Holding the Line: Maintaining Fiscal and Monetary Policy Boundaries in the Midst of a Crisis

Setting the boundaries between fiscal and monetary policy.

Setting the boundaries between fiscal and monetary policy.Not long ago, the CMFA staff and I were preparing to officially launch The Menace of Fiscal QE, my book aimed at countering efforts to have the Fed undertake or otherwise fund off-budget government spending programs.

Then came the crisis. Of course our plans were dashed. But so, I feared, were my hopes of having people take the message of Menace seriously. "Who now," I wondered, "wants to hear about the need to respect policy boundaries? More likely the hue-and-cry will be, 'Let's pull all the stops: boundaries be damned!'"

And so it has come to pass, in some quarters at least. Thus Congresswoman Maxine Waters, Chair of the House Committee on Financial Services (D-CA), declared on March 16th:

This is in many ways an unprecedented crisis which calls for extraordinary federal response. Unfortunately, the Fed appears to be using its old playbook in trying to calm funding markets by flooding them with liquidity. During this time of economic turbulence, it is critical that the Fed go beyond these steps and provide much-needed support to those who are on the front lines of this pandemic. …While Congress works on a bold, fiscal stimulus package to help these individuals, I call on the Fed to reevaluate its response and work creatively to address the needs of everyday Americans.

[In a more complete statement of her proposal, made available after this post was first published, Representative Waters clarifies the burden her proposal would place on the Fed:

The Federal Reserve would be directed through a money-financed fiscal program, to fund automatic stabilizers in the form of at least $2,000 for every adult and an additional $1000 for every child for each month of the crisis*

Some economists, for their part, are recommending that the Fed resort to "helicopter money." Jordi Gali, for example, suggests that it and other central banks finance emergency spending programs by simply crediting their governments' accounts:

That credit would not be repayable, i.e. it would amount to a transfer from the central bank to the government. …[S]uch a transfer from the central bank to the government would be equivalent to a commensurate purchase of government debt by the central bank, followed by its immediate writing-off, thus no longer having an impact on the government's effective debt liabilities.

Gali recognizes that his plan subordinates monetary policy to "the requirements of the fiscal authority" and that it could therefore be considered "an outright violation of the principle of central bank independence." "But," he says,

we have seen many occasions in which rules that were considered sacred have been relaxed in the face of extraordinary circumstances. …Furthermore, the central bank could agree to participate voluntarily in such a scheme, thus preserving its formal independence.

Perhaps I am reading this wrongly, but Gali seems to be saying that central banks need never worry about losing their independence so long as they do whatever the government asks them to do.

Notwithstanding such appeals, and the urgency of the crisis, I believe that it's as important as ever for the Fed and Congress to stick to their respective fiscal and monetary turfs. If there's any reason why they can't do so, while taking all necessary steps to address the crisis, it's that Congress refuses to take responsibility for any potentially risky operations it would rather lay at the Fed's door.

The Power of the Purse

The case for insisting on a strict division of fiscal and monetary responsibilities rests on the principle, enshrined in the U.S. Constitution, that Congress alone should determine how public funds, including funds secured by borrowing against future tax revenues, should be spent. Because losses stemming from any risky government program are also ultimately borne by taxpayers, such losses should also be treated as "potential" government expenditures which Congress alone should be allowed to authorize, and for which it should bear full responsibility.

These stipulations, far from being arbitrary, derive from the U.S. Constitution's Appropriations Clause (Article I, section 9, clause 7):

"No Money shall be drawn from the Treasury, but in Consequence of Appropriations made by Law; and a regular Statement and Account of the Receipts and Expenditures of all public Money shall be published from time to time."

Nor should the rationale for this clause be difficult to fathom. It is simply the spending counterpart of the idea that there should be no taxation without representation, itself enshrined in another part (section 7, clause 1) of the Constitution's first article:

All Bills for raising Revenue shall originate in the House of Representatives; but the Senate may propose or concur with amendments as on other Bills

Together these clauses are intended to award Congress exclusive control of the "power of the [national] purse."

Because it may result in losses that must come out of that purse, risky lending is properly regarded as something Congress alone can authorize, and for which it must be prepared to pay.

The Fed's Independence

The Constitution also awards Congress "the power to coin money [and] regulate the value thereof." Congress in turn has chosen—though hardly without controversy!—to exercise those powers by establishing the Fed and granting it some degree of independence from political, including Congressional, interference.

That the Fed is hardly as independent as it claims to be no one should gainsay. Still it possesses a modicum of independence, if no more than that, and that independence, such as it is, makes it somewhat easier for it to stick to its mandate, or at least to resist pressure to bend to Congress's will, or to that of the Executive.

The Fed's (limited) independence itself rests mainly on two provisions of the Federal Reserve Act. One of these grants members of its Board of Governors nonrenewable 14-year terms, except the Chair, who serves a renewable four-year term. It also prevents elected officials from serving on the Board. The other allows the Fed to operate without a budget from Congress, by covering its expenses using interest income from its security holdings and fees it charges for its services.

Any Congressional interference with the above-mentioned provisions necessarily chips away, however slightly, at the Fed's already tenuous independence. This goes for any action by Congress that might expose the Fed to losses. As Alex Cukierman explains, although central banks differ from ordinary banks in being able to operate with negative net worth, so that they are in that sense able to bear losses, those losses, should they become large enough, may force them to "depend on infusions of funds from the Treasury," thereby raising the possibility that the Treasury will "explicitly or implicitly, condition the recapitalization… on certain policy actions."

Fiscal Backup

Cukierman's observations lead him to recommend that central banks not be asked to take on substantial risk unless the "political authorities" agree to cover any losses they may incur:

If, due to a financial crisis or other reasons, government decides to rescue financial institutions the implementation of such operations should not affect the net capital position of the CB [central bank]. This implies that such operations should appear as explicit items on the government's budget. Such an arrangement is desirable not only because it protects the instrument independence of the bank, but also because of transparency and accountability considerations of politicians to the public that elected them. … More generally, the CB net worth [had] better be shielded from the impact of decisions that are made by other authorities.

During the last crisis, the British government followed this advice, at least to some extent, by offering to indemnify the Bank of England for any losses it incurred by acquiring risky assets. However, as Willem Buiter reported then, even it failed to assume responsibility for the credit risk the Bank took on in offering "repos and other forms of collateralized lending to banks where the collateral offered consists of private securities." The ECB, in contrast, received no protection at all. Instead, Buiter says, it was "hobbled severely by the non-existence of a fiscal Europe, and specifically by the absence of a fiscal authority, fiscal facility, or fiscal arrangement that can recapitalize it should it suffer losses due to credit risk assumed as part of its monetary, liquidity, or credit-enhancing policies."

As for the Fed, although it was not "hobbled" as the ECB had been, it, too, took on risk without the benefit of anything beyond a meager fiscal guarantee or "backup":

For the Fed's potential $1 trillion exposure to private credit risk through the Term Asset-Backed Securities Loan Facility, for instance, the Treasury only guarantees $100 billion. They call it 10 times leverage. I call it the Fed being potentially in the hole for $900 billion. Similar credit risk exposures have been assumed by the Fed in the commercial paper market, in its purchases of Fannie and Freddie mortgages, in the rescue of AIG, and in a host of other quasi-fiscal rescue operations mounted by the Fed and by the Fed, the Federal Deposit Insurance Corporation, and the US Treasury jointly.

Buiter considered "this use of the Federal Reserve as an active (quasi-) fiscal player… extremely dangerous and highly undesirable from the point of view of the health of the democratic system of government in the US." Besides compromising the Fed's independence, he said, it "undermines Congressional and wider public accountability for this vast commitment of public resources." The Fed, he said, "should insist on a full Treasury indemnity for any private sector credit risk it assumes."**

No Time Like Now

Though it may be tempting, in the midst of the current crisis, to set Buiter's advice aside as an encumbering nicety, that temptation needs to be vigorously resisted. What, after all, is the point of having a Constitution that assigns to Congress alone the power of the purse, and a Federal Reserve Act designed to keep the Fed from becoming subservient to Congress, if these safeguards are to be swept aside, or simply ignored, on the very occasions when they're most likely to serve a purpose?

More generally, as John Hawkins (then a senior economist at the BIS) wrote in 2003,

it is relatively easy for governments to proclaim their central banks to be independent when times are good. When times are bad, governments may again be tempted to turn to central banks to help them out of budgetary difficulties. It might be argued that to keep financial markets calm, and bond yields low, not only must central banks be independent, they must be perceived as independent, and (even more difficult) expected to remain independent.

Nor is it so difficult for Congress to protect the Fed's independence, and abide by the spirit of the Constitution, by taking responsibility for risky lending or asset-purchase programs that call for the Fed's involvement. Kevin Warsh's recent proposal for Fed-assisted lending to non-bank businesses and households calls for it to do just that. "The Fed possesses powerful untapped authority," Warsh writes; "and with the help of Congress and the administration there is much it can do to improve economic prospects":

In consultation with the Treasury secretary and congressional leaders, the Fed should immediately invoke its emergency powers under Section 13(3) of the Federal Reserve Act and establish a new credit facility to ensure that sound businesses and households have ready access to cash to get through the crisis. …

The Fed board of Governors would authorize the program and ensure its accord with Walter Bagehot's dictum: lend freely to solvent firms and individuals on good collateral at interest rates higher than are customary. …Borrowers would need to demonstrate that they are unable to obtain credit elsewhere but are solvent, consistent with the requirements of the Federal Reserve Act.

But Warsh's proposal would not expose the Fed itself to any risk:

Crucially, Congress would also authorize a fiscal backstop to offset any loan losses incurred by the Fed or the banks themselves. These actions would maintain an appropriate line between monetary and fiscal policy.

In calling, in his March 6 speech to the Shadow Open Market Committee, that the present emergency might make it desirable for the Fed "to purchase a broader range of securities or assets," Boston Fed President Eric Rosengren was likewise quick to add that before the Fed pursued such a policy, it should "possess an explicit agreement with the U.S. Treasury Department to indemnify [it] against losses."

Whether or not the sort of lending Warsh and Rosengren propose is essential for dealing with the present crisis, they are certainly right to insist that ultimate responsibility for it, and especially for the risks it entails, be taken not by the Fed, but by Congress. It only remains for members of Congress themselves to acknowledge this responsibility, and act accordingly, instead of passing the buck.

President Trump can help. If he needs an example to follow, let him consider what FDR told then New York Fed Governor George Harrison following the passage of the 1933 Emergency Banking Act:

It is inevitable that some losses may be made by the Federal Reserve banks in loans to their member banks. The country appreciates, however, that the 12 regional Federal Reserve Banks are operating entirely under Federal Law and the recent Emergency Bank Act greatly enlarges their powers to adapt their facilities to a national emergency. Therefore, there is definitely an obligation on the federal government to reimburse the 12 regional Federal Reserve Banks for losses which they may make on loans made under these emergency powers. I do not hesitate to assure you that I shall ask the Congress to indemnify any of the 12 Federal Reserve banks for such losses.

President Trump can and should do FDR one better by getting Congress on board before he puts the Fed on the hook.

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* In a more complete statement of her proposal, made available after this post was first published, Representative Waters clarifies the burden her proposal would place on the Fed. "The Federal Reserve," the proposal says, "would be directed through a money-financed fiscal program, to fund automatic stabilizers in the form of at least $2,000 for every adult and an additional $1000 for every child for each month of the crisis." [Note added 3/18/2020 at 9:00PM.]

**As Igor Goncharov, Vasso Ionnidou, and Martin Schmalz observe in a 2018 paper,  some time after Buiter wrote the Fed adopted new accounting rules so as to "to further soften its budget constraint" and thereby better protect its independence in the face of losses. Under the new rules, when the Fed's income falls short of what it needs to cover its expenses and realized losses, instead of drawing on its capital, it can create a "deferred asset" reflecting the shortfall, and then reduce its dividends to the Treasury until it makes up for those losses. This change makes it highly unlikely that the Fed will "ever have to go 'cap-in-hand' to the US Treasury for a capital top-up." However, Goncharov, Ionnidou, and Schmalz observe,

it may also undermine the Fed's credibility and the credibility of the US government who [sic] provides ultimate back-up.  Bank of America Merrill Lynch's Ralph Axel states, 'Such moves do not promote confidence in the Fed, but rather cause concerns within markets. We will not make too much of a fuss over this accounting change, but the overall theme of reduced government credibility is strengthened by it… In our view the ongoing decline in credibility translates into a higher chance of a downgrade in the sovereign credit rating.'

[Note added 3/18/2020 at 10:40PM.]

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