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The Relationship Between Budget Deficits, Fed Independence, and Inflation

I have been critical of both Alan Greenspan and Ben Bernanke for giving recommendations concerning fiscal policy during their testimony before Congress. In Greenspan's case, it was his comments about tax cuts that I found problematic, while for Bernanke it was his comments on entitlements.

But monetary and fiscal policy are connected, and the Fed chair should talk about the impact that a growing debt level might have on monetary policy. That is, while I don't think the Fed chair should give advice on the specifics of fiscal policy, he should make clear how fiscal policy choices will affect or constrain monetary policy.

Let me try to explain how monetary and fiscal policy are connected through the budget deficit. There are two different government budget issues to think about. The first concerns the long-run trajectory for the debt, and the projections are that it will expand to unsustainable levels if we don't do something to stop it. That means, above all else, reducing the growth in health care costs. The second issue concerns the short-run debt created in an attempt to stimulate the economy. This is a small amount compared to the long-run debt problem, but it is still a lot of money and we will need to pay this back when things are back to normal (but not before then, since paying it back too soon could undermine a recovery).

I want to look at the pressures the Fed may come under in the future, so let's focus on the long-run debt problems and assume we are in a more normal economic environment.

In normal times, an increase in government debt increases the demand for loanable funds, and this puts upward pressure on interest rates. (Presently, the continued availability of cheap financing from abroad plus the fact that we are in a liquidity trap means that this is not a problem. Also, interest rates are low and likely to stay that way for awhile, but if the debt continues to expand as the economy returns to normal, it is unlikely that this will continue.)

What will happen if the deficit continues to expand, and this begins to put upward pressure on interest rates?

If the Fed decides to keep interest rates constant, it must "monetize" the debt by expanding the money supply through open market operations (that is, the Fed prints money and uses it to purchase government bonds held by the public, causing the money supply to expand and the debt to contract).

That's good, right? Interest rates stay constant, and the government debt is reduced. It would be, except for one thing -- the expansion of the money supply is inflationary. Instead of paying for government spending with an explicit tax increase, it is paid for through a hidden tax -- inflation -- reducing the value of the dollar. People may not connect the change in the value of the currency to the government deficits in the same way they would an explicit tax increase, but the costs are still there. In addition, as we learned after the 1970s, getting rid of inflation once it is present can take a large toll on output and employment.

What if the Fed decides instead to let interest rates rise, and this causes GDP growth and employment to slow or fall into recession? If this happens, and the Fed allows interest rates to rise and economic conditions deteriorate, it will come under tremendous pressure to bring interest rates back down, risking inflation. The real problem, of course, is the government debt, but the pressure will still fall largely on the Fed. If the Fed gives in and reduces interest rates, it sets the economy up for even larger problems in the future.

This is where Fed independence is important. The way to reduce interest rates is to bring the deficit under control, not expand the money supply, but Congress must feel pressure to change before it will act. If Congress has control of the money supply, then given the choice between raising taxes, cutting government spending, creating more debt, and increasing interest rates -- all of which reduce growth and employment -- or printing money, they are likely to keep financing deficits through money creation. This creates inflation and all the problems that come with it, and sets labor and the economy up for big problems when it comes time to bring inflation back under control. If the Fed has control of the money supply and refuses to expand it to bring interest rates down, and if the Fed does its best to make clear that the problem is the government debt, then Congress will have more reason to act.

I suspect the Fed will come under exactly this type of pressure at some point in the future. As the economy recovers and interest rates start rising, the Fed will face substantial pressure to bring interest rates back down to stimulate employment, and its insistence on keeping inflation under control will cause Congress to threaten its independence. Action that does, in fact, reduce independence and give more control to politicians would be a mistake.

Inflation should not be the only goal the Fed cares about, it's obligated to pursue a dual mandate of stable prices and full employment. But inflation does matter, and too much inflation threatens the full employment goal. While the Fed gets accused of caring too much about inflation and not enough about employment, a charge that's at least debatable, history has made clear again and again that politicians don't care nearly enough.

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