The Interplay of Fiscal Policy and Monetary Control: A Modern Dilemma
In today’s discussions surrounding monetary policy, the focus often drifts into technicalities: Should reserves be scarce or plentiful? Should fintech companies have direct access to the Federal Reserve? What should the nature of those accounts be compared to traditional banks, and to what extent should the Fed maintain its independence? While these queries hold significance, they pale in comparison to the more pressing issue influencing U.S. monetary policy today: the fiscal demands of the federal government.
Currently, the United States is grappling with deficits surpassing five percent of GDP annually, a trend that persists even in times devoid of war or acute crises.
To finance these persistent deficits, the government must continuously mobilize financial resources on a grand scale. Under such circumstances, the hope that monetary policy can remain insulated from fiscal influences becomes increasingly unrealistic. The heightened politicization and centralization of monetary policy we witness today is, in fact, a direct consequence of fiscal dominance: the prioritization of monetary policy in accordance with the government’s borrowing needs.
Historically, the establishment of central banks was not merely about stabilizing prices or adjusting economic fluctuations. Instead, central banks were created as tools for public finance. As noted by Vera Smith, the primary motivation for government involvement in banking stemmed from the ability to use monetary control for state financing. The Federal Reserve, much like the Bank of England before it, functions as a mechanism through which governments gain access to credit markets and maintain the liquidity necessary for public spending.
This dynamic is better understood when we examine the relationship between fiscal deficits, financial markets, and capital formation. Financial markets are not just abstract liquidity systems; they embody claims on real wealth. Their robustness and complexity hinge on the existence of accumulated savings directed toward productive investments. Yet, more often than not, the liquid savings within American society are being utilized to fund the federal government’s current consumption rather than fostering productive investment.
When savings are allocated to entrepreneurial initiatives, infrastructure, innovative technology, or capital goods, the productive capacity of society expands. This leads to the creation of additional wealth beyond current production capabilities. Conversely, when savings are consumed by chronic federal deficits, these resources are squandered rather than invested. While Treasury securities may enjoy financial liquidity and political favor, they essentially represent claims on future taxation rather than new, productive wealth.
This is a contributing factor to why sustained fiscal deficits not only fuel inflationary pressures but also lead to long-term economic stagnation. Financial markets may appear “deep” and liquid, yet beneath this façade, the foundation of productive capital formation is eroding.
The concept of “false rights,” as articulated by Jacques Rueff, remains highly relevant in this context. This notion refers to the political system’s creation of claims on wealth without actually generating corresponding value. Through monetary expansion and deficit financing, governments can mobilize existing resources while masking the transfer from producers and savers to government consumption.
Given these circumstances, the aspiration for a depoliticized monetary system becomes futile while fiscal irresponsibility remains rampant. As long as the federal government relies on continuous large-scale borrowing, monetary institutions will inherently be involved in managing public debt. Although the Federal Reserve may assert its independence, its operational autonomy becomes increasingly tenuous when the stability of public finances hinges on low interest rates, ample liquidity, and orderly Treasury markets.
It is important to clarify that I do not challenge the genuine commitment of the recently appointed Chairman Warsh to the Fed’s independence or a sound monetary policy. My contention lies with the constraints under which he—and his predecessor—must operate.
This does not imply that all government monetary powers are illegitimate. As I have argued elsewhere, there are both economic and moral imperatives that prevent a sovereign political society from entirely relinquishing control over money and finance. National defense requirements can create exceptional circumstances where governments may require swift access to resources beyond typical taxation. In times of true emergency, a fiscal proviso exists, allowing political communities to temporarily subordinate monetary norms to survival.
However, the principles suited for emergencies should not become the standard mode of governance. Ayn Rand wisely noted that moral principles for ordinary life should not be derived from the conduct of survivors clinging to a raft after a shipwreck. This principle applies equally to monetary institutions; extraordinary powers justified during wartime should not morph into permanent features of peacetime governance once the crisis has subsided.
Ideally, the United States should reinstate the constitutional differentiation between fiscal and monetary powers envisioned at its founding. Back then, Congress was entrusted with the power of the purse and the responsibility for public finance, while monetary institutions were expected to facilitate commerce and maintain stable exchange rates—not to perpetually finance structural deficits. Restoring this separation could diminish the politicization of money and bolster both democratic accountability and economic stability.
Yet, such restoration is unattainable without fiscal prudence. The notion of monetary reform devoid of fiscal reform is a mirage. As long as the federal government continues to consume an ever-growing portion of the nation’s liquid savings to finance its current expenditures, monetary policy will remain subservient to fiscal necessity.
The journey towards a more robust monetary order begins not with technical discussions about reserve policies or Federal Reserve governance, but rather with reinstating fiscal discipline within the American republic.
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Leonidas Zelmanovitz is a Senior Fellow with Liberty Fund and teaches part-time at Hillsdale College.
