept deviations from the originally planned allocation of
long-term budget condltion
resources between the prìvate and
public sectors.
l,lithout an explicit policy rule that effectively precludes the financing
of marginal expenditures through the inflation tax, fiscal
authorities can become locked. into what economist
as ð
game
of pollcy chicken.
A cynic might say
and monetary
Thomas Sargent has described
that no Congressman worth his
or her franking priv'ilege would ever choose to take the heat from
budgetary
discipìine
when
there remains hope of an accommodating Fed. A more
benevolent observer would note
process
of formulating
imposing
that the possibllity of seeing the painstaking
'long-term goals undone by the unforeseeable
of high and volatiìe inflation cannot fail to make an already
difficult task infinitely more difficult and certainly cannot contribute to
Congressional enthusi asm for makl ng tough long-term fi scal deci sions.
consequences
Inflation
Can Undermine
the Tax Structure:
Many peopl
problems posed by varlable and unpredictable
moderate
e
have recognized the
inflation, but
have argued that
inflatton is of no concern as long as the rate i s stabì e. I
happen
to believe that "stable inflation" is an oxymoron. But even if it isn't, the
complications that inflation poses for the tax structure provi de addi tional
insight into
why zero
is the magic inflation
The indexing provlsions
that
rate.
have recently become
part of the personal
expliclt recognition of the fact that even stable rates of
i nfl ation can di stort margl nal tax rates, redi rect economi c actì vi ty i n
arbitrary ways, and interfere with the efficient allocation of resources.
tax
code are an
-l I Despite a great deal
of progress,
however, the
tax structure is anything but
fully insulated from the effects of inflation. Capital gains, interest
income
earned by households, and depreciation allowances
ìn the business sector are
but a few of the areas in nhich the tax ruìes are
st'ill distorted by inflation.
Ne
could,
of
course, attempt
to
index
all
of income and expense
forms
activity. But such an attempt would make the tax code
even more complicated than it aìready is. Because of the difficulty
arising from
economic
ðssoci ated wi th compl
ete i ndexation, i nfl ation causes
i nevi tabl
e pressures for
discrete changes in the tax code. The effort to. restore special treatment for
capital gains Ís a
good example, which
also illustrates that attempts to
adJust the tax code may undermlne the progress we have made'in developing
tax
system
There
that is consistent wÍth
is one solution:
make
sustains an average rate
my
definition of
sound
a
fìscal policy.
the lssue rnoot by pursuing a monetary policy that
of inflatlon
equal to zero.
Conclusion
Sound economic
mi n'i mum,
policy, be it fiscal or
be predi ctabl
monetary
policy, must, at
a
e. In the absence of predì ctabi I i ty, the effi ci ent
of the economy, and hence long-run prospects for economic growth,
will be severeìy inhibited. For monetary pollcy, I believe that
predictability translates into the aggressive pursuit of prlce stabtlity.
functioning
The
pursuit of sound monetary policy need not await further progress
toward the establ I shment
monetary poìlcy can
based on
of
desi rabl
offset the
e fi scal po] i cl es. The argument that
economic
effects of fiscal po1ìcy choices is
the idea that monetary policy can conslstently and predictably
control real interest rates and real
economic
activity.
This idea
ls tenuous
-12both theoretically and empirically. Furtherrnore, the progress
made
on the
environment
that has been
front suggests that the
is indeed more favorable for the pursuit of a zero inflation
deficit
and government expenditure
nrcnetary pol icy.
Not onìy
is it
unnecessary
for
sound monetary
policy choices to await
fiscal policy choices, it 'is 'imperative that we adopt sound monetary
policy first. Sound fÍscal policy decisions, like sound private economlc
decisions, require the stable inflation environment that only the Fed can
sound
provi
de. In addi tion,
the tax-rel ated di stortions and
assocjated with even stable posltive rates
economi
of infìatìon
c
compì
exi
argue strongly
ti
es
for
a
zero i nfl ation goal .
tlhat both monetary and fiscal po'licy must accompllsh
is the creation of
of the game are well understood and
desìgned to minimize interference with the realization of society's broader
goals. Precisely because of its independence, the Fed has the unique ability
an economic envlronment
in
whfch the rules
that works toward these goals. Indeed, without a
clear and committed price stability policy by the Fed, the probability of
to
implement a poìicy regime
sustaln'ing a clear and committed
fiscal policy is
reduced.
@FedFRASER