Apparently fiscal and monetary cooperation is alive and well – the US Treasury and the Federal Reserve conspired to kill the platnium coin idea. In retrospect, we should have seen this coming. As the debate continued, it became increasingly evident that the platinum coin threatened the conventional wisdom in very deep and profound ways. It was a threat that could not be endured by Washington.
This realization hit me this morning, working on my last piece. Begin with the effectiveness of monetary policy at the zero bound. Or, more accurately, the lack of effectiveness as the Federal Reserve is swapping one zero-interest asset for another. Rarely do we take this to its logical conclusion for fiscal policy: If there is no difference between cash and Treasury bonds, why should we issue bonds at all? Why not simply issue cash? In other words, at the zero bound, what is the argument against monetizing deficit spending?
Indeed, the lack of any difference explains how Japan can sustain massive fiscal deficits year after year. At the zero bound, cash and government debt are the same thing. We would assume that as long as inflation was not a concern (which it wouldn’t be at the zero bound), the fiscal authority could issue as much cash as it wants, so why couldn’t it issue as many bonds as it wants? After all, at the zero bound the two are equivalent. Hence Japan continues to defy predictions of doom despite ongoing debt issuance.
Carrying the argument further, the illusion of a difference between cash and debt at the zero bound is counterproductive because it prevents the full application of fiscal policy. Fears about the magnitude of the government debt prevent sufficient fiscal policy, but such fears are not rational if debt and cash are perfect substitutes. If cash and debt are the same, the fiscal authority should prefer to issue cash if debt concerns create a false barrier to fiscal policy. Still, I would argue that this is best done in cooperation with the monetary authority. Note that this is not really a new idea, as then Governor Ben Bernanke drew a similar conclusion with regards to Japan:
However, besides possibly inconsistent application of fiscal stimulus, another reason for weak fiscal effects in Japan may be the well-publicized size of the government debt…In addition to making policymakers more reluctant to use expansionary fiscal policies in the first place, Japan’s large national debt may dilute the effect of fiscal policies in those instances when they are used….My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt–so that the tax cut is in effect financed by money creation.
And then we come to the platinum coin, which threatened to expose the illusion that cash and debt are different at the zero bound. By extension, the platinum coin threatened to expose as folly any near-term deficit reduction plan. If you could issue a coin to support near term spending without inflationary consequences, what exactly is the rational for tighter policy now? There is none – but that would run directly contrary to the conventional wisdom among Very Serious People on both sides of the aisle that the debt needs to be addressed right now.
And just think about what it would mean for the Fed if it became evident that, even if only temporarily at the zero bound, deficit spending could be monetized with no impact on inflation. The lines between monetary and fiscal policy would blur further, threatening the existing state of affairs in Washington. Monetary policymakers would face an increasingly hard time defending their need for independence as akin to an Eleventh Commandment.
Ultimately, I don’t believe deficit spending should be directly monetized as I believe that Paul Krugman is correct – at some point in the future, the US economy will hopefully exit the zero bound, and at that point cash and government debt will not longer be perfect substitutes. Note that Greg Ip disagreed with this point:
I disagree. The Fed does not have to sell its bonds, or the $1 trillion coin, to control inflation (though it may do so anyway). It only needs to retain control of interest rates, and that does not depend on the size of its balance sheet.
Ip argues that interest on reserves gives the Fed the power to control interest rates, and consequently the power to control inflation, regardless of the size of the balance sheet. If you follow Ip’s analysis through to its logical conclusion, then why should the Treasury issue debt at all? Why not just issue platinum coins? Could cash and government debt combine to serve the same functions together that they serve separately? Consider the disruptiveness of that outcome to the status quo.
Bottom Line: The platinum coin idea was ultimately doomed to failure because neither the Federal Reserve nor the Treasury could allow for even the remote possibility it might be successful. Its success would not just alter the political dynamic by removing the the debt ceiling as a threat. The success of a platinum coin would fundamentally alter the conventional wisdom about the proper separation of fiscal and monetary policy and the need to control the debt immediately.