Fiscal policy is made by Congress and when a deficit occurs, the Treasury finances it with bond sales. Monetary policy is conducted by the Federal Reserve that independently pursues its legislated objectives – price stability and maximal employment. However, in a little more than a decade we have witnessed two enormous challenges - the Global Financial Crisis (GFC) and the Covid-19 pandemic - to the way economic policy is conducted. As a result, it is now hard to tell monetary and fiscal policy apart.
Is the new normal of very large government deficits and an apparently ever-expanding central bank balance sheet a source of concern?
The figure shows the federal government deficit as a percent of GDP for the past 50 years. From 1970 to 2008, there were deficits in almost every year, but they only occasionally approached 5% of GDP and on average the deficit was 2.4% of GDP. In the GFC, 2009, the deficit soared to 9.8% of GDP. It came down in subsequent years but began to creep up with the Trump tax cuts and soared to 14.9% of GDP in the Covid crisis last year. The Congressional Budget Office estimates that it will be 13.4% this year.
Traditionally, fiscal conservatives held sway in Congress and resisted large deficits. Many liberal economists argued that the fiscal responses to the GFC first by both the Bush and Obama administrations were not big enough and as a result the post-crisis recovery was sluggish. However, fiscal conservatism was nowhere to be seen when the Trump administration pushed through tax cuts in 2017 and when Congress responded to the spring 2020 COVID shutdown by generously and aggressively supporting the economy. Looking past the COVID crisis, there is an increasing awareness that climate change warrants responses that might entail large federal expenditures. Significant government deficits are likely to be baked into the new normal landscape.
Publicly held federal debt has increased from less than $4 trillion at the turn of the century to about $10 trillion in 2010 and over $21 trillion now. As a fraction of GDP, it had not exceeded 50% from the end of World War II until the GFC; it topped 100% in the first quarter of 2021.
Figure 1. Federal Surplus or Deficit [-] as a Percent of Gross Domestic Product (GDP)
Just because something is bigger than it has ever been before does not mean that it must come down. Many countries have higher debt to GDP ratios; in Japan it reached 100% in 2007 and now stands at 184%. The real test is whether a country has difficulty financing its deficits. The Treasury sells untold amounts of bills and bonds without any difficulty. If there was any hint of resistance, we would see it in higher interest rates. The 10-year government bond rate was almost 4% prior to the GFC and has averaged 2.35% since. In both Japan and the US, countries with large corporate and personal saving, government deficits are the sensible way to maintain expenditure and provide important public goods.
Still deficit sceptics will be alarmed and argue that the US can finance its deficits easily because of the dollar’s ‘exorbitant privilege.’ That is the role of the US dollar as the world’s reserve currency and as the unit of exchange for most international trade crates a global demand for dollar assets. Moreover, the demand for safe assets in uncertain times makes it easy for us to issue new dollar debt. The deficit sceptics worry that the Euro and the Yuan might be working hard to take away our exorbitant privilege and that our excessive debt issuance might hasten a loss of confidence in the dollar. Global politics being what they are, it is hard to imagine that other currencies are poised to take over the global role of the dollar soon.
Further, the sceptics will point to the Federal Reserve’s rounds of quantitative easing (QE) both after the GFC and during the COVID crisis and argue that the Fed is helping to finance the deficits. The Fed pays for its purchases of government securities by creating bank reserves. The figure shows that government debt owned by the Federal Reserve Banks almost quadrupled from 2007 to 2017 and doubled again between 2019 and early 2021. The share of all Federal debt owned by the central bank increased from 8% in 2017 to 19% in Q1 2021.
The QE related expansion of bank reserves provides the ability and incentive for banks to make loans and buy assets which leads to deposit creation. Not surprisingly the money supply has increased rapidly. M2 more than doubled between the start of the GFC and early 2020, and it has increased an additional 27% since March 2020.
Figure 2. Federal Debt Held by Federal Reserve Banks (Billions of $)
The expansion of the Fed balance sheet and of the money supply is less worrisome now than it would have been a few generations ago. First, M2 is more of a portfolio choice for individuals and corporations than the transactions medium envisioned by 20th century monetarists. Thus, the causal link from money to inflation has long been broken. Second, the Fed has new tools, such as the interest rate paid on reserves, that it can use to neutralize the effect of QE prices. By paying interest on bank reserves, which the Fed only introduced a decade ago, banks have less of an incentive to use the reserves
Nevertheless, QE and the expansion of the Fed balance can be concerning. First, it drives up asset prices which can create instability (bubbles) in housing and equity markets. Second, the money-inflation monetarist nexus may be broken but it has not disappeared altogether. The potential for inflationary pressures to emerge remains and is already being exacerbated by real sector bottlenecks and shortages. If inflation persists at current levels, above the Fed’s 2% target, increases in interest rates might be called for. In an economy that is still fragile in the wake of the pandemic, the Fed might be unwilling to act.
Both Congress making fiscal policy and the Federal Reserve making monetary policy face serious challenges. Congress moves slowly but the tides are changing and there is a realization that fiscal policy is the proper tool to wield in the face of Covid and climate challenges. We will see a measure of this new reality in just a few months. The suspension of the debt ceiling expired at the end of July and the Treasury, as it has before, is using extraordinary measures to make sure that the legal limit is not breached. However, these measures will be exhausted before year end and Congress will have to show where it stands on the country’s fiscal needs.
As the ratcheting up of its balance sheet seen in the figure indicates, the Federal Reserve is finding its addiction to quantitative easing hard to break. The Fed may be too eager to throw liquidity at any sign of a problem. In fact, the most important responses to the Covid crisis were the fiscal ones taken by Congress which, perhaps uncharacteristically, stepped up to the bat. The Fed on the other hand continues to act as if it is the only game in town. Its QE policy, monthly bond purchases of $120 billion, continues today. Pumping liquidity into the economy is a valuable crisis response but now QE might be a source of fragility and potential inflationary pressures as Fed officials dither about how and when to taper the purchases.
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