ERROR
Main Error Mesage Here
More detailed message would go here to provide context for the user and how to proceed
ERROR
Main Error Mesage Here
More detailed message would go here to provide context for the user and how to proceed
search
Close Nav

An End to Fiscal Dominance

back to top
eye on the news

An End to Fiscal Dominance

We need to find a way to separate our fiscal and monetary policies. June 17, 2016
Economy, finance, and budgets

Never heard of fiscal dominance? Don’t worry, you have lots of company. Even many economists are unfamiliar with the term. That’s going to change, though, as more and more Western governments careen toward insolvency.

Setting aside regulation, government can influence the economy through fiscal policy or monetary policy. Fiscal policy means government spending and taxes. In the United States, federal fiscal policy is set by Congress and the executive branch working together, or not. Monetary policy is often thought of as the setting of interest rates, but it’s really about how much money is available to the economy. The Federal Reserve is the United States’ monetary authority. Ideally, fiscal policy and monetary policy are set independently. That’s why the Fed is said to be independent.

Fiscal dominance occurs when the fiscal authority is so profligate that a conscientious monetary authority is forced to accommodate the profligacy—that is, the monetary authority prints gobs of money to fund endless deficits.

For years, fiscal dominance existed on the fringes of economics, important mostly to economists thinking about fiscally irresponsible countries such as Argentina and Brazil. Italy, too, has a long record of monetary accommodation of deficit spending. There’s a reason none of these countries has achieved its economic potential—fiscal dominance has led to bad outcomes, including ever-increasing inflation, reduced trade, declining consumption, and, eventually, political instability.

Today, developed countries are finding it increasingly difficult to avoid the fiscal-dominance trap—in part because of democracy itself. It’s always tempting for political candidates to offer “free stuff” to attract votes. Once such policies are in place, it’s tough to scale them back. When the population is growing, such profligacy might be sustainable—with a younger generation, larger and wealthier than the last, coming along to pay the bills, it’s easy to ratchet up government commitments. But demographics are turning against Western governments. Birthrates are falling. Already, populations are declining in some developed countries—Japan, for example.

Before populations decline, they get older. Demand for goods and services for the elderly increases at the same time that fewer young people are available to fund those demands. The modern state could still deal with a declining population if productivity were growing fast enough, but as economists Tyler Cowen and Robert Gordon have both pointed out, it’s declining—with dire consequences.

Finally, governments’ responses to the 2008 fiscal crisis have not been encouraging. The United States responded with huge spending increases, massive expansion of the monetary base, and direct bailouts or other support for failing businesses, particularly (but not exclusively) in the financial-services industry. While the debt increase exacerbated the fiscal problems, the incentive problems in the bailout are more pernicious. They virtually guarantee, Dodd-Frank notwithstanding, a repeat performance.

In Europe, the European Central Bank sets monetary policy for several countries. Unless several of those countries have similar problems, though, the central bank should face less pressure to bail out individual governments. Of course, it’s possible—even likely—that several of Europe’s governments could face similar challenges at the same time. The pressure for monetary accommodation would then be significant. Even worse, unanticipated political pressures could compel the bank to accommodate individual countries. Europe’s response to the Greek crisis does not inspire confidence in this regard.

Moving back to the gold standard would remove monetary policy from political considerations. The gold standard, though, is controversial. Another possible approach, proposed by Stanford University economist John Taylor, is a rules-based monetary policy. The Taylor Rule is a formula that sets interest rates based on several key inputs: the equilibrium short-term interest rate, the inflation rate, the target inflation rate, output, and potential output. You feed the data into the formula, and it provides a target interest rate. The rule could potentially remove political considerations from monetary policy and stabilize economic outcomes. But Taylor’s proposal is controversial in the economics profession—and neither the Fed nor Congress nor the executive branch supports it.

And even with a rules-based approach, officials would face tremendous pressure to waive it “temporarily” in times of economic stress—just when we would need the rule most. If you waive a rule from time to time, you don’t have a rule.

All of these options—a central bank removed from a particular country, a gold standard, or a rule-based formula—involve difficult challenges in institutional design. Making monetary authorities truly independent is difficult, but vital. It will only become more important as modern governments confront the challenges of declining populations and waning productivity growth.

Photo by eranicle/iStock

Up Next
eye on the news

A “Comeback” in Name Only

The New York Times sees fit to print only good news about California. Bill Watkins April 10, 2013 Economy, finance, and budgets, California

Contact

Send a question or comment using the form below. This message may be routed through support staff.

Saved!
Close