Fiscal dominance is here, or is it?
One of the more useful AI tools that I have set up recently is a bi-weekly macro and demographics theme scout, which collects material on a given topic and runs through a number of recent and older sources, and synthesises this material into a brief essay, as well as a text to speech (TTS) document so that I listen back with the ElevenLabs text-to-speech app.
I thought it might be useful to recycle some of this material on the blog. One of the topics my AI scout landed on earlier this year was fiscal dominance, and whether developed markets are now slipping into this regime after a long period in which monetary dominance—activist monetary and passive fiscal policy—was the norm. I would frame the question like this. Has fiscal largesse during Covid, the subsequent fiscal support to protect against sequential global supply shocks in energy, and more generally deglobalisation and a focus the government balance sheet as a strategic lever for economic security pushed monetary policy into a Sargent and Wallace world of "unpleasant arithmetic”?
Here is the essay with some additions by me, including the conclusion, and more recent contributions.
Who dominates who in a post-Covid world?
Central banks are usually discussed as though they choose interest rates in a world separate from fiscal policy. Governments decide taxes and spending; central banks decide inflation. The institutional separation is useful, but the economics has never been so tidy. Every monetary policy decision changes the government's intertemporal budget constraint. Higher interest rates alter debt-service costs. Inflation changes the real value of nominal liabilities. Fiscal choices affect aggregate demand and the quantity of government debt the private sector must absorb. Monetary and fiscal policy therefore meet whether policymakers want them to or not.
Thomas Sargent and Neil Wallace gave the classic warning in their 1981 paper on unpleasant monetarist arithmetic. Imagine a central bank that tightens policy today while fiscal policy refuses to adjust future primary balances. Higher interest rates can increase the interest burden on government debt. If the fiscal authority ultimately requires the central bank to generate seigniorage, tighter money today may imply more money creation and inflation later. The crucial insight is not that every indebted government mechanically forces its central bank to print money. It is that monetary control depends on the fiscal regime.
Eric Leeper later made this relationship particularly transparent by distinguishing active and passive policies. An active authority pursues its objective without adjusting to stabilise the government's joint budget constraint. A passive authority accommodates. Conventional monetary dominance combines active monetary policy with passive fiscal policy: the central bank sets policy to stabilise inflation and fiscal policy adjusts sufficiently to make government liabilities sustainable. Fiscal dominance reverses the assignment. Fiscal policy determines spending and taxation without providing the adjustment required to validate the price level implied by monetary policy. Something else must move.
The fiscal theory of the price level, associated with work by Christopher Sims, Michael Woodford and later John Cochrane, takes this logic in a different direction. Government nominal liabilities are assets held by the private sector. Their real value must be consistent with the present value of future primary surpluses. If fiscal policy fixes those expected surpluses independently, adjustment can occur through the price level rather than through future taxes.
This is broader than the Sargent-Wallace mechanism. No finance minister needs to telephone the central bank and order the printing press to start. The valuation of nominal government liabilities can itself connect fiscal expectations to inflation. Why does this old literature feel newly relevant? Because many advanced economies now combine public debt ratios far above pre-financial-crisis norms with interest rates that are no longer close to zero. The cheap-debt environment allowed governments to carry large stocks of debt with modest interest bills. Once refinancing occurs at higher yields, the fiscal consequences become progressively more visible. Yet it is important not to jump from that observation to the conclusion that monetary policy has become impotent.
The Keynesian transmission mechanism still operates. Higher policy rates raise borrowing costs, weaken interest-sensitive demand, affect housing and investment, tighten financial conditions and can reduce inflation. A central bank can therefore slow the economy even if higher rates worsen the fiscal accounts, but whether this translates into durable price stability depends partly on whether higher debt-service costs are credibly absorbed by future fiscal adjustment. Without that backing, higher rates can reduce current demand while increasing expected future inflation through the government budget constraint.
Put very simply, an activist monetary policy can be thwarted by an equally activist fiscal authority.
This creates a tension rather than a simple constraint. The same rate increase that reduces private demand may increase government interest expenditure over time. Which effect dominates depends on debt maturity, the sensitivity of demand to rates, fiscal responses and the credibility of the policy regime. Debt maturity is particularly important. Governments that locked in long-term borrowing during the low-rate period experience a delayed pass-through from policy rates to interest costs. Economies with short-maturity debt or large quantities of floating-rate liabilities feel the effect much faster. The consolidated public-sector balance sheet matters too: interest paid by the central bank on reserves can transmit higher rates to public finances even before conventional government bonds mature. This is why fiscal dominance should not be diagnosed merely by looking at a high debt ratio.
This, at least, is the standard theory, but the equations can play funny tricks with economists, especially when we blur the distinction between the short run and the long run. John Cochrane, in two recent contributions to this debate, explores wheter lower interest rates actually reduce inflation?
The starting point is the Fisherian proposition that nominal interest rates and inflation must move together in the long run, assuming that the equilibrium real interest rate remains unchanged. Add the assumption that inflation eventually converges towards the steady state implied by the central bank's chosen interest rate, and a persistent reduction in nominal rates must ultimately produce lower inflation. This is not the conventional short-run monetary transmission mechanism. Indeed, Cochrane's baseline model produces the familiar initial response: lower rates stimulate demand and raise inflation before inflation eventually declines. Conversely, higher rates can suppress inflation today only at the expense of higher inflation later, provided fiscal policy remains unchanged.
But Cochrane finds that this short-run trade-off depends critically on the maturity structure of government debt. In his model, replacing long-term government bonds with overnight debt eliminates the initial inflationary response to a rate cut. Lower interest rates then reduce inflation immediately, while simultaneously lowering government interest expenditure. His follow-up contribution identifies another possible route: a sufficiently credible, pre-announced reduction in interest rates could diminish the adverse short-run response as existing long-term debt matures.
The implications are striking, but Cochrane himself is sceptical that manipulating the maturity structure of public debt can reliably deliver such an immaculate disinflation. He also acknowledges that the long-run stability assumption is not universally accepted. More fundamentally, the result depends on fiscal policy remaining unchanged. If governments respond to lower debt-service costs by increasing expenditure, the fiscal benefit disappears.
The interesting question, therefore, is not whether central banks should suddenly start cutting rates to fight inflation. It is whether the conventional short-run relationship between interest rates and inflation can be reconciled with the very different long-run equilibrium implied by monetary and fiscal theory. Cochrane's experiments suggest that debt maturity, expectations and the fiscal response may determine how that transition unfolds.
The relevant question ultimately is behavioural and as such state-dependent: when fiscal arithmetic deteriorates, which authority adjusts? If governments raise taxes, restrain spending or otherwise stabilise debt, monetary policy can remain dominant even at high debt levels. If fiscal authorities systematically refuse adjustment and political pressure instead falls on the central bank to tolerate inflation, the regime begins to look different.
Economic models can tell us what must adjust. They cannot, on their own, tell us which authority will ultimately choose to do so.
Expectations make the boundary fuzzy. Investors do not need to wait for an explicit institutional confrontation. If they begin to doubt future fiscal adjustment, term premia can rise. Rising yields are not, in themselves, evidence of fiscal dominance; the distinction depends on what is driving them and how policymakers respond. But higher yields for the ‘wrong reasons’ worsen projected debt service, potentially reinforcing the concern.
What began as a fiscal credibility problem can become a financial-conditions shock. This creates an uncomfortable possibility for central banks. Raising rates to demonstrate inflation-fighting credibility can increase fiscal stress, while failing to raise them can weaken monetary credibility. There is no contradiction here. It is precisely the joint nature of the regime that makes the problem difficult, and arguably a problem that DM central banks now face.
A central bank can be legally independent and still operate in an economic environment shaped by fiscal choices. A government can run persistent deficits without immediate inflation, yet eventually alter the equilibrium if private demand for its liabilities changes. The regime is revealed by adjustment. The question is not whether monetary or fiscal policy matters more in the abstract. It is who ultimately moves when their objectives become inconsistent.
That is what fiscal dominance has always been about, and why it is now being discussed again.
The analysis above identifies several empirical clues to a possible transition from monetary to fiscal dominance: high initial debt levels, large and persistent fiscal deficits without credible plans for future adjustment, and nominally independent central banks struggling to restore price stability while facing the spectre of Sargent and Wallace's unpleasant arithmetic. These conditions look close to the world we live in today.
Most intriguing of all, however, is the possibility that this transition is being driven by changes in the underlying macroeconomic environment. The pandemic, successive energy shocks, deglobalisation and population ageing have placed new demands on fiscal policy, while potentially altering the equilibrium between saving and investment. The AI investment boom adds another dimension, raising demand for capital today even as its prospective productivity gains could improve fiscal capacity tomorrow. These forces need not all push in the same direction, but together they are reshaping the environment in which monetary and fiscal policy interact.
If this hypothesis is correct, the traditional discussion of monetary and fiscal dominance needs an additional dimension. It is not enough to identify which authority adjusts when monetary and fiscal objectives become inconsistent. We must also understand what drives changes in that assignment in the first place. External shocks, structural economic transformations and the political response to them may themselves determine whether a previously stable monetary regime gives way to fiscal dominance.
Fiscal dominance, in other words, is not simply be a consequence of governments refusing to adjust. It may emerge when the economic environment changes faster than the political capacity or willingness to adjust with it.
References
Cochrane, J. H. (2023). The Fiscal Theory of the Price Level. Princeton University Press. https://press.princeton.edu/books/hardcover/9780691242248/the-fiscal-theory-of-the-price-level -
Cochrane, J. H. (2026). Reasons to Lower Rates & More on Lower Rates, The Grumpy Economist Substack
Leeper, E. M. (1991). Equilibria under 'Active' and 'Passive' Monetary and Fiscal Policies. Journal of Monetary Economics 27(1). https://doi.org/10.1016/0304-3932(91)90007-B -
Sargent, T. J. & Wallace, N. (1981). Some Unpleasant Monetarist Arithmetic. Federal Reserve Bank of Minneapolis Quarterly Review. https://www.minneapolisfed.org/research/quarterly-review/some-unpleasant-monetarist-arithmetic -
Sims, C. A. (1994). A Simple Model for Study of the Determination of the Price Level and the Interaction of Monetary and Fiscal Policy. Economic Theory 4. https://doi.org/10.1007/BF01215378 -
Woodford, M. (1995). Price-Level Determinacy Without Control of a Monetary Aggregate. Carnegie-Rochester Conference Series on Public Policy 43. https://doi.org/10.1016/0167-2231(95)90033-0