September 5, 2024
By Thomas Savidge
Outside of some circles of monetary economists, August 15 often passes by unnoticed. It should be remembered because that date commemorates a massive overnight change in US monetary and fiscal policy. Fifty-three years ago, on August 15, 1971, President Nixon announced to the world that “I have directed Secretary Connally to suspend temporarily the convertibility of the dollar into gold or other reserve assets.” This “temporary suspension” is still in place today.
Since 1971, monetary and fiscal policy have become increasingly entangled. With the “temporary suspension” the final link between the U.S. dollar and gold was severed. With the money supply no longer tethered to the supply of gold on reserve, Congress and the White House were able to place even greater pressure on the Federal Reserve to use monetary policy for political purposes than before.
Any policymaker hoping for fiscal policy reform must also understand monetary policy and the importance of keeping a wall of separation between the two. Sound fiscal policy and monetary policy can be achieved when monetary policy is kept safe from political meddling. Blurring the line between the two spells disaster. As history shows, financing government spending with money printing leads to high inflation and weak economic growth, increasing the cost of living for the average person.
Fiat and Expanding Fiscal Policy
A gold standard provides a check on fiscal policy by limiting the amount of paper money that can be issued by a bank to the supply of its gold reserves. In principle, this means government budget deficits have to be covered by tax increases, spending cuts, and/or issuing debt instead of money printing.
The post-World War II system of international gold exchange was far from an ideal gold standard, however. The Bretton Woods agreement significantly curtailed the gold standard’s fiscal policy check by only allowing foreign governments to exchange US dollars for gold. It also enabled the U.S. government to finance increasing spending in the 1960’s by money printing. Economist Brian Custinger notes, the Bretton Woods system of international gold exchange that had been set up at the end of World War 2 was, “destined to fail. Its loose constraints permitted the US to issue much more money than it could redeem [in gold].” In other words, the U.S. issued more paper money than it could redeem in gold, taking advantage of the weakness of the Bretton Woods system.
Faced with foreign governments losing confidence in the dollar, President Nixon, knowing the U.S. government could not honor its commitments, closed the gold window in 1971. As economist George Selgin notes, as the number of dollars increased, confidence in the US government’s ability to convert dollars to gold also increased. This heightened US policymakers’ concern of a “run on the bank” by foreign governments hoping to dump their dollars for gold and, ultimately, the dollar losing its status as the world reserve currency. The loss of that status would mean the US government’s ability to exert influence on the global economy (as well as over diplomatic relations) would significantly diminish.
The change helped resolve an immediate problem. But it also allowed President Nixon to continue pressuring Fed Chair Arthur Burns to use monetary policy to pursue political goals. This heightened ability to pressure the Fed, combined with tariff hikes as well as wage and price controls, resulted in stagflation, rising inflation combined with rising unemployment.
While the Fed suffered from technical, knowledge, and incentive problems prior to closing the gold window, President Nixon’s removal the last link between gold and U.S. money heightened such problems. The dual mandate of pursuing maximum employment and stable prices by Congress in 1977 did little to help keep politics out of the Fed. The dual mandate created enough ambiguity that the Fed could argue it was actively pursuing one or the other. With no gold constraint, the government was now freer than ever to lean on the Fed to expand beyond its originally designated purpose to take on political causes such as allocating credit to businesses and favored industries that are “too big to fail.”
As I have discussed elsewhere, using monetary policy to finance spending spells disaster. History is littered with examples of governments combining monetary and fiscal policy resulting in inflation and weaker economic growth. From 18th Century Sweden, to post-World War I Germany, Argentina before President Milei, and Turkey under President Erdoğan, the lesson is clear: just because a government can finance spending with money printing does not mean it should.
Entangled: The Federal Reserve and The Treasury
The Preamble of the Federal Reserve Act is clear and limits the Fed’s activities, requiring the Fed “to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.” However, new research confirms what many have observed for years: the Fed has spent most of its time focusing on the ambiguous “other purposes.”
Episodes of the Fed suffering from internal and external pressures to expand are extensively documented in Money and the Rule of Law by Peter Boettke, Alexander Salter, and Daniel Smith. Over the past 20 years, the Fed cited Section13(3) of the Federal Reserve Act, which allows for the creation of “emergency lending facilities,” to justify its actions. Research conducted in the wake of the Fed’s actions in 2008 and 2020 found that these actions blurred the lines between fiscal and monetary policy, with mixed results at best. Now, the Fed is engaged in fiscal policy: it allocates credit in an effort to address income inequality and climate change, among other reasons.
By allowing the Fed to engage in fiscal policy, politicians can have their cake and eat it too. This is most clearly seen in President Trump’s promise of “No Blue State Bailouts” while the Municipal Liquidity Facility provided the State of Illinois and the New York Metropolitan Transportation Authority (two blue states) with billion-dollar loans at below-market interest rates. If those loans had not been repaid, the Treasury was prepared to cover the Fed’s losses with funds from the CARES Act.
Because the Fed treats Section 13(3), writes Lawrence White, “as essentially giving it carte blanche,” there currently little we can do to stop it from further delving into fiscal policy. Meanwhile, Social Security and Medicare face a combined $78.2 trillion shortfall, the national debt has surpassed $35 Trillion, and budget deficits have hit $2 trillion. Politicians, unified by a desire not to make any spending reforms lest they lose an election, have never had a greater incentive to pay these debts and deficits off quickly with surprise inflation.
Rules Help Untangle Monetary and Fiscal Policy
As Vance Ginn and I wrote in a previous post, “Proper constraints will nudge even the worst politicians to make fiscally responsible choices and reduce net interest costs.” These constraints must be constitutional so they cannot be overridden by a simple majority vote.
A fiscal rule like the Swiss “debt brake” could be applied, where government spending is required to keep pace with revenue, spending growth is limited to average revenue growth over a multiyear period, and budgets must be balanced each year. Another type of fiscal rule could constrain taxes and spending to the sum of population and inflation. If only fiscal policy is constrained by rules, however, the government may attempt to work around these rules by printing money.
Economist Scott Sumner notes that a nominal GDP (NGDP) targeting rule could constrain fiscal policy because “the Fed would offset any changes from fiscal policy aimed at boosting aggregate spending in the economy” to keep NGDP growth along its target path. Sumner also notes “However, supply-side policy reforms could still boost real GDP, in which case inflation would slow.” Even if monetary policy was bound by a rule, however, unconstrained fiscal policy would still suffer from the same knowledge and incentive problems it does now. If fiscal policy were not constrained by a rule, policymakers could manipulate NGDP target growth measurements to allow for spending increases.
A return to a gold standard in a decentralized monetary system would offer the best protection against political influence over monetary policy. Research shows that, while transitioning back to a gold standard could be feasibly achieved, there are strong political incentives against returning to it. Absent returning to the gold standard and decentralizing monetary policy, applying constitutional rules to both fiscal and monetary policy can keep the two separate and offer the best chance at respective fiscal and monetary reforms.
Unfortunately, politics appears to be pushing the Fed in the other direction. Whether it’s the Fed discussing climate in line with the Biden-Harris Administration or President Trump’s suggestion that the president play a bigger role in the Fed’s decisions, politicians on both sides of the aisle see monetary policy as a weapon to be won and wielded lest the other side gets to it.
The way around this is to focus on reforming incentives. Milton Friedman, echoing the sentiment of many thinkers, noted, “The important thing is to establish a political climate of opinion which will make it politically profitable for the wrong people to do the right thing.” Perhaps a silver lining of the recent economic turmoil and dire fiscal situation is that people with the political courage to enact the necessary restraints on government such that incentives are realigned to get the wrong people to do the right thing once again.
Thomas Savidge is a Research Fellow at the American Institute for Economic Research. Follow him on X.com at @thomas_savidge.
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