What “fiscal dominance” would mean for the U.S. economy

The U.S. government’s debt surpassed $40 trillion last month. Meanwhile, the Federal Reserve continues to fight inflation, which is still higher than its 2% target rate. High inflation is actually good for the national debt, because an elevated inflation rate reduces the real value of the money the U.S. owes.

Sometimes, economies reach a point where their debt gets so out of control that monetary policymakers must prioritize the government’s borrowing needs over stabilizing inflation. It’s called “fiscal dominance.”

“It's a situation where fiscal policy runs the show, and monetary policy is subjugated to fiscal needs,” said Veronique de Rugy, the George Gibbs Chair in Political Economy at George Mason University.

In the U.S., monetary policymakers (that’s the Federal Reserve) control interest rates and money supply, while fiscal policymakers (that’s Congress and the president) control taxes and government spending.

But when monetary policymakers raise interest rates — as they do when trying to combat inflation — the interest the government pays on debt goes up too.

“When the borrowing costs of the government get really high they may start to struggle to bring in enough revenue to cover those borrowing costs,” said Rashad Ahmed, economist at the Andersen Institute for Finance & Economics. “If the central bank starts to set interest rates in a way where they're prioritizing a reduction in the debt burden of the government, you have what's called fiscal dominance.”

In the United States, this happened during World War II and its aftermath.

“It was a war after all,” said Kenneth Kuttner, an economics professor at Williams College. “They needed to raise a lot of funds.”

The government sold around $185 billion worth of war bonds, and the national debt jumped from $49 billion in 1941 to almost $260 billion by the end of 1945.

“And the central bank agreed to buy a lot of debt,” Kuttner said.

That made it easier for the U.S. Department of the Treasury to continue financing the government’s military efforts and making payments on the debt.

“It's debated, but some folks argue that the inflation jumps in the 1970s that followed all of this could have been related to this persistent period of unusually low interest rates that fiscal dominance brought about,” said Ahmed.

In recent history, fiscal dominance in Zimbabwe and Venezuela led to hyperinflation. In those countries, the government debt got so high that the central banks essentially printed money to help cover it.

“Those are really extreme cases,” Kuttner said. “You can imagine a less-extreme case where the government goes to the central bank and says, ‘Hey we're really having trouble … could you please relax monetary policy to lower the interest rates and the debt we have to pay?’”

Right now, the U.S. government is paying $3 billion a day to cover the interest on the country’s debt. That is happening as demand for new government debt — Treasury bonds, bills, and notes — is going down. Yields on 30-year bonds are at a 19-year high.

“Without naming any names, you might see a situation where a certain president might go to the Fed and say, ‘Well, look, interest rates are too high, we would really like you to keep interest rates low, to make it easier to issue more debt,” Kuttner said. “And if that were to happen, then you can imagine after some period of time, if interest rates were held too low for too long, you would start to see inflation rising.”

Still, the U.S. government debt remains one of the safest investments in the world. The Fed isn’t in a position like the central banks in Venezuela or Zimbabwe.

But if the federal government gets too burdened with expensive debt, “the monetary side is going to be put in a position to control the debt by letting inflation go,” de Rugy said. “Or, it's going to be put in a position to fight inflation with the winds blowing in its face.”