Understanding Fiscal Dominance and Its Consequences

Fiscal dominance refers to a situation where a central bank's actions are driven by a desire to maintain a stable economy, often at the expense of inflation. This can lead to a decrease in the value of money.

Central banks can implement policies to combat inflation, such as raising interest rates, which can reduce borrowing and spending. However, this can also slow down economic growth.

In extreme cases, fiscal dominance can lead to a complete loss of control over monetary policy, as governments may try to finance their spending through money creation. This can result in hyperinflation, where the value of money drops dramatically.

The consequences of fiscal dominance can be severe, including a loss of trust in the currency and a decrease in economic stability.

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Fiscal dominance is a phenomenon where a government's spending and debt levels limit what central banks can do, especially around inflation and interest rates. This can lead to a situation where the central bank is unable to effectively combat inflation using traditional monetary policy tools.

In a fiscal dominant regime, the actions of fiscal policy (Congress and the President) overwhelm the ability of the Federal Reserve to fight inflation using interest rates. The real interest rate, which is the current interest rate minus current inflation, is a key indicator of the effectiveness of monetary policy.

A positive real interest rate is considered restrictive, meaning the cost of money is higher than the growth rate in wages and business profits. Conversely, a negative real interest rate is considered easy, meaning the wages and profits used to pay back debt are growing faster than the rate of interest.

The Federal Reserve's ability to set real interest rates is crucial in combating inflation. A restrictive monetary policy, like the one seen in the 1980s under Volcker, can effectively combat inflation.

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Fiscal dominance has been a recurring theme in economic history, with several notable instances where it played a significant role.

Post-WWII, many countries relied heavily on central banks to cover wartime debts, effectively making fiscal dominance a reality.

The 1980s saw a surge in inflation and debt meltdowns in Latin America, highlighting the dangers of fiscal dominance.

In the 1990s, Southeast Asia experienced economic instability due to unsustainable fiscal practices, a pattern that would repeat itself in the future.

The recent pandemic stimulus marked a return of fiscal dominance across major economies, sparking concerns about its long-term implications.

Here are some key periods in history where fiscal dominance was evident:

The new bank rules would force banks to preposition billions more in collateral at the Fed to support future discount window borrowing, requiring collateral matching up to 40% of a bank's uninsured deposits.

Banks would be required to borrow from the window numerous times a year to help remove the program's stigma, essentially creating a new way for the banks to hold significant collateral balances at the Fed.

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This new rule would also help the Treasury fund its massive deficits and stock of outstanding debt from years past, as collateral for Fed loans is often U.S. Treasury securities.

The bank bailout BTFP enacted in March 2023 addresses the problems of funding Treasury assets and avoiding losses on them, allowing banks to buy Treasury notes and fund them via the BTFP if the borrowing rate is less than the bond yield.

Under such a regime, the banks could make money and be very willing to participate, as there is potentially no downside.

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Fiscal dominance can have a significant impact on the economy, and it's essential to understand the risks involved.

The Federal Reserve's ability to combat inflation is hindered by high government debt levels and the interest costs of servicing that debt. This creates a vicious circle where investors demand higher interest rates, which in turn raises the interest costs on government debt.

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If interest rates double from 10% to 20%, it can become an immediate problem for government finances, making it challenging for the Fed to create restrictive monetary policy to combat inflation.

A $1.1 trillion annual interest payment on government debt is a significant burden, surpassing the cost of running Social Security or Medicare. This vicious cycle of high deficits and rising interest costs can lead to economic chaos, including hyperinflation, capital flight, and sovereign debt crises.

The current Federal Reserve cannot enact restrictive enough policy to fight inflation, as they did in the 80s, due to high government debt levels and the interest costs of servicing that debt.

The government's average interest rate on debt is 3.06%, which may seem relatively low, but it's still a significant burden. The interest expense on the debt has risen substantially, and it's expected to continue rising as debt issued years ago with low interest rates matures and new debt with higher interest rates replaces it.

If the government's average interest rate is 4.75%, the interest expense will rise to $1.65 trillion, which is over $300 billion above the government's next largest expenditure, Social Security. This highlights the significant risks associated with fiscal dominance.

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Here are the potential winners and losers in a fiscal dominance scenario:

The federal budget deficit has become a pressing issue, with the deficit amounting to -6.2% of GDP in 2023, a level not seen since WWII. This is partly due to the unprecedented spending blitz brought on by COVID.

Mandatory programs like Medicare and Social Security account for nearly two-thirds of annual government spending. These costs are on autopilot, driven by higher healthcare costs and cost-of-living adjustments.

The cost of interest payments on government debt has risen significantly, surpassing the cost of running Social Security or Medicare. Interest payments are at an annual run rate of $1.1 trillion.

Discretionary spending, which includes defense spending, makes up a relatively small portion of the budget. However, cutting defense spending is highly unlikely given current global tensions.

The primary deficit, which is the total deficit minus interest payments, is a key indicator of the government's fiscal health. The primary deficit has been in the red since the 2010s, with the last time it was near 0% of GDP being in the mid-1980s.

The government's debt burden is a major concern, with total government debt outstanding as a percent of GDP currently much higher than it was during the 1970s and 1980s. This makes it more challenging for the government to control interest costs and reduce the deficit.

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Fiscal dominance can have a significant impact on the economy, and it's essential to understand the risks and potential investment strategies to mitigate them.

In a fiscal dominance regime, inflation is likely to heat up, causing prices to rise. This can be a problem for investors, but it also presents opportunities for certain asset classes to perform well.

The bond market is a key indicator of fiscal dominance, and if investors grow uncomfortable with the government's fiscal outlook, they may demand higher interest rates or even refuse to buy new bond issues.

Fiscal dominance can lead to a decrease in currency confidence, causing the value of the currency to decline. This can have a ripple effect on the economy and investment markets.

Here are some asset classes that may perform well in a fiscal dominance regime:

The U.S. economy is facing significant challenges, with large and increasing budget deficits and already-high government debt levels. This has raised concerns about the potential for fiscal dominance, where the government struggles to raise cash to pay for its daily operations.

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Investors are still comfortable buying U.S. government bonds, but demand could drop if the bond market becomes concerned about the fiscal outlook. This could lead to higher interest rates and even a "failure" of an auction.

The Treasury Department regularly auctions new debt to investors, and these sales usually go smoothly. However, if investors become uncomfortable with the fiscal outlook, they may demand higher interest rates or even refuse to buy new bonds.

Large pension funds are still investing in bonds, but this could change if the fiscal situation worsens. They can earn a 5% return from government bonds, which is more attractive than other investments right now.

The risks of fiscal dominance are higher than ever, thanks to the large budget deficits and high debt levels. This makes it a good idea to be prepared for a potential shift in the bond market.

Inflation-linked bonds could do well in a fiscal dominance regime, as they are immune to inflation's effects. Inflation is clearly a problem in this scenario, so owning these bonds makes sense.

Commodities, such as gold and silver, could also see price increases in a fiscal dominance regime. This is because precious metals tend to perform well when inflation is high.

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Fiscal dominance is a risk that investors haven't had to deal with before, but it's an emerging threat that's worth paying attention to. The government is spending money like never before, and higher interest rates are causing a surge in interest costs on government debt, worsening the budget outlook.

The potential for fiscal dominance introduces an unknown risk to investors, one that none of us has had to think about in our lifetimes. If you're an investor who's ever worried about the debasement of the dollar, then fiscal dominance would be a trigger for such a scenario.

Here are the 4 most important ways that fiscal dominance can impact the economy:

If left unchecked, fiscal dominance can spiral into full-blown economic chaos: hyperinflation, capital flight, crashing currencies, and sovereign debt crises. History has receipts, and we should be paying attention to the warning signs.

Investors who are prepared for fiscal dominance can consider asset classes that historically perform well in such environments. Inflation-linked bonds, for example, are a good option because they're immune to inflation's effects.

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Social Security and Government Programs are a significant concern in the context of fiscal dominance. The cost of Social Security is on autopilot, driven by higher healthcare costs and cost-of-living adjustments.

Social Security benefits increase each year for inflation, and these costs cannot be cut without action by Congress and the President. This is highly unlikely in the current political environment.

Medicare and Social Security account for nearly two-thirds of annual government spending, making it difficult to cut spending. The rising cost of these programs is a major contributor to the fiscal dominance problem.

The government has to pay whatever the prevailing interest rate is for new debt, which accounts for another 15% of total spending. This means that interest costs are also largely uncontrollable.

Mandatory spending and interest costs account for 80% of government spending each year, leaving little room for discretionary spending cuts. Defense spending is highly unlikely to get cut, given current global tensions.

Social Security is expected to "run out" of money in 10 years, creating a ticking time clock for Congress to address the issue. Lifting Social Security wage limits so higher-income earners pay more into the system is one possible solution.

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The game of chicken between the central bank and the government can be a complex and delicate dance. The key determinant of this game is the net public debt in the hands of the private sector, which includes government bonds and central bank reserves.

This level of net public debt compared to overall real public resources determines whether the central bank will implement a price level in line with its objective, increase the price level to ensure solvency, or let the government default. Figure 1 illustrates these findings.

In some cases, the fiscal authority may not always prefer fiscal dominance, especially when the distortionary cost is larger than the fiscal gains from fiscal dominance. This can occur when initial public liabilities are small, interest rates are highly sensitive to public debt issuance, or the future fiscal capacity is large.

Low interest rates can actually lead to endogenous shifts from monetary to fiscal dominance regimes, as the present value of future fiscal resources may decrease over time. This can shift the economy from a situation of monetary dominance due to high future fiscal capacity to fiscal dominance due to low future fiscal capacity.

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The game of chicken is a delicate balance of power between the central bank and the fiscal authority. The key determinant of this game is the net public liabilities, which is the sum of central bank reserves and government bonds minus those held by the central bank.

The central bank may implement a price level in line with its objective, increase its price level to ensure solvency, or let the government default depending on the level of net public debt compared to overall real public resources. Figure 1 illustrates these findings.

The fiscal authority has a choice to make: it can either raise primary surpluses to repay net public liabilities or deliberately exhaust its fiscal capacity to force the central bank to chicken out. This decision depends on whether the fiscal authority has some available fiscal capacity.

In our model, the fiscal authority may decide to run large deficits and flood the bond market to force the central bank to chicken out in the future. This decision results from comparing the fiscal gains from fiscal dominance with the cost associated with distorting fiscal policy to exhaust future fiscal capacity.

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Low interest rates can give rise to endogenous shifts from monetary to fiscal dominance regimes, where the present value of future fiscal resources may decrease over time. In such a situation, the economy may shift from a situation of monetary dominance due to high future fiscal capacity to fiscal dominance due to low future fiscal capacity.

Multiple different equilibria may arise, some featuring fiscal dominance and the other one monetary dominance, depending on how private sector liquidity reacts to the public situation. This is a more problematic situation that we label market dominance, where public liabilities may be subject to self-fulfilling market expectations and contain a bubble component.

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The fiscal authority may not always prefer fiscal dominance. In fact, there are certain conditions under which monetary dominance prevails.

A distortionary cost larger than fiscal gains from fiscal dominance is one such condition. This is measured by delta, a cost-benefit analysis that determines the government's best course of action.

Highly sensitive interest rates to public debt issuance is another condition that favors monetary dominance. This is especially true when initial public liabilities are small.

A large future fiscal capacity can also lead to monetary dominance. This is because the government has more room to maneuver and can afford to restrict its debt issuance.

Being patient is also a key factor in the government's decision to prioritize monetary dominance. This allows the government to take a long-term view and make decisions based on long-term fiscal capacity rather than short-term gains.

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The cleanest way for the U.S. to deal with the threat of fiscal dominance is to get its budget in order. To do this, the primary fiscal deficit needs to be reduced to 0% of GDP. Social Security, Medicare, Defense, and other discretionary spending drive the primary surplus or deficit. Reforming either Social Security or Medicare, or cutting defense spending is a huge hurdle in today's political climate.

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The last time the government reformed Social Security was in 1983, at the very moment they were grappling with high inflation and rising budget deficits. Those reforms increased the retirement age from 65 to 67, amongst other measures to shore up the program. This shows that reform is possible, even in challenging times.

Demand for bonds is still very good, particularly as interest rates have risen to more reasonable levels. Big pension funds with a mandate to generate annual investment returns of 7% are very comfortable owning more bonds. They can get 5% from "risk-free" government bonds, compared to 1-2% just a few years ago.