What Does Fiscal Dominance Mean For The Economy?

As 2023 draws to a close, perhaps the biggest lesson we learnt in economics this year was that inflation turned out to be (dare I say) transitory after all. This should mark a major turning point in our understanding of the causes and cures of inflation and impact future policy in a positive way. More on that later.

2023 was also a reminder of how much the public really hates inflation. Look no further than the US opinion polls. Despite full employment and the American economy continuing to grow strongly, Joe Biden’s bid for re-election next year hangs in the balance. While inflation has fallen back towards pre-pandemic levels, wages only outpaced the consumer price index for the first time in 24-months since March of this year. The cost of living pressures are still fresh in the memory of many American voters.

The enormous stimulus packages that protected jobs during the pandemic also added to America’s debt. For years, the national debt and deficits have irked most Americans. Given the scale of the debt, now a whopping 123% of GDP, the fiscal programmes under Biden’s administration have come under severe scrutiny. Since the pandemic, approximately $6 trillion has been added to the total debt pile which now stands at $33 trillion.

And yet the solution to bringing borrowing under control for Biden is a no-go area. Spending cuts or tax increases would undoubtedly end any hope of his re-election next year. Economically, closing the gap between tax revenue and expenditure would be viewed as prudent. But politically it would be disastrous. While the American public are unhappy with deficits, the backlash from austerity would far outweigh any benefit from sound fiscal governance. Cuts to the big offenders such as defence, Medicare and Social Security are thus firmly off the table.

With interest rates at their highest levels since the 1980’s, the cost of servicing the national debt in 2023 was 39% higher than 2022. Approximately 30 cents in every dollar received in tax revenue is now eaten up by net interest payments. The US deficit for fiscal 2023 was $1.6 trillion, an annual increase of 23%, which was fully funded by issuing new debt.

Many economists believe that the US economy has entered into a period of ‘fiscal dominance’ which means, in brief, that the government’s desire to borrow and spend dominates the central bank’s ability to keep inflation in line with its target. Some predict, such as US economist and professor at Columbia Business School, Charles W. Calomiris, that as national debt rises, an eventual “buyer's strike” in the bond market could push bond yields to unfeasibly high levels. This would force the Fed (US central bank) to print money, monetize the debt directly and cut interest rates to zero percent. In return for on-going support from the Fed, the government would accept a higher rate of inflation as a trade-off for less debt.

In recent decades, central banks targeted inflation at around 2%. At this rate, and as debt levels rise, the ability to close the gap between debt and national income becomes more difficult since lower inflation generally means lower GDP. If on the other hand the government continuously prints money and targets an inflation rate of 10%, the real value of debt declines while GDP rises. And as GDP rises, so too do government taxes.
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Since wages rise with inflation, the public are less aware of the “inflation tax” that they are now paying, which makes the inflation tax popular among politicians. As Milton Friedman famously said in 1974, “inflation is a tax which is imposed without representation and which nobody has to vote for.”

In addition, as Calomiris’s theory goes, the government would impose the inflation tax on the banking sector by instructing banks to hold a larger fraction of their reserves in non-interest bearing accounts at the central bank. The net effect would be lower costs to the Treasury and a much less profitable banking sector. Credit in the economy would dry up, the money supply would fall and inflation would be kept in check. An inflation tax on banks would, again, be politically more acceptable to the public. Or so Calomiris believes.

One obvious criticism I would have of these assertions is - given what we already know about the public’s view of inflation - targeting persistently high inflation as a trade-off for lower debt and deficits, seems politically unsustainable. For instance, how certain could policymakers be that wages would match 10% inflation year after year? Judging by the last number of years, this would be a big assumption to make. While the public notionally care about the national debt, in reality they care far more about the purchasing power of their dollars.

I would also question the ability of policymakers to cause inflation in the first place. As we’ve seen in the last decade through quantitative easing (QE), the correlation between the money supply and inflation is much weaker than previously assumed. Printing trillions of dollars to buy government bonds did little to affect consumer prices between 2009-2019.

Moreover, during that period China purchased more treasury bonds from the US than any other period in its history - even as interest rates were as low as 0%. When you’re running a huge trade surplus with America like China does, it pays to have a weak exchange rate. A stronger dollar is a boon for Chinese exporters and another incentive for foreigners to hold US debt securities. Barring major geopolitical tensions or a war with China, a buyer's strike in the treasury market seems overplayed to me. Also worth mentioning is that cheap imports from China keeps a lid on US inflation.

So without regular supply shocks or an outright collapse of the dollar, there really is no guarantee that continued deficit spending or high levels of debt could push inflation to very high levels. While government spending has remained extremely high in the US in recent years, inflation has fallen back towards the Fed’s 2% target nonetheless.

How much of that disinflation can be attributed to the Fed raising interest rates? I would argue very little since the vast majority of Americans had locked in lower fixed interest rates prior to the pandemic. Similar disinflationary trends are occurring here in Ireland, the UK and across most of the EU as food and energy prices in particular have fallen. This suggests that a significant portion of the price increases since 2021 was supply-driven rather than simply too much demand.

Perhaps in time, a very long time from now, if the US economy declines considerably and the dollar loses its global reserve currency status, the US government might be forced to accept a much higher rate of inflation to reduce its debt. But that’s a big ‘if’. So long as the US continues to invest in education, infrastructure, R&D, promotes the right environment for investment and entrepreneurship and continues to produce profitable companies like Apple, Amazon, Microsoft etc I think we’re many years (decades perhaps) away from a run on the dollar.

The way I see it, the national debt in America will remain a lazy stick that Republicans use to beat Democrats with during every political cycle. But ultimately, for the foreseeable future, debt and deficits will be a mere distraction for either party in government rather than being a national priority. Pursuing a balanced budget or worrying about deficits will, as it has been for decades, be conveniently kicked down the road until the day of reckoning arrives, if it ever does.

In the meantime, there are more important things on Joe Biden’s mind like Russia, Ukraine and the Middle East. Indeed if the domestic economy remains in good shape, it could well be foreign policy that decides the outcome of next year’s election. To appease his detractors, perhaps pulling funding from Ukraine, a potential saving to the US economy of approximately $60 billion which most republicans would approve, would be Biden’s ‘Trump’ card to win the election. A Russian victory in Ukraine would be a disaster for global peace and democracy. But given his poor ratings at home, maybe it’s a gamble Joe Biden would be willing to take?