What is the relationship between monetary policy and fiscal policy?
This is not an easy question to answer, especially since there are many ways of conceptualizing the relationship. For simplicity, let’s consider two theories. The first is naïve and unsupportable, but is quite popular in economic and financial journalism. The second is more tenable, but receives less attention.
Former Fed Chairman Alan Greenspan recently worried that rising government deficits will cause inflation to rise. Although the article in which Greenspan is quoted does not directly state it, the underlying theoretical justification seems to be old-school hydraulic Keynesianism. The economy is conceived as a machine with several levers. One lever is government spending. Pull the lever — increase government spending without increasing taxes to pay for it — and the machine starts to heat up. The result is rising prices across the economy, or inflation.
While this theory was popular from the end of the Second World War up through the 1970s, it was rightly cast out of academic respectability with the rise of monetarism. The “theoretical apparatus” that underlies these kinds of stories is not actually a theory, in that it contains no meaningful statement about purposive human behavior. Hydraulic Keynesianism is now usually found in the comparatively unsophisticated realm of the popular press.
But there is another way to think about the relationship between fiscal and monetary affairs. When governments run deficits, they can be paid for three ways. First, the debt can be rolled over via additional borrowing. Second, it can be amortized (paid down through tax surpluses). Third, it can be inflated away. This last one is clearly relevant to monetary policy. If fiscal authorities can pressure monetary authorities for favorable policy, the monetary authorities can run the printing presses to erode the real value of the debt.
Many economists find this theory unpersuasive, since it requires active and conscious pressure on monetary policy makers by fiscal agents, which seems unlikely in countries with traditions of independent central banks. But, as I haveargued before, such independence is largely a mirage. There is, and always has been, significant behind-the-scenes manipulation of central bankers by politicians and their agents.
Furthermore, there is no reason to suppose pressure needs to be active and conscious. William Luther and I argue in a recent paper that because monetary policy is inherently political, the same filtering processes that select for political outcomes in general apply to central banking in particular. The political process can select for monetary policy makers who will accommodate fiscal needs, even without overt coordination between fiscal and monetary agents. In other words, fiscally accommodative central bankers are adaptively successful in the political environment of fiscal–monetary decision making. If this is so, then deficits can indirectly cause inflation by creating the conditions in which central bankers find it incentive-compatible to enact expansionary policy.
Ultimately it is an empirical question how monetary policy makers respond to fiscal conditions. Given that the era of perpetual trillion-dollar deficits is just over the horizon, however, it seems we will soon have an interesting test case. The economics of politics suggests it is Pollyannaish to assume these difficulties will be navigated in a way that is both economically sound and politically palatable.