Fiscal dominance refers to a situation when a government’s fiscal policy (spending and taxation) takes precedence over monetary policy (central bank actions) in shaping the economy and financial markets.

In such a scenario, the central bank’s ability to control inflation is undermined by the government’s fiscal decisions, particularly its borrowing and spending practices.

This can lead to a shift in power from the central bank to the government, potentially undermining the central bank’s ability to control inflation and maintain financial stability.

What is Fiscal Dominance?

Fiscal dominance occurs when the fiscal authority such as the treasury or finance ministry of a government, faces large current deficits and debt burdens that leave little room for additional borrowing.

To fund spending, the government turns to the central bank to help finance the deficits through money printing.

In regular circumstances, the central bank is independent and pursues monetary policy objectives like inflation targeting, employment stabilization, or exchange rate management.

However, the government’s funding pressures and budget constraints force the central bank to subordinate its policy goals to help accommodate the government’s financing needs through loose monetary policy.

Key features of fiscal dominance include:

  • Government Borrowing: When a government has high levels of debt and continues to borrow extensively, it may pressure the central bank to keep interest rates low to reduce the cost of borrowing and avoid debt crises.
  • Inflation Control: The central bank’s primary goal of controlling inflation may be compromised because it may need to accommodate the government’s financing needs, even if this means allowing higher inflation.
  • Monetary Policy Constraints: The central bank may lose its independence and effectiveness as its policy decisions become subordinated to the fiscal needs of the government.
  • Debt Monetization: In extreme cases, the central bank may be forced to monetize the government debt, meaning it prints money to finance the government’s deficit, which can lead to hyperinflation.
  • Impact on Economic Stability: Fiscal dominance can lead to economic instability, as the central bank is unable to use its tools effectively to manage the economy. It can also erode the credibility of the central bank, leading to higher inflation expectations and economic uncertainty.

Let’s take a deeper dive into each one:

Government Borrowing

When a government runs large budget deficits and accumulates high levels of debt, it may need to borrow extensively to finance its expenditures.

This borrowing can pressure the central bank to maintain low interest rates to reduce the government’s debt servicing costs.

High levels of government borrowing can crowd out private investment, as the government competes with the private sector for available funds, potentially leading to higher interest rates if not accommodated by the central bank.

Inflation Control

The central bank’s primary objective often includes controlling inflation. However, under fiscal dominance, the central bank might be pressured to prioritize financing the government’s debt over maintaining price stability.

This can happen through mechanisms such as keeping interest rates artificially low or directly purchasing government bonds (monetizing the debt).

As a result, inflation control becomes secondary, leading to the risk of higher inflation if the economy overheats due to excessive fiscal spending without corresponding monetary tightening.

Monetary Policy Constraints

Fiscal dominance constrains the central bank’s ability to implement independent monetary policy. The central bank’s decisions on interest rates and other monetary tools become subordinated to the fiscal needs of the government.

For instance, even if economic conditions warrant higher interest rates to combat inflation, the central bank may keep rates low to make government debt servicing more affordable.

This undermines the central bank’s independence and limits its ability to achieve its macroeconomic objectives, such as controlling inflation and stabilizing the economy.

Debt Monetization

In extreme cases, the central bank may be compelled to directly finance the government’s budget deficit by printing money to purchase government bonds.

This process is known as debt monetization.

While it provides the government with immediate funds, it increases the money supply, leading to inflationary pressures. If sustained, this can result in hyperinflation, eroding the purchasing power of the currency and leading to economic instability.

Impact on Economic Stability

Fiscal dominance can lead to economic instability for several reasons.

First, it can undermine the central bank’s credibility, as markets and the public may perceive that monetary policy is driven by fiscal needs rather than economic fundamentals.

Second, persistently low interest rates and high inflation can distort investment and consumption decisions, leading to misallocations of resources.

Finally, the erosion of central bank independence can increase uncertainty, as market participants become unsure about the future path of monetary policy. This uncertainty can lead to higher risk premiums, increased volatility in financial markets, and reduced economic growth.

How does fiscal dominance occur?

Some ways fiscal dominance can emerge are:

  • Large Budget Deficits – Sustained high fiscal deficits require increased government borrowing and debt issuance, which then depends on central bank support.
  • High Debt Levels – High existing public debt diminishes a government’s fiscal space and ability to fund further deficits, again relying on the central bank.
  • Financial Crises Bailouts – Governments may run huge deficits and take on massive public debt due to banking sector bailouts or economic stimulus programs in times of crisis. This expands financing needs.
  • Implicit Government Control – Even without large deficits or debt, government influence over appointments and operations may sway central bank decision-making.

What are the consequences of fiscal dominance?

Fiscal dominance can have several implications:

  • Higher Inflation – Money printing to fund deficits risks high inflation which the central bank would otherwise try to prevent.
  • Interest Rates Distortion – Accommodating government borrowing can keep rates too low for too long rather than based on economic conditions.
  • Currency Depreciation – Expanding the money supply this way stokes currency depreciation pressure.
  • Constrained  Policy Space – Fiscal needs limit the central bank’s ability to use monetary policy flexibly to achieve its macroeconomic objectives.
  • Debt Monetization – Excessively monetizing debt undermines confidence in the government’s commitment to fiscal prudence.

What are examples of fiscal dominance?

An example of the United States experiencing fiscal dominance can be observed during and after significant periods of government spending, such as during wartime or major economic crises.

One notable instance is the period following the 2008 financial crisis and the subsequent Great Recession.

Post-2008 Financial Crisis

In response to the financial crisis, the U.S. government implemented large-scale fiscal stimulus packages to stabilize the economy. The American Recovery and Reinvestment Act of 2009, for example, involved $831 billion in spending and tax cuts aimed at boosting economic activity.

The Federal Reserve (Fed) took aggressive actions to support the economy, including lowering interest rates to near-zero levels and implementing quantitative easing (QE) programs, where it purchased large amounts of government securities to inject liquidity into the financial system.

While the Fed’s actions were aimed at stabilizing the financial system and promoting economic recovery, they also effectively supported the government’s borrowing needs by keeping interest rates low. This made it cheaper for the government to finance its growing debt.

World War II Era

Another historical example is the period during and after World War II:

The U.S. government significantly increased its spending to finance the war effort, leading to substantial budget deficits and a dramatic rise in public debt.

The Fed maintained low interest rates throughout the war to help the government finance its spending. This was done through an agreement known as the Treasury-Fed Accord, where the Fed agreed to keep interest rates low to support government borrowing.

After the war, the need to manage and service the large public debt continued to influence monetary policy. The Fed’s policies during this time were heavily influenced by the fiscal needs of the government, demonstrating a period of fiscal dominance.

In both cases, the central bank’s policies were significantly influenced by the government’s fiscal actions, illustrating the concept of fiscal dominance where fiscal policy needs take precedence over the central bank’s traditional monetary policy objectives.

In summary, fiscal dominance occurs when fiscal policy, especially excessive government borrowing and spending, limits the central bank’s ability to conduct independent and effective monetary policy. This can lead to higher inflation and economic instability.