The Monetary and Fiscal Mechanism
Part 1 of this blog series focused on the distributive aspects of taxation: public goods and the market failure that they address; why it is preferable that taxes be progressive and relative to income and wealth; the political and economic case for taxing capital and redistribution; and the economic and distributive implications of tariffs. This part segues into the overall monetary and fiscal mechanism, introducing the reader to central banking, fiat money, and how the present arrangement of central banking and treasury functions is a compromise to mitigate moral hazards and limitations.
Since the turn of this millennium, the Great Recession and the COVID-19 pandemic have catastrophically disrupted global production, trade, and investment systems. Governments and central banks across the world responded to these crises through a diverse set of fiscal and monetary prescriptions aimed at stabilising employment, inflation, demand, and growth. Deferment of tax collection and debt obligations, direct and indirect fiscal stimulus, financial bailouts, credit expansion, and unconventional ‘quantitative easing’ are some of the measures employed during these episodes.
As the macroeconomic consequences of unabated bailouts, stimulus, and expansion played out, four major precarities emerged. First, wealth and income inequality around the world has been severely exacerbated during this period.[i] The second challenging condition is that the trade-off between prices and employment reflected in the Phillips Curve is either flattening or worsening, leading to stagflationary conditions.[ii] Third, the trade-off between price stability on the one hand and interest rates, stimulus, and monetary expansion on the other is becoming unsustainable in the long run due to the uncoupling of growth and productivity.[iii] Finally, there is the mounting public and private debt situation that needs to be addressed.[iv]
The fiscal and monetary domains are conventionally assumed to be discrete. The normative justification for the distribution of decision-making powers is located within the political discourse on separation of powers and accountability through a system of checks and balances.[v] This may be due to the limits of the knowledge and information possessed by any one decision-maker, as well as the moral hazard of unilateralism and state capture by special interest factions. As per this constructed division, it has been assumed that public revenue and spending are within the fiscal domain, except for the lending role played by central banks.[vi] However, the measures adopted since the Great Recession reflect a reinterpretation of public finance and the consolidation of monetary and fiscal functions. After decades of monetary autonomy, the need for fiscal and monetary coordination has become prominent since 2008. This coordination has proven challenging due to macroeconomic dogma and a lack of clarity about the real constraints of a fiat currency. In this part of the series, we first examine the separation between monetary and fiscal domains and then the moral hazards and limitations of central banks and fiscal authorities and how these affect money creation and public revenue/ spending.
- The Separation
1.1. Monetary Mechanism
1.1.1 Functions and Organisation
The monetary mechanism in contemporary economies is within the remit of central banks. This makes central banks responsible for at least three interrelated functions. First, liquidity management within the economy. Central banks undertake active management of the supply of and demand for money and debt in the private and public sector.[vii] Decisions on interest rates, open market operations, reserve requirements, and monetary financing are made with this responsibility in view. Also, as liquidity is impacted by cross border financial flows, which are in part influenced by exchange rates, management of exchange rates and foreign exchange reserves is included within the domain of central bank decision-making.
Second, credit intermediation. Central banks normally do not deal directly with economic actors and entities; they authorise commercial banks to perform financial operations on their behalf. Commercial banks are the most significant instrumentalities of monetary transmission. They perform three prominent macroeconomic functions:
- Credit expansion through the fractional reserve system: central banks prescribe overall lending norms that are supplemented with the additional criteria adopted by commercial banks. They are entrusted with ensuring that the quantity and quality of credit expansion are as per these norms.
- Credit intermediation for channelling savings and investment: commercial banks ensure that the savings of households, individuals, and firms are matched with suitable borrowers, thereby ensuring substantial cost savings for both parties.
- Investment-intermediation and investment on its own behalf: banks invest on behalf of individuals and other institutions; they also invest in assets in the same way as households, individuals, and firms. This carries significant moral hazard and has both macroeconomic as well as distributive implications.[viii]
While banks and other financial institutions are instrumentalities of credit intermediation (as explained above), central banks play a critical role in ensuring the flow of credit by providing deposit insurance and being the lender of last resort. These functions reduce the transaction costs of credit both ex ante (by instilling confidence in savers and creditors) and ex post (by reducing the impact of bank runs/bank failure).[ix]
Third, banking supervision. The network of commercial banks is the means by which money is transmitted through the financial and economic systems. The significance of this is often underemphasised within neoclassical economics. Commercial banks are the default mode of transmitting and managing public spending as well. Both crediting to and transferring money from government accounts are made possible by this network of institutions. Taxes and other government revenue are also credited to and debited from accounts held in commercial banks. The transmission of both monetary and fiscal decisions, therefore, depends on their existence. Central banks are responsible for regulating the banking sector by setting prudential requirements (e.g., minimum capital requirements, liquidity ratios) and monitoring them for compliance.
The exact scope of central bank decision-making, in any jurisdiction, will depend upon the specific law adopted for this purpose. In India that law is the Reserve Bank of India Act, 1934 (‘RBI Act’). In addition to this, the relationship between the RBI and the banking system is governed by the Banking Regulation Act, 1949. Subject to the overall legislative framework, a wide discretion is vested with the central bank in carrying out these functions. As the monetarist prescriptions of strict, rule-based approaches to decision-making have limited practicability,[x] the discretion of central banks is sought to be guided by statutory objectives. Initially, the target of monetary policy in the fiat system was the total quantity of money in the economy. This gave way to price stability as the primary criterion of monetary policy. In view of the expected trade-off between inflation and employment (Phillips Curve), maintaining employment and growth are also often included within the remit of central banks. Since the Great Recession, maintaining financial stability has been added to central bank objectives. It is possible to think of other qualitative targets as well such as distribution and sustainability, but it is well understood that the possibility of achieving these exclusively through monetary means is limited.
1.1.2 Classification of central banking models
Most jurisdictions have a unitary central bank (such as in India).[xi] There are, however, notable variations. Both the United States and the European Union (‘EU’) have sui generis structures. The American Federal Reserve system (‘Federal Reserve’) has both public and private aspects. It comprises the Board of Governors (an ‘independent’ federal government agency), 12 regional Federal Reserve Banks (which are set up as private corporations owned by commercial banks that are referred to as member banks) and the Federal Open Market Committee (members are selected from across the Federal Reserve System). The EU’s central banking system has a two-tiered structure. The narrower ‘Eurosystem’ – consisting of the European Central Bank (‘ECB’) and the national central banks of the 20 member states in eurozone – is the monetary authority.[xii] Monetary policy decisions are transmitted by the ECB. The wider European System of Central Banks (‘ESCB’) consists of the ECB and the national central banks of all 27 EU member states. This secondary institution is tasked with maintaining price stability and coordination within the system. Supranational monetary unions exist in some other parts of the world as well. The Eastern Caribbean Central Bank, the Bank of Central African States, and the Central Bank of West African States manage common currencies and monetary mechanisms for their member states.[xiii] The broad aim of these banks is to maintain price and financial stability.
1.1.3 Political challenges
The different central banking models in existence underline the potential for political conflict between integration and sovereignty that is embedded within monetary mechanisms. When otherwise sovereign nations integrate themselves into a monetary union, it represents a challenge to the autonomy and self-interests of the member states. Within the EU, a complex mechanism involving the central banks and finance ministers of the member states administers the monetary mechanism along with the ECB. This provides a de jure safeguard for the interests of individual states, even though its efficacy has often been doubted.
These are minimum safeguards that are needed when a central bank performs monetary functions for otherwise sovereign states with potentially divergent and conflicting economic interests and political goals. The member states of the EU have merely agreed to a monetary union; they have not surrendered their sovereignty to the ECB. While this fact is obvious in the case of the member states of the EU, it is also relevant to a certain extent for countries elsewhere whose political systems are federal in nature, as in India’s case. There is substantial awareness about the legal, economic, financial and political implications of insufficient fiscal resources for states in India. Constitutional experts, the higher judiciary and individual states have taken up this cause – historically and especially over the last decade.[xiv] However, the implications of consolidating the monetary mechanism within central banks for federal entities have not been adequately articulated or evaluated.
1.2 Fiscal Mechanism
1.2.1 Functions and Organisation
The remit of fiscal decision-making covers decisions over public spending; collection of public revenue (mainly taxation); and maintenance of public debt.
While central banks are the universal monetary authority in contemporary economies, the components of the treasury are jurisdiction specific. In India, fiscal decision-making is the responsibility of the Ministry of Finance (for the Union) and the Finance Department (at the state level). The functions of each are detailed in the allocation of business rules.[xv] In performing these functions, they are subject to constitutional arrangements regarding – (a) the approval of the expenditure and receipt budget (for proposed spending and corresponding appropriations from the Consolidated Fund); (b) the distribution of taxation powers as well as the revenue collected; and (c) borrowings and public debt.[xvi] These are supplemented by statutes, such as those governing the levy and collection of taxes (e.g., the Income Tax Act, 1961; the Goods and Services Tax Act, 2017) and public debt (e.g., Fiscal Responsibility and Budgetary Management Act, 2003 (‘FRBM Act, 2003’)).
1.2.2 Classification
The fiscal mechanism in India is contained within the Ministry of Finance and Finance Department and does not have any institutional independence as such. While, the legislature can hold the government accountable for its fiscal decision-making[xvii] that position is not backed by any real authority. In the United States, on the other hand, the Department of Treasury was created by legislation, thereby giving it a distinct legal identity. That does not, however, make it an independent institution in reality. The difference between India and the US is that, in certain aspects, the Treasury in the US is accountable to Congress[xviii] in reality (unlike in India).[xix] Later in this series, we will elaborate on how accountability in certain cases is preferable to institutional independence within public finance.
In the United Kingdom, while the Treasury is treated as a part of the government, it has retained a set of de facto practices and outlook about the government’s taxation, spending and economic policy – referred to as the Treasury orthodoxy. Nonetheless, this element of institutional autonomy cannot be taken at face value for at least two reasons. First, the control over public finance exercised by the Treasury in the UK can be viewed as an economic dogma that is equally problematic for both progressive and conservative politics.[xx] Second, this so-called control by the Treasury is simply an unwritten practice without any legal safeguards to it. The Treasury could not prevent the Liz Truss government from enacting a disastrous mini-budget in 2022 (discussed below in 2.2).
1.2.3 Recent History
The conventional narrative and expectation about public finance is that governments’ responsibility for budgeting is similar to that of individuals, households, and firms; spending more than they collect as revenue requires borrowing and leads to increased debt. The capacity for public spending, therefore, would be a function of the tax revenue raised and the prescribed statutory limits on public debt. However, the history of debt monetisation by central banks belies this theoretical constraint on money creation. The US Federal Reserve was only nominally independent until 1951. The US Treasury Department routinely pressurised the Reserve into using monetary expansion to allow the US administration to manage its debt situation. After decades of interference by the US Treasury, the 1951 Treasury-Fed Accord was intended to prevent further abuse of the monetary mechanism for temporary political gains by the US administration.[xxi] In India, prior to 1997, government debt was routinely monetised by the RBI. This arrangement was finally altered by an agreement between the RBI and the Union government in 1997 which prohibited direct RBI support for government borrowing; and, this agreement was reinforced by the specific targets set under the FRBM Act, 2003.[xxii]
Although the prohibition against direct monetisation of public debt has not been formally erased in the aftermath of the Great Recession and the Covid Pandemic, the concept of fiscal responsibility has been eviscerated. Emergency monetary financing in response to these crises supported massive and sustained fiscal expansion. This in turn led to persistent breaches of fiscal discipline targets in most countries, including India.
Against this backdrop, tethering public spending to legislated budgetary constraints would have made fiscal policy less responsive than was needed under the circumstances. Keynesian interpretations emphasise the relationship between output, growth and price stability ;[xxiii] public spending is largely responsible for the capital formation needed for this growth.[xxiv] Fiscal discipline that is not compatible with the fiscal investment multiplier effects of public spending is, therefore, counterproductive. Moreover, proponents of alternative monetary explanations argue that monetary dogma forces governments to forgo spending decisions that may be necessary to meet public needs in the cause of imaginary fiscal prudence.[xxv] The different interpretations of financial constraints and (mis)allocation that apply to a government issuing its fiat currency will be addressed in Part 3 of this series.
1.3 Credit Policy
Fiat money and public finance has been largely interpreted in view of the monetary-fiscal binary. This binary interpretation is a quantitative approach that obfuscates and distorts the qualitative aspects of the money mechanism. The balance sheet treatment, liquidity implications and risk assessment of the money that is created by central banks is subject to the credit policy decisions of both central banks and governments. Since central banks can potentially finance government expenditure, there is a pronounced conflict-of-interest inherent within credit policy.
Central bank credit policies include discount window lending to individual banks based on the collateral posted by them. While both the assets and liabilities of the central bank increase due to this, it does not necessarily increase the balance sheet. The central bank can potentially ‘sterilise’ the discount window loan by selling treasuries from its portfolio to offset the transaction.[xxvi] This is essentially indirect fiscal policy; the resulting composition of central bank assets would carry more risk than earlier. Another aspect of central bank credit policy is foreign exchange interventions. Whether such interventions are sterilised (or not) has implications for balance sheets and liquidity.[xxvii]
Credit policy can be exercised by the government or the legislature as well. Credit policy on the fiscal side is a function of the treasury, but the absence of an independent treasury often results in political decisions instead. The temporal composition of public debt is a crucial aspect of debt management. The treasury is supposed to manage the spread between long- and short-term treasury instruments and ensure smooth refinancing of public debt, if needed. It needs to ensure that the temporal supply of debt instruments is optimised for cost of borrowing and sustainability of tenure. For instance, around $9 trillion of US government debt is slated for maturity in 2025. The US Treasury will need to ensure that the debt is refinanced through an adequate and optimal spread of long-to-short terms instruments. However, the massive supply-demand gap this represents, and the recent tepid demand for long-term US debt in particular, have made this challenging. The pressure on the US Treasury has increased even further due to the US government’s $1.9 trillion spending deficit in FY 2025, which is slated to increase steeply due to the additional spending proposals and tax cuts contained in the One Big Beautiful Bill Act. This means that the interest rates of borrowing will be higher than earlier, thereby increasing the debt servicing burden.
Any loans or loan guarantee made to a private entity by either the government or the legislature is a politically motivated credit policy decision. This exposes taxpayer funds to a risk in case the private entity is unable to repay the loan. A notable case in the US was in 2009, when the US Department of Energy made a loan guarantee of $535 million to Solyndra Corp., a manufacturer of solar panels. Solyndra filed for bankruptcy in 2011, resulting in a loss of $528 million to the taxpayer. In India, the Union government operates several credit guarantee schemes for,inter alia, micro and small enterprises, startups and low-income housing.[xxviii] State governments have similar schemes of their own. While some of these are motivated by distributive and socioeconomic concerns, the element of risk and the attendant moral hazard cannot be ignored. Oversight and implementation of credit policy, therefore, remains a major concern within the money mechanism
- Moral hazards and limitations of the government and the central bank
2.1 Moral hazard
2.1.1 Moral hazard of the fiscal authority (political incumbent)
The political moral hazard within electoral democracies is that public spending could be motivated by a government acting with a short-term view towards ensuring its popularity and re-election, instead of by tangible needs and purposes.[xxix] This moral hazard is referred to as the ‘incumbent problem’ of public spending. The narrow interpretation of the incumbent problem was developed and formalised by William Nordhaus as the ‘political business cycle’ (‘PBC’) – pre-election spending (or tax cuts) by the incumbent creates a short-term boom, followed by a subsequent downturn as the stimulus tapered off.[xxx]
Nordhaus’s PBC theory is a realist explanation of political behaviour – political actors are guided by their own self-interest above all else. The political incumbent will seek to exploit the trade-off between employment and inflation, leading up to the elections by artificially boosting employment.[xxxi] This is likely to increase inflation, and the new incumbent will, therefore, be forced to implement austerity measures after the election – thereby increasing unemployment once again. However, political actors (parties; coalitions) may have differing ideological/electoral considerations in deciding how to manipulate voters. Progressive parties, by and large, tend to pursue higher employment, while conservatives push for lower inflation. Progressives provide greater representation to the interests of those who consume public goods, whereas conservatives claim to represent the interests of taxpayers and property owners. Consequently, the pre-election PBC will differ depending on the party/coalition in government – progressive incumbents will favour stimulus spending, while conservative ones will focus on tax-cuts to make themselves popular with voters – this leads to a ‘partisan’ PBC .[xxxii]
Since the value of money in the fiat framework is not constrained by finite reserves of gold, unfettered money creation by the central bank or through the fractional reserve system can devalue the currency altogether. Germany endured hyperinflation against the backdrop of moving away from the gold standard on the eve of World War I .[xxxiii] In recent years, Zimbabwe has experienced a similar situation.[xxxiv] Several countries have struggled with inflation due to massive public spending and money creation in the aftermath of the Covid Pandemic.[xxxv] While the preceding circumstances in these situations have been diverse, irresponsible political short-termism has definitely been a contributing factor.
However, it is pertinent to note that the political moral hazard within electoral democracies cannot be explained away entirely by the PBC and irresponsible stimulus provided during emergencies. Due to State and institutional capture by partisan thinking, the interests of select interest groups will be promoted over others. As mentioned above, progressives tend to prioritise spending and transfers, whereas conservatives favour tax cuts and other benefits for the wealthy. Also, the idea that politicians only need to influence voters is inaccurate, especially within electoral systems where elections cannot be won without the financial support of a donor class. Regardless of the PBC, both the incumbent and the opposition will try to protect and forward the interests of those who fund their election campaigns. In many countries (like in India and the US), the ultra-wealthy end up paying relatively lower taxes than middle-income earners today.[xxxvi] They also corner most of the tax incentives on offer.[xxxvii] The bulk of public spending (selective infrastructure, loans and financial incentives) and forgone revenue (concessions, free land and other waivers; subsidised energy and utilities) are in favour of the donor class that funds our electoral system.
There is an excessive focus on the moral hazard aspect of political decision-making, especially within democracies. The positive aspects of democratic accountability, however, are not duly emphasised. Aristotle mentioned the ‘wisdom of the crowd’ in The Politics ;[xxxviii] and Condorcet elaborated on this in his ‘jury problem’.[xxxix] Collective decision-making is a better approach in many circumstances, especially when dealing with contentious and subjective choices. Also, political voting and legislative bargaining are effective safeguards for minority interests in societies with significant adversarial plurality and material inequalities.[xl] While the fiscal side may be susceptible to many ills, voting and bargaining within democracies also allow for greater wisdom and accountability, thereby curbing the worst excesses of partisan decision-making.
2.1.2 Moral hazard of the monetary authority (central bank)
Public spending and the resultant debt are not the only moral risks within the fiat framework; money creation through the fractional reserve system and private debt can be equally responsible for inflation and macroeconomic instability. Ludwig von Mises and Friedrich Hayek identified the tendency towards unsustainable credit expansion within the fractional reserve system due to low-interest rates as the initiator of business cycles and eventual economic contraction.[xli] Japan’s experience of an asset bubble crisis in the 1980s is the most well-known example of speculation following monetary expansion.[xlii] Persistently low-interest rates that are aimed at economic growth through monetary and credit expansion initiate a cycle of credit and asset misallocation experienced as a business cycle. The Keynesian and Monetarist explanations for business cycles are framed from differing perspectives, but the risk of resource misallocation due to misdirected investment is generally agreed upon as a primary risk factor.
The monetary and credit expansion undertaken in response to the Great Recession and COVID-19 Pandemic crisis included low-interest rates and asset purchase programmes. The assumption that this will lead to investment in the real economy, resulting in a broader economic recovery, has been belied by data.[xliii] Productivity growth in the real economy has declined since the interventions were made, and this decline was compounded after the Covid Pandemic crisis. The easy money thrown at the crises improved the market performance of large corporations, but the ensuing profits were mostly distributed as dividends or used for share buybacks, thereby further boosting share prices and investor wealth.[xliv] There is evidence that low-interest rates did not work as anticipated due to existing income and wealth distribution, and they contributed to a further increase in these inequalities. While the results of monetary and fiscal measures did show variations depending on the context, the general experience mentioned does hold up to scrutiny. The data on productivity, profit transfer, and inequality show that a monetary policy aimed at corporate bai-outs can be counterproductive in the medium-to-long term .[xlv]
The assumption that economic and political decision-making is based on rational self-interest extends to central bankers as well. In the absence of safeguards, central bank decision-making is not free of the risk that the interventions are discretely focused on meeting the specified statutory targets/objectives without attention to the overall costs of the decision (especially negative externalities).[xlvi] Apart from institutional success, central bankers may prioritise personal (career) goals, leading them to make decisions that would align with the interests of their prospective principals.[xlvii]
2.2 Limitations
In The Use of Knowledge in Society, Friedrich Hayek mentioned the demerits of a centralised price mechanism.[xlviii] According to Hayek, no single economic actor possesses information about all the factors relevant for pricing. The central bank is only one of several agents within the economy and possesses limited information like others. Its ability towards setting the price of money will, therefore, be limited. This limitation extends beyond the price of money. Central banks administer monetary policy by employing certain macroeconomic variables, known as instruments, to alter other identified variables – known as targets.[xlix] Interest rates, the sale or purchase of bonds, reserve requirements, lending norms, and other monetary policy instruments are used to address price stability, employment and growth of income and demand. However, these variables are not just quantities that can be manipulated through monetary interventions alone. The prevailing economic conditions – level of capital formation, income distribution, availability and productivity of labour and inputs – are qualitative factors that are not within the remit of monetary policy.
Credit intermediation by commercial banks and other financial institutions is contingent on both savings and the appetite to borrow. Robust commercial banking and financial sectors entail banking and capital market regulation,[l] sound accounting practices, debt and insolvency management, risk assessment, statutory audits, and other laws and institutional safeguards that are not under the exclusive purview of either the central bank or the treasury.[li]
Central banks are not mandated to redress conditions of market failure within the economy. Barriers to entry, bargaining, and information asymmetries in specific markets create monopolistic or oligopolistic rent .[lii] Similar conditions in the market for labour demand distort the transfer of income as monopsonistic or oligopsonistic rentrent; this is a prominent reason for the collapse of the Phillips Curve.[liii] The conditions that influence savings/ borrowings and address market failures are contingent upon effective competition laws and regulations; minimum wage and collective bargaining legislations; wealth and income redistribution; targeted capital formation (both public and private) through public spending and the banking system.
Price stability is causally related to both public spending and the fractional reserve system and cannot be managed exclusively through either fiscal or monetary means. The inability to meet inflation targets and other negative indicators can be primarily attributed to reliance on a singular approach towards the money mechanism.[liv] In the period leading up to the Great Recession, central banks generally kept interest rates low; along with a low savings rate, this was credited with high economic (consumption) growth during that period. Creeping inflation was the eventual fallout of this unsustainable consumer spending. The Federal Reserve hiked interest rates in 2004 in response to this inflation, which led to pressure on banks and was a precursor to the lending crisis in 2007–2008.[lv] The banking crisis that unfolded in 2023 was also caused in part by the hike in interest rates and the resulting losses suffered by banks attempting to profit from the yield differential between long and short-term bonds. Commercial banks such as Silicon Valley Bank, Signature Bank, and Credit Suisse traditionally invested in high-yield long-term bonds. As the Federal Reserve and ECB increased interest rates, older bonds with lower yields started losing value in comparison to newer bonds.[lvi] Having relied heavily on the monetary instrument of rate adjustment, central banks had no option but to choose between financial or price stability.
The unilateral decision to either reduce or hike rates to manage price stability has an established recent history of triggering bank runs and market panic. Conversely, the instrumental impact of fiscal expansion or contraction on liquidity and inflation is similar to credit expansion or contraction through interest rates. If fiscal decisions are not coordinated with the central bank’s monetary policy, it may lead to unintended macroeconomic consequences and policy failure. In 2022, an ill-planned tax cut for the wealthy in the UK government’s mini budget was meant as a fiscal stimulus measure; it ended up spooking the markets, and borrowing costs surged instead. The Bank of England had to intervene through the emergency purchase of government bonds to restore stability.[lvii]
Moreover, subjective or contentious macroeconomic decisions can frequently be attributed to ideological preferences. The moral hazard inherent in the Great Recession and COVID-19 pandemic interventions has been mentioned above in 2.1. The decision to implement money creation through asset purchases by the Federal Reserve, ECB, and Bank of England in the aftermath of the Great Recession and COVID-19 pandemic was a ‘trickle-down’ supply-side intervention.[lviii] While it stabilised the economy and markets in the short run, income and wealth inequality have been exacerbated significantly since then.[lix] The poor quality of assets purchased by the Federal Reserve during the stimulus period was the result of a faith-based decision, and its implications for financial markets, as well as its balance sheet and surplus transfers to the federal government, are being realised at present.[lx] These decisions were not taken through a process of consultation with all stakeholders and demonstrate the perils and limitations of ‘monetary unilateralism’.
Key takeaway:
The monetary and fiscal domains are two halves of the fiat money mechanism. The decision-makers on each side employ the available information and instruments towards fulfilment of their respective responsibilities. The institutional arrangement of the money mechanism follows economic causality for the larger part – which means that both the monetary and fiscal sides are effective in their own way. For instance, monetary policy has a more immediate impact on price stability; whereas taxes are more decisive in draining liquidity in a targeted manner. However, the choice between monetary and fiscal instruments is not merely macroeconomic in nature – the moral hazards and limitations of each institution are equally relevant, including the political nature of electoral systems themselves.
[i] Lucas Chancel and others, ‘World Inequality Report 2022’ (World Inequality Lab) <https://wir2022.wid.world/www-site/uploads/2021/12/WorldInequalityReport2022_Full_Report.pdf> accessed 30 May 2025. For granular, country-specific data, refer to the World Inequality Database website.
[ii] Kristen Tauber and Willem Van Zandweghe, ‘A Growth-Augmented Phillips Curve’ (Federal Reserve Bank of Cleveland, 7 February 2020) <https://www.clevelandfed.org/publications/economic-commentary/2020/ec-202016-growth-augmented-phillips-curve> accessed 30 May 2025.
[iii] Marinko Skare and Damian Skare, ‘Is the Great Decoupling Real?’ (2017) 18 Journal of Business Economics and Management 451. Lawrence Summers disputes singular explanations – such as technology – but an overall decoupling of economic activity and productivity has been playing out over the past few decades (Anna Stansbury and Lawrence H. Summers, ‘Productivity and Pay: Is the Link Broken?’ in Adam S. Posen and Jeromin Zettelmeyer (eds), Facing up to Low Productivity Growth (Peterson Institute of International Economics 2019)).
[iv] M. Ayhan Kose, Franziska Ohnsorge, and Naotaka Sugawara, ‘A Mountain of Debt: Navigating the Legacy of the Pandemic’ (2022) Journal of Globalisation and Development 233; ‘General Government Debt Data’ (Organisation for Economic Co-operation and Development) <https://data.oecd.org/gga/general-government-debt.htm> accessed 15 April 2023.
[v] Montesquieu’s identification of concentration of powers with tyranny has widely influenced the organisation of State power. For example, James Madison quotes Montesquieu (with approval) in the Federalist Paper No. 47 on the subject of ‘The Particular Structure of the New Government and the Distribution of Power Among Its Different Parts’, <https://avalon.law.yale.edu/18th_century/fed47.asp.> accessed 1 February 2023.
[vi] Public spending has been, by convention, assumed to emanate either through taxes and other receipts (revenue and capital), or borrowing.
[vii] Within economic theories there is a divide over whether money supply is exogenous or endogenous. This dichotomy is a non-issue for those who do not have to grapple with economic theory, same as the supply-side versus demand-side perspective of economic systems. In reality, the money mechanism exhibits both exogenous and endogenous elements. For this reason, central banks work on both sets of variables under their control – those that will ensure the supply of money as well as those that are necessary to create the demand for money. Also, they need to account for the needs and motives of several classes of economic actors – commercial banks, producers, workers, consumers, and governments. (Arkadiusz Sieron, ‘Endogenous versus exogenous money: Does the debate really matter?’ (2019) Research in Economics 329. Also see Stephanie Kelton, The Deficit Myth: MMT and the Birth of People’s Economy (Hachette Book Group, 2020) (Chapter 1) for an explanation of the spend-tax cycle of government spending, instead of the conventional tax-spend view.)
[viii] Subprime lending for real estate loans is often cited as the trigger for the Great Recession crisis. However, sub-prime lending became attractive as the banks could parcel risky assets into mortgage-backed securities and subsequently, as collateralised debt obligations and swaps – which were then sold to investors unaware of the risks. The Glass-Steagall Act, 1933 ensured a separation between consumer and investment banking, one of the safeguards to ensure that such risky speculation did not occur. This safeguard in the Act was repealed in 1999, which allowed for the instruments and investment strategies that triggered the Great Recession. (Yeva Nersisyan, ‘The Repeal of the Glass-Steagall Act and the Federal Reserve’s Extraordinary Intervention during the Global Financial Crisis’ (Levy Economics Institute, Working Paper No. 829, 2015) <https://www.levyinstitute.org/publications/the-repeal-of-the-glass-steagall-act-and-the-federal-reserves-extraordinary-intervention-during-the-global-financial-crisis> accessed 3 March 2023.
[ix] Paul Tucker, ‘The Lender of Last Resort and Modern Central Banking: Principles and Reconstruction’ (Bank for International Settlements, 2014) <https://www.bis.org/publ/bppdf/bispap79b_rh.pdf> accessed 1 August 2025.
[x] Alan S. Blinder, ‘The Rules-versus-Discretion Debate in the Light of Recent Experience’ (1987) Review of World Economics 399.
[xi] Generally, national governments are the sole subscribers to and holders of the capital of the central bank. However, that does not entail the control and financial interest given to holders of common stock in a body corporate. Control over the central bank (in terms of personnel, policy, and other decision-making) and the right to receive a share of its profits/surplus arise from the applicable law. In other words, the relationship between the government and the central bank is a function of the legal-institutional arrangement and not on account of capital contributions.
[xii] National central banks of EU Member States subscribe to and hold the capital of the European Central Bank.
[xiii] The single currencies are the Eastern Caribbean dollar, the Central African CFA Franc and the West African CFA Franc, respectively.
[xiv] The concept of ‘fiscal federalism’ has gained widespread recognition in recent years. The negative implications of the Goods and Services Tax for state finances has been highlighted (Tushar Chakrabarty and Tanvi Vipra, ‘State of State Finances’ (PRS Legislative Research, October 2023) <https://prsindia.org/files/budget/budget_state_finance_report/2023/State_of_State_Finances_2023-24.pdf> accessed on 31 August 2024). The Supreme Court has been required to intervene in several disputes between the Union Government and states on the issue of financial resources in recent years (Mineral Area Development Authority v Steel Authority of India 2024 INSC 554; State of Kerala v Union of India (2024 INSC 253) (Interim Order dated 1 April 2024)).
[xv] Refer Second Schedule to The Government of India (Allocation of Business) Rules, 1961, for details of responsibilities allocated to the Ministry of Finance. There are separate rules for each state.
[xvi] Articles 112 to 116 read with Articles 266, 267 and 282 (appropriations); Articles 246, 246A, 268 to 274, among others (distribution of taxation and revenue); Articles 292 and 293 (borrowings).
[xvii] As per the Constitution of India, the annual budget has to be laid by the Union Government before the Parliament for approval and grant of appropriations from the Consolidated Fund. (Articles 113 and 114) Further, as per the FRBM Act, 2003, the Union Government is required to submit a variety of fiscal statements before the Parliament that inter alia provide “information on government policies for the ensuing financial year relating to taxation, expenditure, market borrowings and other liabilities, lending and investments, pricing of administered goods and services, securities and description of other activities such as underwriting and guarantees which have potential budgetary implications” (Section 3). A similar arrangement is provided in the Constitution for the budget/appropriations process at the state level. Also, there are state specific fiscal responsibility and budgetary management laws.
[xviii] Section 2 of the Treasury Act, 1789.
[xix] The term ‘accountability’ refers to answerability for decisions to an identified principal. ‘Direct hard accountability’ – where the principal has the power to sanction the decision-making authority for non-compliance with the accountability requirements or omissions/commissions in decision-making – is one model of accountability mechanisms. Treasury’s accountability to the Congress may be viewed as a combination of ‘indirect hard accountability’ and ‘soft accountability’. In the former, though the principal cannot impose sanctions, its authority is meaningful owing to its control over other outcomes that directly concern the decision-maker. For instance, the legislature has control over spending and taxation by the government (through the appropriations process as well as legislative bargaining over other laws, including big-ticket spending and revenue laws). In the case of the latter, public disclosure of information (transparency), responsible media scrutiny, and effective democratic accountability all come together in order to make the principal’s authority meaningful.
[xx] The austerity-minded fiscal policy exercised by the Treasury in the UK has been in place since Margaret Thatcher’s government. Mrs. Thatcher mirrored the neoliberal, ‘small government’ and supply-side outlook that was shaped by Ronald Reagan in the US – informally known as ‘Reaganomics’.
[xxi] The Great Inflation of the late 1960s and 1970s in the US was largely due to the pressure exerted by Presidents Lyndon Johnson and Richard Nixon on the Federal Reserve to support their spending programmes, including the Vietnam War. Admittedly, though, the Great Society initiatives of Lyndon Johnson were laudable in their intent – they were meant to reduce poverty and expand social welfare.
[xxii] M. Ramachandran, ‘Fiscal Deficit, RBI Autonomy and Monetary Management’ (2000) Economic and Political Weekly 3266.
[xxiii]Tauber and Zandweghe (n 2).
[xxiv] Raphael A. Espinoza, Juliana Gamboa-Arbelaez, and Mouhamadou Sy, ‘The Fiscal Multiplier of Public Investment: The Role of Corporate Balance Sheet’ (International Monetary Fund, Working Paper 2020/199, 2020). The counter-cyclical requirement for this fiscal intervention and its implications will be addressed in Part 3 of this series.
[xxv] Warren Mosler, ‘Soft Currency Economics’ (University Library of Munich, 14 February 1995) <https://econwpa.ub.uni-muenchen.de/econ-wp/mac/papers/9502/9502007.txt> accessed 1 July 2024 . In contrast to the monetary approach prevalent among neoclassical economists, proponents of Modern Monetary Theory emphasise the role of the fiscal mechanism in economic production and growth.
[xxvi] Many of the Federal Reserve’s interventions in response to the Great Recession were pure credit policies, as they were largely sterilised. These interventions, therefore, did not increase the balance sheet and did not directly affect monetary policy.
[xxvii] Andrew J. Filardo and Stephen Grenville, ‘Central Bank Balance Sheets and Foreign Exchange Rate Regimes: Understanding the Nexus in Asia’ (Bank of International Settlements, 1 October 2012) <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2185355> accessed 1 July 2024.
[xxviii] The Union government in India has several credit guarantee schemes at present that are aimed at present. Some of these are: a) Credit Risk Guarantee Fund Scheme for Low Income Housing (CRGFS); b) Mutual Credit Guarantee Scheme for MSMEs (MCGS-MSME); c) Loan Guarantee Scheme for COVID-Affected Sectors (LGSCAS); d) Pradhan Mantri Mudra Yojna (PMMY); e) Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE); and f) Credit Guarantee Scheme for Startups (CGSS).
[xxix] The view that ‘public interest’ is the guiding factor of governance in democracies has been superseded for the most part by the realism of ‘public choice’ – that governments in electoral democracies will do whatever is needed to get re-elected. (James M. Buchanan and Gordon Tullock, The Calculus of Consent: Logical Foundations of Constitutional Democracy (first published 1962, Liberty Fund 1999)).
[xxx] Eric Dubois, ‘Political business cycles 40 years after Nordhaus’ (2016) Public Choice 235. Subsequent research work has observed this pattern across a range of political systems (including some authoritarian regimes).
[xxxi] ibid.
[xxxii] Douglas A Hibbs, ‘The Partisan Model of Macroeconomic Cycles: More Theory and Evidence for the United States’ (1994) Economics & Politics 1.
[xxxiii] Jan Thiessen, ‘The German Hyperinflation of the 1920s’ in David Fox and Wolfgang Ernst (eds), Money in the Western Legal Tradition: Middle Ages to Bretton Woods (OUP 2016). Hyperinflation had also occurred in other European countries during the 1920s under similar circumstances – Austria, Hungary and Poland (Andres Solimano, A History of Big Recessions in the Long Twentieth Century (Cambridge University Press 2020)).
[xxxiv] Thomas Stoddard Conkling, ‘Analysis of the Zimbabwean Hyperinflation Crisis: A Search for Policy Solutions’ (The Pennsylvania State University Schreyer Honours College, 2010) <https://honors.libraries.psu.edu/files/final_submissions/953> accessed 1 July 2024.
[xxxv] For example, Francois de Soyres, Ana M. Santacreu and Henry Young, Fiscal Policy and Excess Inflation During Covid-19: A Cross-country View (Board of Governors of the Federal Reserve System (U.S.), FEDS Notes 2022-07-15-1, 2022).
[xxxvi] Jesse Eisinger, Jeff Ernsthausen, and Paul Kiel, ‘The Secret IRS Files: Trove of Never-Before-Seen Records Reveal How the Wealthiest Avoid Income Tax’ (Propublica, 8 June 2021) <https://www.propublica.org/article/the-secret-irs-files-trove-of-never-before-seen-records-reveal-how-the-wealthiest-avoid-income-tax> accessed 1 July 2025.
[xxxvii] Regressive tax treatment of wealth, high personal income, corporate income, capital gains, dividends and luxury consumption are presented and viewed as ‘economic policy’, and not as largesse for specific cronies, donors and the wealthier class in general. The incumbent problem has been framed in a manner so that only progressive tax measures in favour of the largest number would be considered as a political inducement.
[xxxviii] Franz Dietrich and Kai Spiekermann, ‘Jury Theorems’ The Stanford Encyclopedia of Philosophy (Spring edn, 2023) <https://plato.stanford.edu/entries/jury-theorems/> accessed 1 July 2024.
[xxxix] ibid.
[xl] Buchanan and Tullock (n29).
[xli] Ludwig von Mises, The Theory of Money and Credit (first published 1912, Yale University Press 1953). Keynes, John Hicks and Nicholas Kaldor, among others, opposed this view, but Hayek did predict the Great Recession in February of 1929 (Gerald R. Steele, Keynes and Hayek (Routledge 2001)).
[xlii] Kunio Okina, Masaaki Shirakawa and Shigenori Shiratsuka, ‘The Asset Price Bubble and Monetary Policy: Japan’s Experience in the Late 1980s and its Lessons’ (Monetary and Economic Studies, Bank of Japan, 2001).
[xliii] Romain Duval, Gee Hee Hong, Yannick Timmer, ‘Financial Frictions and the Great Productivity Slowdown’ (2020) The Review of Financial Studies 475.
[xliv] Molly Kinder, Katie Bach and Laura Stateler, ‘Profits and the Pandemic: As Shareholder Wealth Soared, Workers Were Left Behind’ (Brookings Institution 2022), <https://www.brookings.edu/wp-content/uploads/2022/04/Pandemic_Profits_report.pdf> accessed 10 March 2023.
[xlv] Viral V. Acharya and others, ‘Whatever It Takes: The Real Effects of Unconventional Monetary Policy’ (2019), The Review of Financial Studies 3366.
[xlvi] Donald T. Campbell, ‘Assessing the Impact of Planned Social Change’ (1979) Evaluation and Program Planning 67. Campbell identified the moral hazard of objectified and restricted evaluative criteria that applies to any institution, including central banks.
[xlvii] Christopher Adolph, Bankers, Bureaucrats, and Central Bank Politics: The Myth of Neutrality (Cambridge University Press, 2013).
[xlviii] Friedrich Hayek, ‘The Use of Knowledge in Society’ (1945), The American Economic Review 519.
[xlix] Changes made to the variable within the control of the policymaker (instrument) affect the correlated variable that is sought to be influenced (target). Central banks attempt to influence the target of inflation using the instrument of short-term interest rates. The target-instrument model was developed by Dutch economist Jan Tinbergen.
[l] For example, in 2018 RBI issued a circular prohibiting all ‘entities regulated by the Reserve Bank’ from dealing in virtual currencies or providing services for facilitating any person or entity in dealing with or settling virtual currencies. The Supreme Court quashed the circular on the ground that it was in violation of Article 19(1)(g) of the Indian Constitution. A key consideration for the Court was that no law prohibited use/trade of such currencies. (Internet and Mobile Association of India vs. RBI 2020 SCC Online SC 275).
[li] For an Indian view on how fiscal and monetary coordination could work, see Viral Acharya, Quest for Restoring Financial Stability in India (SAGE 2020), xxv to Iiv.
[lii] Mariana Mazzucato and others, ‘Theorising and Mapping Modern Economic Rents’ (UCL Institute for Innovation and Public Purpose, Working Paper Series, 2020); ‘Pricing Power of Big 5 – Reliance, Tata, Birla, Adani, Bharti – Driving Inflation: Viral Acharya’ (The Wire, 14 March 2023) <https://thewire.in/economy/big-five-inflation-india-viral-acharya> accessed 15 March 2023.
[liii] The Phillips Curve is the major conventional ‘rule-of-thumb’ behind the Federal Reserve’s twin mandate of stable prices and full employment. It informs the Monetarism of Milton Friedman, as well as the neoclassical macroeconomic thinking of Paul Samuelson, among others.
[liv] Qianying Chen and others, ‘International Spillovers of Central Bank Balance Sheet Policies’ (Bank of International Settlements, 2012) <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2185394> accessed 1 May 2024; Gianluca Benigno and Paolo Pesenti, ‘The International Experience of Central Bank Asset Purchase and Inflation’ (Federal Reserve Bank of New York, 2021) <https://libertystreeteconomics.newyorkfed.org/2021/10/the-international-experience-of-central-bank-asset-purchases-and-inflation/> accessed 1 May 2024.
[lv] Marc Labonte and Gail E. Makinen, ‘Federal Reserve Interest Rate Changes: 2000-2007’ (Congressional Research Service Report for Members and Committees of the U.S. Congress, 2007) <https://www.everycrsreport.com/files/20070131_98-856_05489a1e2fcd00f0487299431ec432bd1af847fb.pdf> accessed 1 May 2024.
[lvi] Erica Xuewei and others, ‘Monetary Tightening and U.S. Bank Fragility in 2023: Market-to-Market Losses and Uninsured Depositor Runs?’ (National Bureau of Economic Research, Working Paper Series, July 2024) <https://www.nber.org/system/files/working_papers/w31048/w31048.pdf> accessed 1 December 2024.
[lvii] Daniel Thomas and Noor Nanji, ‘Bank of England Steps in to Calm Markets’ (BBC, 12 October 2022) <https://www.bbc.com/news/business-63061614> accessed 15 April 2023.
[lviii] It has been highlighted that investment fund managers (who stood to benefit the most from such interventions) advised the Federal Reserve on its quantitative easing program after the Great Recession. (‘The Power of the Fed’ (Frontline PBS, 2021) <https://www.youtube.com/watch?v=9RbL8lTsITY&t=577s>).Alternative or supplementary actions would be to stimulate demand by ensuring that paychecks and small businesses are protected, or even direct transfers to consumers. For example, in response to the crisis induced by the Covid Pandemic, the Federal Reserve initiated several measures that were outside the conventional definition of monetary policy actions. Notable examples are the “Main Street Lending Program (“MSLP”), Paycheck Protection Program Liquidity Facility (“PPPLF”), and the Municipal Liquidity Facility (“MLF”). The MSLP provided loans to medium-sized businesses and non-profit organisations, PPLF facilitated loans for the Treasury Department’s Paycheck Protection Program for small businesses, and the MLF allowed the Fed to lend directly to state and municipal governments.” (Stanley Fischer, ‘Comparing the Monetary Policy Responses of Major Central Banks to the Great Financial Crisis and the COVID-19 Pandemic’ (MIT Management Sloan School, Working Paper, 2021).
[lix] Giulio Bianchi, ‘To be Made Sick by Medicine: Quantitative Easing and Inequality After the Financial Crisis’ (2016) Undergraduate Economic Review Article 1.
[lx] Joseph Gagnon and others, ‘The Financial Market Effects of the Federal Reserve’s Large-Scale Asset Purchases’ (2011) International Journal of Central Banking 3; Andrew L. Smith and Victor J. Valcarcel, ‘The Financial Market Effects of Unwinding the Federal Reserve’s Balance Sheet’ (2023) Journal of Economic Dynamics and Control 104582.