Fiscal Dominance As Obfuscation

Historical Stock, Securities, Certificates, Fund, Bonds

One phrase that keeps being used by mainstream economists is "fiscal dominance." This is a fuzzy term that is being used to express disapproval but yet appearing to be a neutral technical term. However, the simplest way to view the discussion is that neoclassical economics was ambushed by reality, and that they are hiding behind jargon to distract from this.

What is Fiscal Dominance?

Although there might exist a formal definition of fiscal dominance somewhere, in practice, usage in commentary is somewhat fuzzy. A recent example is in the speech "The shadow of fiscal dominance: Misconceptions, perceptions and perspectives", by Isabel Schnabel -- a member of the executive board of the ECB.

At the time of the Maastricht Treaty, high government debt was seen as a major threat to central bank independence, and it was feared that fiscal dominance could induce a central bank to deviate from its monetary policy objectives, endangering price stability.


This was not just idle speculation. History is full of examples of high government debt eventually being resolved through higher inflation and financial repression.[1]

The examples of "high government debt eventually being resolved through higher inflation and financial repression" is based on an article by Carmen Reinhart and M. Sbrancia. I have not seen the article in question, but based on Carmen Reinhart's track record in the area of fiscal policy (routinely conflating currency sovereigns with ones within a pegged currency system), I think the fact that no examples are given is telling. If we confine ourselves to relevant examples for developed currency sovereigns, we are stuck with the relatively small sample of developed welfare state economies in the post-World War II era. Although "financial repression" existed, inflation was generally minor until the 1970s -- when debt levels had been reduced by growth.

However, the precise definition of fiscal dominance has been left aside. In practice, it appears to be as follows: central banks are forced -- for some unspecified reason -- to set aside their inflation mandates because of fiscal policy. However, there seems to be an even vaguer version: central banks have to take into account fiscal policy when determining monetary policy.

Since no developed country has faced high inflation in the past decade, one would need to be wildly revisionist to believe that central banks have set aside their inflation mandates because of fiscal policy. In fact, central bankers have failed in their promise that they could hit their inflation targets solely with monetary policy: they generally missed to the downside in the post-Financial Crisis period. They came up with an excuse -- it's all the Zero Lower Bound's fault -- something that they neglected to warn anyone about in the 1990s when inflation targeting was being pushed.

So we are stuck with the weaker version: they need to take into account fiscal policy when setting monetary policy.

At the Operations Level, Monetary Policy and Fiscal Policy are Joined at the Hip

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