The nature of “fiscal dominance” in OECD countries: “Unpleasant monetarist arithmetic” revisited

In their famous 1981 article (1) , Thomas Sargent and Neil Wallace showed how “fiscal dominance” operates. The government conducts an expansionary fiscal policy and the public debt ratio rises. When the public debt ratio reaches the upper bound of what can be financed, the central bank has to stabilise it. To do so, it monetises public debt, with rapid growth in the money supply and high inflation. The monetarist arithmetic is unpleasant, since inflation, which is initially low, which drives up the public debt ratio, ends up becoming high. Today, fiscal dominance (when fiscal policy determines monetary policy) has another nature: central banks in OECD countries are keeping interest rates abnormally low relative to growth in a situation of low inflation. It is therefore the below-growth interest rate and not inflation that reduces the public debt ratio. But if, in the long term, the real interest rate returns to normal, it will be close to real growth and, like in the Sargent and Wallace model, only inflation would then be able to stabilise the public debt ratio if fiscal policy remains expansionary. So it is the ability to abnormally depress the real interest rate that is allowing today’s policymakers to not use inflation. 1 T. Sargent, N. Wallace, “Some Unpleasant Monetarist Arithmetic”, Federal Reserve Bank of Minneapolis Quarterly Review, February 198 1