Fiscal Dominance

2024-06-04 See all posts

For 50+ years the United States’ (US) deficit/debt situation has been debated ad nauseum. Hawks warn of a looming debt spiral and ensuing collapse of the Dollar while doves point at the scoreboard and to other high-debt advanced economies that are still chugging along. Hawks are correct in the sense that we are in a Thanksgiving Turkey scenario, but they keep underestimating the upper bound for debt-to-GDP in the world’s #1 national economy and reserve currency issuer, and overestimating their ability to see into the future. The US has a longer runway than most countries given its powerful position in the world economy, but we don’t know how much longer.

Over time, too-loose fiscal policy (more expenses than revenues) can render a country’s central bank ineffective:

• Loose fiscal + loose monetary (lower rates) = overheating and inflation.
• Loose fiscal + tight monetary (higher rates) = increased debt servicing costs on the money borrowed to finance the deficit, which leads to more borrowing.

This is called “fiscal dominance”, referring to the imbalance in effectiveness between fiscal and monetary policy that results from a high level of debt. It’s a real thing that has happened in many countries less fortunate than us even in recent times (Argentina, Venezuela, Zimbabwe, Greece, Turkey…), and it always results in hardship either via hyperinflation or austerity measures.

The last time pre-2022 that Fed Funds was above 2.5% was just before the Great Recession. Since that time debt has more than doubled, going from 63% in Q4 2007 to 128% today. Fed Funds is holding steady at 5.3%. A concern that arises in this regime of debt and interest rates is the US Treasury’s interest payments on the securities it issues. What happens when we need to pay interest with money that could have gone towards energy grid upgrades and public sector job salaries? Productivity goes down. Job losses. Fed lowers rates. Recession. Now interest rates are lower, we are in a recession, and we are talking about borrowing more money to stimulate the economy thereby increasing debt. As a result the Fed is handcuffed to low rates.

Debt discourse will pick up in the next year or two when we break records for interest outlays as a share of GDP, expense, and revenue. Turning this around while avoiding disaster will require a deft mix of tapering the deficit while keeping inflation just high enough to cheapen the debt; easier said than done especially in a politically polarized nation. More likely what will happen is we test the debt limit of a global superpower and continue down the path of central bank ineffectiveness.