Examining the Intersection of Monetary and Fiscal Policy

Understanding the Distinction Between Monetary and Fiscal Policy

The common perception is that the Federal Reserve system (known as the "Fed") and the US Treasury Department are separate entities. The Fed, established in 1913, is a legally and financially independent federal agency, privately owned by its member banks and does not receive funding from the federal budget. The US Treasury, however, is a cabinet-level department within the Executive branch, reporting directly to the President and funded through the federal budget. The general understanding is that the Fed's monetary policy, which involves managing the money supply and interest rates, is distinct from the Treasury's fiscal policy, which involves tax collection and federal spending. The contemporary separation of the Treasury and the Fed can be traced back to the 1951 Treasury-Federal Reserve Accord, which affirmed the Fed's independence from the Treasury.

Clarifying the Roles of the Fed and the Treasury

Despite these delineations, many Americans remain unclear about the respective responsibilities of the Fed and the Treasury, particularly in relation to the coordination between the two when the Fed provides new bank credit to support the Treasury's need for spendable funds. The Treasury sells bonds to both foreign and domestic investors when federal tax revenues are insufficient to cover its spending needs. Once these bonds are in the open market, the Fed can purchase them for its own portfolio, creating new bank credit, or spendable funds, out of "thin air". This process is sometimes referred to as "monetizing the debt".

Monetary and Fiscal Policy in the Covid Era

This coordinated expansion of credit by the Fed and the Treasury reflects a novel approach to monetary and fiscal policies, developed to meet one-off federal spending needs. This began when Ben Bernanke, Fed Chair from 2006 to 2014, created Quantitative Easing (QE) during the 2008-09 financial crisis. QE involves large-scale open-market purchases of Treasury debt and, for the first time in the Fed's history, mortgage-backed securities, to flood financial markets with newly-created bank credit.

Introducing "Helicopter Money"

QE can be seen as a supercharged version of traditional monetary policy. However, another new policy tool, "helicopter money", can be seen as a hybrid of monetary and fiscal policy. This term, coined by Milton Friedman in 1969, refers to a type of stimulus that injects cash into an economy as if it were being dropped from a helicopter. A variant of helicopter money was used during the financial crisis of 2008-09 and again in 2020 during the early months of the Covid pandemic. After Congress authorized consumer "stimulus" payments, the IRS deposited prescribed amounts into the bank accounts of qualifying taxpayers.

Comparing QE and Helicopter Money

Although QE and helicopter money may seem similar, they are fundamentally different. QE involves an "asset swap" between the Fed and another economic entity. The Fed purchases Treasury bonds or other financial assets from private parties, adding them to its balance sheet and creating new bank credit. On the other hand, helicopter money does not involve an asset swap. The Fed simply gives away the money created without increasing assets on its balance sheet. Economists do not all agree whether helicopter drops qualify as monetary policy or fiscal policy.

Debate on QE and Helicopter Money

There are differing views on the use of QE and helicopter money. John Cochrane of Stanford University's Hoover Institution considers the Fed to be a vital part of fiscal theory. Stephen Miran of the Manhattan Institute warns that the Fed has allowed QE to remain in place far too long. Modern Monetary Theory (MMT), a fringe movement within economics, suggests that the Fed should create money to directly fund public expenditures or tax cuts. MMT advocates consider helicopter drops a form of fiscal policy, not monetary policy.

Looking Ahead for the Fed and Treasury

The distinction between monetary and fiscal policies is now blurred. Some may see this as the Fed and Treasury overstepping their traditional responsibilities, while others may view it as necessary cooperation to flood credit markets with liquidity. It may be time for a new Treasury-Fed Accord to clarify the respective responsibilities and limits of the Fed and Treasury. Alternatively, it may be time for Congress to increase its oversight of both the Fed and the US Treasury Department.

Bottom Line

The intersection of monetary and fiscal policy is a complex and evolving issue. The strategies and tools used by the Fed and the Treasury, such as QE and helicopter money, have far-reaching implications for the economy. As we move forward, it will be crucial to clearly define and understand the roles and responsibilities of these two entities. What are your thoughts on this matter? Share this article with your friends and join the conversation. Don't forget to sign up for the Daily Briefing, delivered every day at 6pm.