SORTING OUT MONETARY AND FISCAL POLICIES.

• Author: Levy, Mickey D.

Monetary and fiscal policies have both have gone off track. Excessively easy monetary policy, marked by a massive increase in the Federal Reserve's balance sheet and sustained negative real interest rates, has failed to stimulate faster economic growths but has distorted financial behavior and involves sizable risks. Fiscal policies have resulted in an unhealthy rise in government debt, and projections of dramatic further increases heap burdens on future generations and involve incalculable risks. Monetary and fiscal policies interact in undesirable ways. The Fed's expanded scope of monetary policy has blurred the boundaries with fiscal and credit policies, and the ever-growing government debt may eventually impinge on the Fed and its independence.

A reset of monetary and fiscal policies is required. The Fed has begun to normalize monetary policy so, at this point, a shift in fiscal policy is much more pressing.

The Fed must continue to raise interest rates and unwind its balance sheet but be more aggressive than indicated in its current strategy. The Fed should aim to reduce its balance sheet to the point in which excess reserves are kept relatively low, and it should fully unwind its holdings of mortgage-backed securities (MBS). A full normalization of monetary policy would benefit economic performance and improve financial health. Equally important, the Fed must acknowledge the limitations of monetary policy and step back from policy overreach, including removing itself from credit allocation policies and toning down its excessive focus on short-term fine-tuning.

The longer-run projections of government debt are alarming and must be taken seriously. General government debt has risen to 100 percent of GDP, up from 61 percent before the 2008-09 financial crisis, while publicly held debt, which excludes debt held for accounting purposes by the Social Security Trust Fund and other trust funds, has risen to 78 percent from 40 percent. The Congressional Budget Office (CBO) estimates that under current law, the publicly held debt-to-GDP ratio is projected to rise to nearly 150 percent by 2047. Congress must develop and implement a strategy that guarantees sound longer-run finances. This requires tough choices, particularly as it addresses the ever-growing entitlement programs, but the costs of inaction are rising. Many acknowledge the risks of rising debt for future economic performance, but in reality the burdens of the government's finances are already affecting current economic performance and the government's allocation of national resources. Witness how the persistent increases in entitlement programs and concerns about high government debt squeeze current spending on infrastructure, research and development, and other activities that would enhance economic performance. Under current laws, these budget constraints--those at the federal level as well as those facing state and municipal governments--will only increase in severity.

Congress's fiscal agenda must be two-pronged. First, Congress must develop and enhance programs and initiatives that directly address the sources of undesired economic and labor market underperformance while restructuring and trimming spending programs that are ineffective and wasteful. This requires transforming the government's annual procedure of budgeting of appropriations for the array of the so-called discretionary programs and dealing with the entitlement programs from a "deficit bean-counting" exercise into a strategic process that carefully assesses the structure of key programs and their objectives--whether they are meeting their policy and social objectives; whether they are doing so effectively; their unintended side effects; and how they may be enhanced, modified, and cut.

Second, Congress must enact laws that gradually phase in reforms of the entitlement programs that constrain the projected growth of future spending in a fair and honest way, improving the benefit structures of the programs with the objectives of protecting lower income retirees and providing sufficient time for older workers to plan for retirement.

The Proper Roles of Monetary and Fiscal Policies

I fully understand the frustrations stemming from the underperformance of the economy in recent years--the sizeable pockets of persistently high unemployment and low wages facing many working-age people, and weak trends in business investment and productivity that underlie disappointingly slow growth. We all want better performance. But the issue is how to achieve it.

Neither the Fed's sustained monetary ease nor high deficit spending addresses structural challenges facing labor markets, business caution in expansion and investing, weak productivity, and other critical issues. This is particularly apparent with the unemployment rate at 4.3 percent, below standard estimates of its "natural rate" (so-called full employment).

The reality is monetary policy cannot create permanent jobs, improve educational attainment or skills, permanently reduce unemployment of the semi-skilled, or raise productivity and real wages. Rather, monetary policy is an aggregate demand tool. The major sources of underperformance involve structural challenges that are beyond the scope of monetary policy to address. Yet in recent years, there has been excessive reliance on the Fed. All too frequently, analysts and observers opine "fiscal policy is dysfunctional so the Fed has to ease policy." This assumes that monetary policy and fiscal policy are two interchangeable levers. They are not. Monetary policy is not a substitute for fiscal policy. Monetary policy involves the Fed's control of interest rates and the amount of money in the economy, which influences aggregate demand and longer-run inflation.

Fiscal policy operates differently. Government spending programs and tax structures allocate national resources--for income support, national defense, health care, public goods like infrastructure, and an array of other activities--and create incentives favoring certain activities while discouraging others. In a critical...