The Struggle for Dominance: Central Banks, Fiscal Policy, and the Risks of Debt-Fueled Inflation

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<span class="h4 size-55 size-md-30 h-not-condensed ">The Struggle for Dominance: Central Banks, Fiscal Policy, and the Risks of Debt-Fueled Inflation</span> </div> </div> <div class="page-top__content-inner"> <div class="row mt-lg-4 mt-md-3"> <div class="col-lg-2 pr-lg-4"> <div class="d-flex flex-lg-column flex-md-row"> <a href="/en/knowledge?themes=1246" title="Economics"> <div class="cartridge bg-theme-1 text-uppercase size-12 font-family-condensed"> Economics </div> </a> <div class="pl-lg-0 pl-md-4"><div class="article-knowledge-item__date-infos mt-lg-3 mt-md-0"><div class="article-knowledge-item__date-label"> Published on: </div> <div class="article-knowledge-item__date"> <div><time datetime="2024-09-05T22:00:00Z">September 06th, 2024</time> </div> </div></div> </div> </div> </div> <div class="col-lg-10 pl-lg-5"> <div class="size-18 font-weight-medium"> <div><div class="rte"><p><strong>Central bankers have recently been under considerable pressure. They responded to the recent surge in inflation with rate hikes that not only raised concerns about economic growth but also increased the cost of issuing new public debt, constraining fiscal policy and potentially making some public debt unsustainable.</strong><br>  </p> </div> </div> </div> </div> </div> </div> </div> </div> </div> </div> </div> <div class="l-container"> <div class="l-container__col p-0 margin-neg-40 position-relative"> <div class="l-container__col-content l-container__col-content--1"> <div> <img loading="lazy" class="img-max-w" src="/sites/default/files/styles/knowledge_articles_full/public/2024-09/central_banks_and_dept.png?itok=vtK67f6n" width="657" height="390" alt="central banks and debt" typeof="foaf:Image" /> <div class="rte"><p><em>Photo credits: Nazakru on 123RF</em></p> </div> </div> </div> </div> </div> <div class="l-container"> <div class="l-container__col "> <div class="l-container__col-content l-container__col-content--1"> <div class="blocks-list "> <div class="blocks-list__area "> <div class="row"> <aside class="col-lg-3 pl-lg-5"> <div class="article-info"> <div class="article-info__authors">By <strong> <a href="https://www.hec.edu/en/knowledge/authors/mengus-eric" hreflang="en">Eric Mengus</a> </strong> </div> <div class="d-lg-block d-md-none"> <div class="article-info__link article-info__download"> <a href="#" class="downloadButton" data-for="knowledge-print-1815965967" title="Download & Print">Download & Print</a> </div> <div class="article-info__link article-info__share share-link "> <a href="#share-block-824588321" data-toggle="collapse">Share</a> <div class="collapse share-link__box" id="share-block-824588321"> <div class="share-link__box-content"> <div class="share-link__box-link"> <span st_url="https://www.hec.edu/en/struggle-dominance-central-banks-fiscal-policy-and-risks-debt-fueled-inflation" st_title="Knowledge - instant - The Struggle for Dominance: Central Banks, Fiscal Policy, and the Risks of Debt-Fueled Inflation" class="icon st_facebook_custom"> <i class="icon__icon webfont webfont-facebook size-13 mr-2 color-facebook" aria-hidden="true"></i> <span class="icon__content"> <span class="icon__title color-yiq-dark">FACEBOOK</span> </span> </span> </div> <div class="share-link__box-link"> <span st_url="https://www.hec.edu/en/struggle-dominance-central-banks-fiscal-policy-and-risks-debt-fueled-inflation" st_title="Knowledge - instant - The Struggle for Dominance: Central Banks, Fiscal Policy, and the Risks of Debt-Fueled Inflation" class="icon st_twitter_custom"> <i class="icon__icon webfont webfont-twitter size-13 mr-2 color-twitter" aria-hidden="true"></i> <span class="icon__content"> <span class="icon__title color-yiq-dark">TWITTER</span> </span> </span> </div> <div class="share-link__box-link"> <span st_url="https://www.hec.edu/en/struggle-dominance-central-banks-fiscal-policy-and-risks-debt-fueled-inflation" st_title="Knowledge - instant - The Struggle for Dominance: Central Banks, Fiscal Policy, and the Risks of Debt-Fueled Inflation" class="icon st_linkedin_custom"> <i class="icon__icon webfont webfont-linkedin size-13 mr-2 color-linkedin" aria-hidden="true"></i> <span class="icon__content"> <span class="icon__title color-yiq-dark">LINKEDIN</span> </span> </span> </div> <div class="share-link__box-link"> <a href="mailto:?subject=Knowledge - instant - The Struggle for Dominance: Central Banks, Fiscal Policy, and the Risks of Debt-Fueled Inflation&body=https://www.hec.edu/en/struggle-dominance-central-banks-fiscal-policy-and-risks-debt-fueled-inflation" class="icon"> <i class="icon__icon webfont webfont-email size-13 mr-2 color-hec" aria-hidden="true"></i> <span class="icon__content"> <span class="icon__title color-yiq-dark">EMAIL</span> </span> </a> </div> </div> </div> </div> <div class="article-info__link article-info__font-size"> <a href="#" class="plusButton" data-for="knowledge-print-1815965967"> <img src="/themes/custom/hec_theme/assets/plus.png" alt="" /> </a> <a href="#" class="minusButton" data-for="knowledge-print-1815965967"> <img src="/themes/custom/hec_theme/assets/minus.png" alt="" /> </a> </div> </div> </div> </aside> <article class="col-lg-9 pr-lg-5"> <div><div class="rte"><p>Simultaneously to this rate hikes, threats to formal central bank independence have been piling up. One recent example is the proposal in the US presidential campaign that the <a class="link-rte" href="https://www.wsj.com/livecoverage/stock-market-today-dow-sp500-nasdaq-live-08-08-2024/card/trump-says-president-should-have-influence-on-fed-s-decisions-wYiEwqxjp9oG4iFWN4o7">POTUS should be consulted</a> before any interest rate decision and may terminate the mandate of the Fed chairperson.</p> <p>These developments seem connected to the high levels of public debts accumulated in response to the 2008 financial crisis and the COVID crisis.</p> <p>“Unpleasant monetary arithmetic” or “Fiscal or monetary dominance”: the literature has clarified that the consolidated budget constraint of the public sector implies that either monetary or fiscal policy must accommodate the other <a class="link-rte" href="https://x.com/MinneapolisFed/status/1819383676901220671">to ensure sovereign solvency</a>.</p> <p>Yet, no theory sheds light on which authority imposes discipline on the other. Why should the fiscal authority be the dominant one now? Wasn’t there seemingly more fiscal discipline in the US before 2008? Was the Fed interested in accommodating the Treasury during the Volker era?<br> With Jean Barthelemy and Guillaume Plantin, we have just published a <a class="link-rte" href="https://authors.elsevier.com/c/1jYMi50wadqoL">research paper</a> in the Journal of Economic Theory, which provides some answers to these questions.</p> <p>We build a theory in which either fiscal or monetary dominance arises as the outcome of a game between the central bank and the government. This theory allows us to characterize the determinants of fiscal dominance and, in particular, the precise role of public debt. This contrasts with the previous literature, which takes as exogenous whether fiscal or monetary dominance prevails.</p> <p>In our theory, fiscal dominance may arise when the government has a small fiscal space—i.e., a limited ability to raise taxes and/or cut spending—and when interest rates are low and not sensitive to large debt issuance. In this situation, the government doubles down on debt issuance to credibly force the central bank to raise the price level and avoid sovereign default.</p> <p>Our theory points to the critical role of the market reaction to government debt issuance but also emphasizes that the central bank may have tools to avoid fiscal dominance or at least to attenuate its costs. We show, for example, that a little bit of inflation to create fiscal space in the present may be preferable to fiscal dominance and higher inflation in the future. </p> <p>From a positive point of view, fiscal dominance is a potential risk in many countries with large debt levels. For example, our theory helped us understand episodes such as the <a class="link-rte" href="https://www.nytimes.com/2022/10/04/business/economy/bank-of-england-truss.html">mini-budget in the UK</a> in 2022 (learn more in French <a class="link-rte" href="https://theconversation.com/poids-de-la-dette-et-inflation-quelles-lecons-apres-lepisode-britannique-193256">here</a>).</p> <h2><span class="h4">Is there a game between the fiscal and the monetary authority?</span></h2> <p>But, is there really a game between fiscal and monetary authority? Do we expect fiscal authorities to deliberately and precisely design fiscal expansions as strategies to force monetary ones to deviate from their price-stability objectives?</p> <p>In the paper, we argue that our theory captures more situations in which the fiscal authority “kicks the can down the road” by postponing the resolution of policy problems. This is a form of “insidious fiscal dominance,” as <a class="link-rte" href="https://www.mercatus.org/research/policy-briefs/fiscal-dominance-how-worried-should-we-be">described </a>by Eric Leeper. Alternatively, the fiscal authority, focused on another objective, fails to internalize the inflationary consequences of its own actions when designing bold fiscal expansions, such as during and after the COVID crisis.</p> <p>To learn more about the theory, read the full article on LinkedIn <a class="link-rte" href="https://www.linkedin.com/pulse/inflation-central-bank-independence-public-debt-eric-mengus-ofgie/?trackingId=zwkoSyXQSue4D0FToacfCw%3D%3D%C2%A0">here</a>.</p> <p> </p> </div> </div> </article> </div> </div> <div class="blocks-list__area"> <div class="row"> <div class="col-lg-7 offset-lg-3 border-top pt-3 px-lg-0"> Article by Eric Mengus (HEC Paris) on his paper, “<a class="link-rte" href="https://www.sciencedirect.com/science/article/pii/S0022053124000917?dgcid=coauthor"><em>The central bank, the treasury, or the market: Which one determines the price level?</em></a>” co-authored by Jean Barthélemy (Banque de France) and Guillaume Plantin (Sciences Po and CEPR). </div> </div> </div> </div> </div> </div> </div> <div class="l-container"> <div class="l-container__col pt-0"> <div class="l-container__col-content l-container__col-content--1"> <div> <div class="bottom-article-block border-top"> <div class="bottom-article-block__area"> <span class="bottom-article-block__label">Related topics:</span> <a href="/en/knowledge?themes=1246" title="Economics"> <div class="bottom-article-block__cartridge"> <div class="cartridge bg-theme-1">Economics</div> </div> </a> </div> <div class="bottom-article-block__area"> <div class="bottom-article-block__tool"><div class="article-info__link article-info__download"><a href="#" class="downloadButton" title="Download & Print" data-for="knowledge-print-1815965967">Download & Print</a></div></div><div class="bottom-article-block__tool"><div class="article-info__link article-info__share share-link "><a href="#share-block-1793755603" data-toggle="collapse">Share</a><div class="collapse share-link__box" id="share-block-1793755603"><div class="share-link__box-content"><div class="share-link__box-link"><span st_url="https://www.hec.edu/en/struggle-dominance-central-banks-fiscal-policy-and-risks-debt-fueled-inflation" st_title="Knowledge - 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The Struggle for Dominance: Central Banks, Fiscal Policy, and the Risks of Debt-Fueled Inflation | HEC Paris