Since 2008, public sectors have issued an unprecedented level of liabilities either in the form of government debt (outstanding debt is equal to 125% of GDP in the US and 100% in the euro area) or as central bank reserves, which are now up to more than 30% of GDP at the Fed and 60% at the ECB. High levels of government debt can prevent central banks from achieving price stability (Landau 2020). Persistently low real rates and inflation have thus far led many observers to play down such a risk of inflation as a fiscal phenomenon (Blanchard 2019).
However, the recent surge in inflation on both sides of the Atlantic together with stretched public finances have raised concerns that fiscal dominance has become more likely to rear its head. A number of observers (Cochrane 2021, Summers 2021) worry about central banks’ ability to raise interest rates or reduce central bank reserves whenever needed so as to fulfil the price-stability part of their mandates. Such concerns highlight a risk of switching from monetary dominance, whereby the central bank faces no fiscal obstacle to fulfil its price stability objective, to fiscal dominance, whereby inflation is determined by the solvency constraint of the fiscal authority. With this shift to fiscal dominance, the inflation that is currently thought to be transitory may well become more persistent (Goodhart and Pradhan 2021).
In a recent working paper (Barthélemy et al. 2021), we determine the conditions under which fiscal dominance or monetary dominance prevail and characterise the actions of both authorities leading to each regime. In particular, we shed light on the extent to which the central bank can either deter the fiscal authority from entering into fiscal dominance or mitigate the resulting inflationary pressure. To this end, we write down a model in which a monetary authority issues the unit of account and seeks to stabilise the price level and, to some extent, cares about a potential default by the fiscal authority, and in which the fiscal authority issues debt and cares about public spending, while also seeking to avoid default.
Four results about the dynamic game of chicken
Result 1: Net public liabilities are the key determinant of the game of chicken
We first show that the critical variable that determines the current price level is the net public debt in the hands of the private sector – the sum of central bank reserves and government bonds minus those held by the central bank. Depending on this level of net public debt compared to overall real public resources, the central bank may implement a price level in line with its objective (monetary dominance), increase its price level to ensure solvency (fiscal dominance), or, when net public debt is too large, let the government default. Figure 1 illustrates these findings.
Figure 1 Price level as a function of outstanding net public liabilities
Notes: This figure shows price level as a function of outstanding net public liabilities (government debt + central bank reserves - holding of government debt by the central bank).
Result 2: Fiscal dominance prevails when the fiscal authority has exhausted its fiscal capacity
As long as the fiscal authority has some available fiscal capacity, the central bank can refuse to chicken out – that is, to inflate debt away – and let the fiscal authority raise primary surpluses if needed to repay net public liabilities. Thus, fiscal dominance prevails when the fiscal authority has exhausted its fiscal capacity so that it cannot raise additional resources (e.g. due to fiscal limit, distortionary cost of taxation) or to cut spending (e.g. political pressures, high fiscal multiplier).
But then, would the fiscal authority deliberately exhaust its fiscal capacity or is this necessarily the outcome of exogenous shocks such as a fall in fiscal revenue due to a recession?
Result 3: Fiscal dominance can result from a deliberate fiscal action to flood the bond market
The fiscal authority may decide to run large deficits and flood the bond market to force the central bank to chicken out in the future. Such a decision results from comparing the fiscal gains from fiscal dominance with the cost associated with distorting fiscal policy to exhaust future fiscal capacity. In our model, this latter cost stems from the inefficient allocation of public spending over time – due to excessive real interest rates for instance. Other costs may entail the government’s limited ability to absorb future adverse shocks.
Figure 2 summarises our findings. In this figure, the government compares the blue point – the intertemporally optimal consumption path – with the red point, where the government exhausts its future fiscal capacity (in our model, this means that it does not consume in the future) but gains resources from pushing the central bank away from its price level objective.
Figure 2 Government choices of expenditure plans
Result 4: The fiscal authority not always prefers fiscal dominance
When the distortionary cost is larger than fiscal gains from fiscal dominance (delta measures this cost-benefit analysis), monetary dominance prevails as the government is better off restricting its issuance of debt. This occurs when initial public liabilities are small, when interest rates are highly sensitive to public debt issuance, when the future fiscal capacity is large, and when the fiscal authority is patient. Notice that this happens in the absence of coordination, fiscal rules, or any form of commitment.
Pre-emptive actions by the central bank?
A natural question is whether the central bank has any power to tilt the game towards monetary dominance or to reduce the inflationary cost imposed by fiscal dominance.
First, quantitative easing is not an effective tool to avoid fiscal dominance (see also Allen et al. 2021). Any purchase of private assets by the monetary authority increases the net public liabilities and hence the fiscal gains from fiscal dominance. Absent any other considerations, the central bank should therefore limit its issuance of reserves to reduce the risk of fiscal dominance. Purchases of government bonds by the central bank do not modify the fiscal incentives to flood the bond market. The reserves that finance these purchases let the net public liabilities unchanged.
Second, we show that the central bank may be better off engaging in pre-emptive inflation: by raising current inflation, the central bank decreases the real value of past liabilities and thus increases fiscal capacity. According to our model, such larger fiscal capacity reduces the incentives for the government to engage into fiscal dominance.
Dynamic game of chicken and market dominance?
Low rates as we currently experience may well give rise to endogenous shifts from monetary to fiscal dominance regimes. The main reason is that the present value of future fiscal resources may evolve over time. In particular, with sufficiently low rates, the present value of future fiscal resources may decrease, thus shifting the economy from a situation of monetary dominance due to high future fiscal capacity to fiscal dominance due to low future fiscal capacity over time.
Low rates may also give rise to another, more problematic, situation that we label market dominance. In this case, public liabilities may be subject to self-fulfilling market expectations and contain a bubble component. We then show that, depending on how private sector liquidity reacts to the public situation, multiple different equilibria may arise, some featuring fiscal dominance and the other one monetary dominance.
Authors’ note: The views expressed in this column are entirely those of the authors. They do not necessarily represent the views of the Banque de France or the Eurosystem.
Allen, W A, J Chadha and P Turner (2021), “Quantitative tightening: Protecting monetary policy from fiscal encroachment”, VoxEU.org, 23 October.
Barthelemy, J, E Mengus and G Plantin (2021), “The Central Bank, the Treasury, or the Market: Which One Determines the Price Level?”, CEPR Discussion Paper 16679.
Blanchard, O (2019), “Public Debt and Low Interest Rates”, American Economic Review 109(4): 1197-1229.
Cochrane, J (2021), “The end of “the end of inflation””, 10 June.
Goodhart, C and M Pradhan (2021), “What May Happen when Central Banks Wake Up to More Persistent Inflation?”, VoxEU.org, 25 October.
Landau, J-P (2020), “Money and debt: paying for the crisis”, VoxEU.org, 23 June.
Sargent, T and N Wallace (1981), “Some Unpleasant Monetarist Arithmetic”, Federal Reserve Bank of Minneapolis Quarterly Review.
Summers, L (2021), “Interview on Bloomberg”, 6 November.