Romina Boccia and Dominik Lett
With entitlement spending growth driving a worsening fiscal picture, the US could enter a new period of fiscal dominance where monetary policy serves fiscal ends, threatening central bank independence and America’s economic future. Following aggressive fiscal and monetary stimulus during the pandemic, legislators should avoid the siren’s call of elevated deficit spending or risk higher inflation.
During the COVID-19 pandemic, Congress unleashed a deluge of emergency spending—roughly $6 trillion, according to the Committee for a Responsible Federal Budget (CRFB)—bringing deficits to new heights. For context, the deficit in 2020 was nearly 15 percent of Gross Domestic Product—deficits haven’t been that severe since World War II.
At the same time, the Federal Reserve increased the broad money supply (M2) by 40 percent and massively increased its asset holdings, including government bonds and mortgage‐backed securities, by $4 trillion. Record‐high deficits and an intense bout of inflation accompanied the unprecedented fiscal and monetary expansion as the pandemic came to an end.
Eventually, the Fed responded to elevated inflation with interest rate hikes and by reducing its asset holdings. While inflation appears to have slowed, it remains a problem, underscoring the challenge of using monetary instruments to deal with a fiscally driven problem. The pandemic episode illustrates an example of fiscal dominance whereby, as the Mercatus Center’s Eric Leeper puts it, “some fiscal action forces the central bank to react in ways that it otherwise would not.”
With Congress currently unwilling to seriously address the entitlement spending problem that’s driving the US toward a fiscal cliff, it’s worth evaluating the possibility of more frequent episodes of fiscal dominance and their consequences.
History as a Guide
To understand whether we live in a fiscal or monetary dominance regime, we should ask: is the central bank’s prime directive to maintain an inflation target, or is the central bank primarily focused on accommodating government spending? When fiscal dominance reigns supreme, countries experience higher inflation and sometimes hyperinflation (high and accelerating inflation). Several historical examples illustrate the dangers of fiscal dominance.
During emergencies, central banks may temporarily accommodate expansionary fiscal policy, such as during World War II or the COVID-19 pandemic. As Cato’s James Dorn points out, “Fiscal authorities normally dominate central banks during wartime. That was certainly the case during the two world wars. The Fed kept yields low on government securities by monetizing a large share of the US debt. Dorn further highlights the 1960s and early 1970s, when the “Fed engaged in easy monetary policies to fund fiscal deficits, which led to inflation.”
Fiscal dominance can also be observed abroad. According to Greg Ip, writing in the Wall Street Journal, Argentina is a textbook case of fiscal dominance. To finance fiscal deficits, the Argentine treasury issues bonds that are bought up by the central bank. This debt monetization has led to devastating inflation, reaching a 12‐month rate of 276 percent in February.
Leeper identifies two more examples of fiscal dominance overseas. After World War I, Germany realized it could not pay off its debts through conventional taxes alone, so it rapidly printed money to finance new spending. Likewise, President Erdoğan of Turkey eroded central bank independence, pushed for lower interest rates, and expanded government spending in recent years. As Leeper stated, “Erdoğan effectively converted an independent inflation‐targeting central bank into a fiscal ATM.” In both cases, fiscal dominance resulted in severe and economically damaging inflation.
The US Threat of Fiscal Dominance
Fiscal dominance has a track record of triggering severe inflation and leading to economic decline. With US deficits at crisis levels in the face of rising entitlement spending, and with the federal debt to GPD ratio exceeding its record high of 106 percent in 2028 (Figure 1), the risks of fiscal dominance in the United States are rising. An excessive and rising debt, high interest rates, and a political landscape hostile to entitlement spending reductions create a dangerous fiscal environment that may exhaust the US fiscal space over the next 15–20 years.
If Congress leaves spending corrections to the last minute, legislators may perceive the draconian fiscal consolidation necessary to bring debt under control as less desirable than monetizing the debt. In such a scenario, printing more money might become the easiest or only politically feasible way out.
At a recent House Budget Committee hearing on the need for a fiscal commission to resolve the US debt challenge, former chairman John Yarmuth suggested just such a policy, stating on the record,
We are a sovereign currency, we can print all the money we want to serve the people whom we serve. … [W]hy are we paying interest on the money we borrow? And why do we borrow money anyway? We can print it and put it in the Treasury.
No amount of balance sheet manipulations will allow the US to print more money ad infinitum with no adverse consequences. Should this type of thinking become more mainstream, it is not entirely unrealistic to think that fiscal dominance and debt monetization might be willingly undertaken under the right political circumstances.
Avoiding Fiscal Catastrophe
Rising US spending and debt in light of heightened political polarization and congressional budgetary gridlock raise concerns about the sustainability of government finances. The recent credit downgrade by Fitch Ratings and Moody’s Investor Service lowering its outlook on the US credit rating is a reflection of the nation’s concerning long‐term fiscal trajectory and poor fiscal governance. Without a political willingness to reduce the growth in old age benefit programs, the erosion of central bank independence to finance future spending represents a growing risk. Argentina, Germany, Turkey, and other historical cases serve as stark reminders of the dangers of fiscal dominance. Central bank money printing to finance government spending can lead to hyperinflation and economic ruin.
Fiscal dominance could also deteriorate the reputation of the US as a guarantor of its credit. The perception of Treasury securities as safe assets undergirds the entire financial system. US policymakers should not clumsily waltz into additional periods of fiscal dominance that could contribute to economic instability and reduce the global standing of the US dollar.
As Charles Calomiris notes, “Ultimately, the US may face a political choice between reforming entitlement programs and tolerating high inflation and financial backwardness.” Confronting the entitlement spending behemoth is politically daunting but necessary and can be done through a well‐designed fiscal commission. Establishing smart fiscal guardrails, backed by a shared understanding of the budgetary future the US faces, can similarly reduce the risk of a fiscal crisis.
Time is of the essence to slow the growth in spending before fiscal dominance becomes the seemingly more attractive option.
