Simultaneously to this rate hikes, threats to formal central bank independence have been piling up. One recent example is the proposal in the US presidential campaign that the POTUS should be consulted before any interest rate decision and may terminate the mandate of the Fed chairperson.
These developments seem connected to the high levels of public debts accumulated in response to the 2008 financial crisis and the COVID crisis.
“Unpleasant monetary arithmetic” or “Fiscal or monetary dominance”: the literature has clarified that the consolidated budget constraint of the public sector implies that either monetary or fiscal policy must accommodate the other to ensure sovereign solvency.
Yet, no theory sheds light on which authority imposes discipline on the other. Why should the fiscal authority be the dominant one now? Wasn’t there seemingly more fiscal discipline in the US before 2008? Was the Fed interested in accommodating the Treasury during the Volker era?
With Jean Barthelemy and Guillaume Plantin, we have just published a research paper in the Journal of Economic Theory, which provides some answers to these questions.
We build a theory in which either fiscal or monetary dominance arises as the outcome of a game between the central bank and the government. This theory allows us to characterize the determinants of fiscal dominance and, in particular, the precise role of public debt. This contrasts with the previous literature, which takes as exogenous whether fiscal or monetary dominance prevails.
In our theory, fiscal dominance may arise when the government has a small fiscal space—i.e., a limited ability to raise taxes and/or cut spending—and when interest rates are low and not sensitive to large debt issuance. In this situation, the government doubles down on debt issuance to credibly force the central bank to raise the price level and avoid sovereign default.
Our theory points to the critical role of the market reaction to government debt issuance but also emphasizes that the central bank may have tools to avoid fiscal dominance or at least to attenuate its costs. We show, for example, that a little bit of inflation to create fiscal space in the present may be preferable to fiscal dominance and higher inflation in the future.
From a positive point of view, fiscal dominance is a potential risk in many countries with large debt levels. For example, our theory helped us understand episodes such as the mini-budget in the UK in 2022 (learn more in French here).
Is there a game between the fiscal and the monetary authority?
But, is there really a game between fiscal and monetary authority? Do we expect fiscal authorities to deliberately and precisely design fiscal expansions as strategies to force monetary ones to deviate from their price-stability objectives?
In the paper, we argue that our theory captures more situations in which the fiscal authority “kicks the can down the road” by postponing the resolution of policy problems. This is a form of “insidious fiscal dominance,” as described by Eric Leeper. Alternatively, the fiscal authority, focused on another objective, fails to internalize the inflationary consequences of its own actions when designing bold fiscal expansions, such as during and after the COVID crisis.
To learn more about the theory, read the full article on LinkedIn here.
