Fiscal dominance occurs when fiscal deficits become as significant as, or more important than, private sector lending and monetary policy in driving economic activity.
- lyn alden.
To understand fiscal dominance, it’s essential to understand how money is created in the economy. Broadly, there are two main mechanisms:
- Private Sector Lending: includes lending from banks and private credit markets (non-bank institutions). Commercial banks and non-bank institutions create new money whenever they issue a loan. By crediting the borrower’s account with a deposit, these institutions essentially create money out of thin air, backed by the borrower’s promise to repay.
- Monetized Government Deficits: When governments spend more than they collect in taxes, they borrow to cover the gap. If the central bank funds the government spending by purchasing this debt, directly or indirectly, it expands the money supply.
In cases like those of Argentina and Venezuela, central banks have directly financed government deficits by purchasing government debt outright, a practice known as direct monetization. In the United States and Eurozone, policies like Quantitative Easing (QE) allow central banks to buy government debt from financial institutions in secondary markets, injecting liquidity into the financial system without directly funding deficits.
Over the last four decades, fiscal deficits have become a more powerful force in shaping the economy. Historically, private sector lending has played a leading role in driving economic activity alongside central banks through interest rate policy.
navigating fiscal dominance
- The world is engulfed in an era in which fiscal policy, rather than monetary policy, is the dominant force driving economic activity and inflation. Unlike the countercyclical deficits of the past, today’s fiscal deficits are structural in nature and rooted in systemic obligations like entitlement spending, rising healthcare costs, and compounding interest on decades of accumulated debt.
- Central banks today face the difficult task of trying to manage inflation while addressing the escalating costs of sovereign debt. As this report highlights, interest rate cuts could offer a meaningful path to fiscal sustainability by reducing the government’s interest expenses. However, this threatens central bank independence, which could lead to a loss of confidence in the currency.
- Meanwhile, the structural nature of fiscal deficits means that even well-intentioned initiatives like DOGE are unlikely to put a meaningful dent in government spending. In an era of perpetually high deficits and persistent inflation, central banks’ traditional tools become ineffective at combating inflation, creating an increasingly uncertain economic backdrop.
- While federal debt is growing at a 7–8% annual rate, this is significant but not yet at levels associated with major fiscal crises. Historically, severe currency crises tend to occur when a nation is dealing with extreme impairments, such as war, economic collapse, or large external obligations it cannot print its way out of—conditions that the U.S. does not currently face.
- This combination of factors points to a fiscal dominance era that is less dramatic in any given year than alarmists might predict but also far more persistent and intractable than optimists might hope. The deficit problem is unlikely to be resolved this decade, nor is it likely to culminate in a sudden collapse. Instead, it will run structurally hot, punctuated by occasional moments of drama, while nominal figures steadily rise amid ongoing currency debasement.
full source: https://www.lynalden.com/full-steam-ahead-all-aboard-fiscal-dominance/
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