During Congressional testimony in February, Republican Senator Joe Kennedy tried to pin U.S. Federal Reserve Chairman Jerome Powell down on whether or not he supported the $1.9 trillion stimulus plan. Powell responded: “On every public occasion when I’ve been asked about it, I’ve said that it’s not appropriate for the Fed to be playing a role in these fiscal discussions about particular provisions in particular laws.” Throughout the hearing, he dug a moat around the bank’s narrow price stability mandate and refused to comment directly on anything that might fall outside of it.
This separation of fiscal and monetary policy also featured in a heated discussion in Indonesia several months ago. During the Asian Financial Crisis, the collapse of the rupiah plunged Indonesia into a balance of payments crisis and subsequent IMF-led reforms formalized the policy independence of Bank Indonesia. This was intended to insulate the country’s central bank from political influence as it carried out its mandate to keep the currency stable.
But in late 2020, on the heels of a controversial omnibus bill that expands centralized state power in the name of economic development, a proposal was floated to establish more direct government control over monetary policy. Many commenters were quick to characterize the effort as an attack on the independence of the central bank, and framed it as a negative that would shake market confidence and lead to the looting of public coffers. Under such blowback, the proposal was shelved.
But why should central banks be walled off in their own autonomous policy space in the first place? Why shouldn’t monetary and fiscal policy be actively coordinated? Why must central bankers like Jerome Powell pretend they have no opinion on enormous fiscal stimulus packages or tax cuts? The rise of monetary at the expense of fiscal policy reflects the victory of Milton Friedman’s monetarist philosophy that economic activity is best regulated through simple and neutral policy tools like the rate of interest.
Essentially, monetarists believe that there is one, or maybe several, natural rates of interest, the rate at which economic growth can be maximized with stable inflation. Because this is believed by some to be a natural but unobservable threshold, it naturally follows that setting interest rates is best left to a neutral arbiter who will manage policy in a clinical manner. This is why central banks have become increasingly independent from the supposedly dirtier political skulduggery of fiscal policy, left to their own technocratic devices to chase the perfect interest rate in equilibrium. In emerging markets like Indonesia, the goal is usually to use these same neutral policy tools to dial in an optimal exchange rate.
But what if there is no natural rate of interest? What if these supposedly neutral policy rates actually reflect political choices made by human beings based on their best judgement? If that’s the case, then the logic of keeping fiscal and monetary policy sequestered from one another begins to weaken. Almost 60 years ago the economist Joan Robinson wrote that monetarists were fond of the policy rate because it “conceals the problems of political choice under an apparently impersonal mechanism.” She was aware that this value-neutral approach was appealing precisely because of its impersonality, and she rejected it, writing: “There is no simply right policy; it is all a matter of judgement.”
If that’s so, then such judgements should be made in close coordination with fiscal authorities, especially elected officials who are accountable to voters. Bank Indonesia is currently monetizing billions of dollars of government debt as the country runs big deficits to fund COVID-19 stimulus efforts. Such an operation demands tightly coordinated action between the central bank and fiscal authorities, and there is nothing inherently wrong with that. We’ve been conditioned to think otherwise, but fiscal and monetary policy are natural complements so why shouldn’t they be more actively coordinated?
The precise form of such an arrangement is of course an open question. But the technocrats at Bank Indonesia who actually make policy are very good at what they do. It’s unfair to assume that weakening the divide between fiscal and monetary policy would automatically result in mass pilfering, and if markets balk at such coordination that merely highlights the problems with letting Mr. Market have the final say on sovereign monetary policy. The dividing line need not be demolished, but that the mere mention of tighter central bank control was rejected out of hand in Indonesia reveals the extent to which Milton Friedman is still living in all of our heads. And much like with Daylight Savings Time, the reasons why this should be have seemingly been forgotten.