A Farewell to monetary dominance?

Fiscal Dominance is a spooky concept, at least for the generations of economists and policymakers trained in a world in which inflation targeting by independent central banks was perceived as the alpha and omega of macroeconomic steering, while budget deficits were relentlessly castigated as signs of unruly governments and unhealthy states. "Keep your fiscal house in order and we will take charge of the rest" was the universal message conveyed by central bankers to ministers of finance. However, when monetary policy hit the Zero Lower Bound (ZLB) somewhere in the mid-2010s in Europe, as it did prior to that in Japan and as it is doing right now in the United States, there was a perceptible change in the subtle phrasing of central bankers. As soon as she was appointed at the head of the European Central Bank, Christine Lagarde advocated a more expansive fiscal policy for the Eurozone countries that had ample room to do so, targeting without naming them, Germany, the Netherlands, Austria and Finland. These calls were met with resistance for some time. It took the COVID19 pandemic for Germany to tear up its fiscal Golden rule and to open up wider the purses of its Federal budget after years of restrain.

The €750 billion fiscal stimulus package hastily put together by the European Commission in May and endorsed in July by the EU's 27 Member states after much political tinkering was a case in point toward a change of economic doctrine in Europe. Necessity is the mother of invention as the saying goes. The package would allow the disbursal of more than €390 billions of grants to finance growth-enhancing projects and income redistribution across the Zone. The mutualization of debt achieved by this new special fiscal instrument could pave the way toward a proper European budget. This is still not a Hamiltonian Moment which would see fiscal power move decisively from the national to the supranational level. But then again, the EU is not a Federal state, as has been timely reminded by the German Constitutional Court in its Decision earlier this year on the lawfulness of the ECB's Asset Purchase Programme (cf. our thorough analysis of that decision accessible for subscribers to our Premium Research service).  

In Japan, the steady move toward fiscal dominance - a situation in which the government can spend regardless of its budget deficit, which is then bankrolled by the central bank - will remain a lasting legacy of Abenomics, even after the departure of its main inspirational figure, Prime minister Shinzo Abe (cf. our discussion of Abenomics in the previous edition of The Multipolarity Letter). The Bank of Japan now holds around half the country's outstanding government debt. While not there yet, the United States has moved a few steps closer to fiscal dominance as the free float of federal debt has been significantly reduced by the latest $3 trillion expansion in the Fed's balance sheet, in the wake of the COVID-19 pandemic.

Advocates of Modern Monetary Theory would like to go further down that road by turning the government into a massive money creating machine, spending and redistributing money at will. The word "Modern" in MMT is misleading. Looking back into history, this was actually the situation which most states enjoyed before private bankers who lent money to governments, mostly in order to finance costly wars, started to gain control on public finances by instituting lending syndicates which gave birth to the first central banks. Prior to that, Treasuries could pump money at will by debasing the gold or silver content of the currencies they minted and later by issuing redeemable debt certificates which were bankrolled and discounted by private banks. In a way it could also be argued that the Soviet Union and other centrally planned economies practiced MMT without knowing it by distorting relative prices or by replacing market derived prices altogether by a system of input-output balances, which required a heavy statistical apparatus - the GOSPLAN in the case of the Soviet Union - and eventually failed to accommodate the needs of an increasingly complex economy (Cf. Ludwig Von Mises prescient critique of this system in Economic Calculation in the Socialist Commonwealth, 1920). 

Yet, the case could be made for moderate fiscal dominance in the years to come, as a way to redistribute income - both horizontally through social transfers and across generations or inter-temporally through public investment programmes - and to overcome the limits of monetary policy, especially in a situation in which the natural equilibrium interest rate has been moving steadily downward over the years. Indeed, following the Great Financial Crisis, Quantitative Easing and related unconventional monetary policies have managed to somewhat reflate the major western economies. But the risk of a deflationary trap is still looming in Japan, in the Eurozone and perhaps even in the United Kingdom, as the latest data on UK inflation for August shows (although the dismal inflation number is largely the result of the Eat Out programme). The Fed's readiness to overshoot its inflation target is also a sign of more things to come on the fiscal front, beyond the pre-electoral bipartisan infighting. Call it fiscal dominance or MMT-lite but governments across the world need to spend more. At least those governments that have the luxury to borrow money in their own currency. Lenin once said that inflation could destroy the capitalist system. But this time around inflation might actually save it. Even conservative Central bankers now seem to acknowledge the fact.

Alexandre Kateb