Are we moving toward fiscal dominance?

A recent Bloomberg article suggested that we may be moving toward a regime characterized by fiscal dominance, at least part of the time:

In their paper, three economists from New York University, Stanford and London Business School argue that the US is moving from a regime of “monetary dominance” to one of “fiscal dominance.” In the former, the Fed controls inflation by adjusting short-term nominal interest rates. The government supports these efforts by committing to increase future taxes, ensuring that other interest rates don’t change too much and debt doesn’t overwhelm markets. Under a monetary dominance regime, interest rates and inflation are low and relatively stable.

I don’t agree with the claim that monetary dominance implies low and stable interest rates or inflation. We clearly had monetary dominance in the 1960s and 1970s, when budget deficits were small as a share of GDP. And yet inflation was high and unstable. Both in the Great Inflation, and in the more recent bout of high inflation, the problem was the Fed’s misguided belief that easy money is a good way to create jobs.

The regime changed during and after the pandemic, when wartime-sized debt was issued with no care of paying it back. . . . Under such a [fiscal-dominance] regime, the Fed is less powerful.

I wouldn’t say the Fed “manages” bouts of inflation, as that term makes them seem like an innocent bystander. The Fed created the high inflation of 2021-22 with a highly expansionary monetary policy. And the Fed was no less powerful than before, as it had plenty of “ammunition” to adopt a tighter monetary policy if it had wished to.

Not only is its job harder, but its tools are less powerful — it has less influence over interest rates.

Its power doesn’t come from control of interest rates; it comes from control over the gap between the target rate and the natural rate. And it has just as much power over that gap as before deficits became large.

After spending moderated and monetary policy became more restrictive, the US returned to a monetary policy regime. But the nation’s debt trajectory risks a future turn to fiscal dominance.

It moderated only relative to the Covid period. In absolute terms, fiscal policy is currently highly irresponsible, especially if compared to the Great Inflation of 1966-81. If the fiscal dominance model were true, the US would currently be experiencing very high inflation. On the other hand, I agree that our current path does impose at least some risk of slipping into fiscal dominance. That’s what tends to happen in banana republics.

Fiscal policy, which has become more ambitious in recent years, is finally doing the job it’s supposed to do. Both parties have been vocal in supporting policies that aim to shift production from services to manufacturing, either through tariffs or with industrial policy. There are also goals related to improving infrastructure, lowering the cost of housing, and reforming the immigration system. These policies change the supply side of the economy . . .

In a recent Econlog post, I pointed out that tariffs might end up shifting output toward services, by increasing the relative price of manufactured goods. (Tariffs might reduce the trade deficit, but probably won’t.) And those three goals sound fine, but I don’t see much action.

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