Fixed exchange rates limit the degrees of freedom for policymakers. The breakdown of Bretton Woods in 1971 removed this constraint on official action, and the results were larger budget deficits and higher inflation. The zero bound on interest rates also posed a constraint on behavior. Until this year, despite the long struggle against deflation, the Bank of Japan never instituted a negative policy rate. 

Since the early days of the Great Financial Crisis, some had warned of limits of monetary policy. Many investors, analysts, and journalists argued that the world had entered a liquidity trap, and monetary policy offered no way out. It would be pushing on the proverbial string, they argued. Japan was the future. 

Such grim scenarios were premature. Ideological constraints were relaxed. A new playbook was written. Unorthodox policies become, well, the new orthodoxy.  From the Great Depression, the federal government’s balance sheet became a permanent way to underwrite aggregate demand. Government purchases account for a third to half of GDP through the high income countries.  From the Great Financial Crisis, the central bank’s balance sheet was employed to expand the quantity of some measure of money when the zero bound of interest rates was respected.  

We anticipate the size and shape of central bank balance sheets will be a semi-permanent feature for years to come. As the situation stands now, it is naive or disingenuous not to appreciate the linkages between fiscal and monetary policy. For example, last year, to service the US debt, the federal government paid about $225 bln.  

The Federal Reserve is the single biggest owner of US debt. As is typically the case, the Federal Reserve, like many central banks, returns some part of its profits to the central government. Last year, the Federal Reserve gave the federal government nearly $100 bln. It amounts to cutting 40% of the government’s debt servicing costs.  

Understanding the Great Financial Crisis as primarily a debt crisis, fiscal policy (federal government’s balance sheet) could not be used in Europe. The EU, ECB, and Germany seemingly prescribed pro-cyclical fiscal policy. Despite the economic shock, governments were forced to accept austerity. ‘A debt crisis could not be addressed by more debt’ was the push back against a caricature of those who advocated a strong Keynesian response of public investment.   

Europe, after an initial half-hearted fiscal effort, has relied on monetary policy. The same is true of Japan, but to a lesser degree.  Since 2011, for example, Japan has consistently added a supplemental spending bill in the later part each fiscal year. Moreover, Japan has been very slow to reduce its budget deficit as a percentage of GDP. The deficit stood at 7.7% of GDP in 2009 and had eased to 6.0% last year.  The US budget deficit peaked higher and last year was less than half of Japan’s.