The Federal Reserve on Fiscal Dominance

The Federal Reserve recently published a research paper on the fiscal and monetary situation of the US titled Fiscal Dominance and the Return of Zero-Interest Bank Reserve Requirements.

The paper essentially says:

I've provided quotes from the research paper along with my plain-English translations. There is a lot of financial lingo you have to read between the lines to understand.

Abstract

"As a matter of arithmetic, the trends of US government debt and deficits will eventually result in an outrageously high government debt-to-GDP ratio. But when exactly will the United States hit the constraint of infeasibility and how exactly will policy adjust to it? This article considers fiscal dominance, which is the possibility that accumulating government debt and deficits can produce increases in inflation that “dominate” central bank intentions to keep inflation low. Is it a serious possibility for the United States in the near future? And how might various policies change (especially those related to the banking system) if fiscal dominance became a reality?"

Translation: The US fiscal situation is unsustainable. But when exactly will it all collapse, with the US defaulting on all its debt? This article considers fiscal dominance, which refers to an inflationary debt spiral, culminating in hyperinflation. It could happen very soon. How could we possibly delay or prevent this?

Introduction

"Indeed, if global real interest rates returned tomorrow to their historical average of roughly 2 percent, given the existing level of US government debt and large continuing projected deficits, the US would likely experience an immediate fiscal dominance problem."

Translation: If the US was forced to pay a real interest rate of 2% on its future debt starting today, we would immediately enter an inflationary debt spiral.

"Even if interest rates remain substantially below their historical average, if projected deficits occur as predicted, there is a significant possibility of a fiscal dominance problem within the next decade."

Translation: We're probably going to enter an inflationary debt spiral in the next decade.

"The essence of fiscal dominance is the need for the government to fund its deficits on the margin with non-interest-bearing debts. The use of non-interest-bearing debt as a means of funding is also known as “inflation taxation.” Fiscal dominance leads governments to rely on inflation taxation by “printing money” (increasing the supply of non-interest-bearing government debt)."

Translation: The key part of an inflationary debt spiral is the need for the government to finance itself by printing money.

Thoughts: "Non-interest-bearing-debt" is doublespeak, because who in their right mind (I suppose this mindset is contrary to riba/usury) would lend you money without charging interest? Additionally, "debt" is only debt if you actually intend to pay it back. If you don't intend to pay it back, it really just means taking money from someone else and never returning it. So combining these two facts, we should interpret "non-interest-bearing-debt" to really mean "stolen money".

"As the money supply is forced to grow by fiscal dominance, inflation rises, which creates a new means of funding government expenditures via “inflation taxation.” Inflation taxation has two components: expected and unexpected inflation taxation. Both are limited in their ability to fund real government expenditures."

Translation: When money is printed, inflation rises and governments are able to pay for stuff. The value of what the government spends consists of two parts - "expected" and "unexpected" inflation taxation. Both are not unlimited resources (obviously).

"The expected component of inflation taxation (per period) is the product of the nominal interest rate and the inflation tax base, which consists of all non-interest bearing government debt. (Typically, this consists of currency and non-interest-bearing bank reserves at the central bank.) Total real government expenditures that can be financed by the expected inflation tax are limited because the tax base of this inflation tax is determined by the demand for money. The inflation tax earned per period is the product of the nominal interest rate (the inflation tax rate) and the amount of real demand for currency and zero-interest reserves."

Translation: The obvious part of inflation taxation is when cash-holders are diluted by inflation. This part of inflation taxation is limited because only people who need to use cash (or fools) would hold cash when they know they are losing money by holding it.

Thoughts: The sober categorization of currency as non-interest bearing government debt is duly noted.

"Unexpected inflation taxation occurs when the nominal value of outstanding government debt falls unexpectedly (thereby taxing government debtholders), and this component is also limited by the ability of government to surprise markets by creating unanticipated inflation."

This part is somewhat confusing and took me quite a bit to fully understand. Let me do my best to explain it.

The non-obvious part of inflation taxation is when the US government "surprises" government debtholders by simultaneously:

Bonds get devalued when the inflation rate of money unexpectedly rises.

It has to be a SURPRISE devaluation because if it isn't, it would be priced in already and no one would be "losing money". If bondholders knew a devaluation was coming, they would have either:

This part of inflation taxation is limited because the government can only surprise the market so many times before the market learns to predict that the US government is likely to continue doing this and prices it in on future bond purchases, ultimately refusing to buy any more debt.

When the government does it once, it's essentially a soft default on the debt. Another way to look at it is that the government scams bond purchasers by selling the bond at an overinflated price which doesn't price in future money printing. Later, when the government prints money, the bond is devalued and the bond purchaser is left with an asset that is worth less than what he bought it for.

"If the US government faced a fiscal dominance problem, it would have to fund real deficits by real inflation taxation, which is a limited tax resource. Thus, not all real deficits are feasible to fund with inflation taxation."

Translation: You can't keep funding yourself by printing money forever because the real value you can extract from the market by printing money is limited.

"Furthermore, some changes in policy with respect to reserve requirements are likely if fiscal dominance becomes a reality. The existing amount of the zero-interest debt (the inflation tax base) is currently limited to only currency, given that bank reserves bear interest today. Given the small size of the currency outstanding, if the government wishes to fund large real deficits, that will be easier to do if the government eliminates the payment of interest on reserves. This potential policy change implies a major shock to the profits of the banking system."

Translation: The US government is broke. In order to slow the inflationary spiral, it will implicitly default on some of its debt to the banking system by no longer paying the banks interest on bank reserves. This interest happens to be a large part of bank cash flows. TLDR the US government is going to rug the private banking sector by cutting off a large part of their cash flows.

The theoretically rigorous way of understanding this quote is that stopping interest payments on bank reserves recategorizes the reserves from interest-bearing government debt to non-interest bearing government debt, which is cash. Increasing the cash base allows the government to extract more value via inflation taxation, allowing the government to fund larger deficits.

"Second, as the history of inflation episodes has shown, even an inflation tax base of currency plus zero-interest reserves would decline in real terms in the face of a significant increase in inflation. Based on data for the US as of 2023, the resulting inflation rate could be very high. (That rate is derived by calculating the inflation rate that, when multiplied by the inflation tax base, results in inflation taxation sufficient to fund projected deficits.)"

Translation: The described policy change of rugging the banking sector's cash flows won't even be that helpful because the large amount of money printing required to fund our very large deficits will quickly reduce the real value of our small inflation tax base.

"For that reason, it is quite possible that a fiscal dominance episode in the US would result in not only the end of the policy of paying interest on reserves, but also a return to requiring banks to hold a large fraction of their deposit liabilities as zero-interest reserves."

Translation: Therefore, not only will we rug the revenues of the private banking sector, we will force the banking sector to rug the markets by selling a large portion of the assets on their balance sheet for cash.

Essentially, it's a daisy chain of defaults and rugging that increases the amount of cash in the system that the government can then tax using inflation taxation.

"...many people are unfamiliar with the concept of the inflation tax (especially in a society that has not lived under high inflation), they are not aware that they are actually paying it, which makes it very popular among politicians. If, as I argue below, a policy that would eliminate interest on reserves and require a substantial proportion of deposits to be held as reserves would substantially reduce inflation, then I believe it would be hard for the Federal Reserve Board to resist going along with that policy."

Translation: This method of taxation is good because people don't even know we're taking their money when we take their money like this. Therefore, we recommend the US government to secretly take people's money like this.

"Such a policy change would not only reduce bank profitability but also reduce the real return earned on bank deposits to substantially below other rates of return on liquid assets, which potentially could spur a new era of “financial disintermediation,” as consumers and firms seek alternatives to low-interest paying bank deposits."

Translation: If we rug banks' cash flows and reduce their profitability, banks will have to reduce the interest rate they pay to depositors. This could lead to bank runs as people seek higher returns in other asset classes.

"Of course, banks and their political allies might try to oppose financial innovations to allow firms and consumers to exit from banks, which would lead to a potentially interesting regulatory battle over the future of financial intermediation. The need to preserve a high inflation tax base could lead to a political choice to preserve a technologically backward banking system."

Translation: We will likely have to implement capital controls on banks so that people are trapped into being unable to remove their money from our banks (so that we can keep taking their money).

When does fiscal dominance become apparent as a constraint?

"When exactly does fiscal dominance lead to monetization, and how much does that threaten monetary policy’s inflation goals? How much dollar inflation might result from excessive US government borrowing?"

Translation: When exactly does an inflationary spiral lead to government money printing, and how does that reinforce the inflationary spiral? How much dollar inflation could be caused by excessive government debt?

"...the total debt held by the public is limited by the present value of prospective future fiscal surpluses. At some point, as the government debt-to-GDP ratio rises sufficiently (for a given real interest rate and rate of real growth of the economy), the real demand for government debt reaches a maximum. Any issues of nominal debt beyond that amount will not be accepted by the bond market as increases in real debt."

Translation: Total government debt is limited by the expected value of future government profits. When debt becomes too large relative to the size of the economy, the market refuses to lend more money to the government in real terms.

"Where is the ceiling? If nominal GDP is $24 trillion, and current interest-bearing debt not held by government agencies or by the Fed is about $20 trillion, how much higher can the debt-to-GDP ratio go, given our current long-term real interest rate and real rate of growth?2 First, note that much of the Fed-held debt nowadays pays interest (whether through $3 trillion in excess reserves to Fed member banks or $2.4 trillion in Fed reverse repos mainly with money market mutual funds). If the Fed is paying interest on the debt, then this should be added to the Treasury debt held by the public."

Translation: How much debt is too much? The US government has 20 trillion of debt. Additionally, a lot of the Fed-held debt pays interest (5.4 trillion) and should thus be counted towards interest-paying debt. This makes the total interest-paying debt of the US government 25.4 trillion.

"So that means that the current size of interest-bearing public debt is greater than GDP. This is a historical high in the debt-to-GDP ratio reached only once before, during World War II. Not only that, but the deficit has been running, and is projected to continuing running, at greater than 5 percent of GDP per year. CBO projections imply that the debt-to-GDP ratio will reach about 200 percent by 2050, but that assumes that real interest rates will remain at their historical lows; if they rise even by a small amount, the implied debt growth scenario is much worse."

Translation: Therefore, the US government debt is greater than the size of its economy. This has only happened once before, during World War II. At current projections, US government debt will be twice the size of the economy by 2050, but if the market demands a higher interest rate than the historically low interest rates that we have today, it will be much worse.

"The current debt-to-GDP ratio is in the range associated historically with the fiscal dominance ceiling."

Translation: In the past, countries with the same debt-to-GDP ratio as we have now have typically entered hyperinflation.

"As a country gets close to the ceiling, the interest rates creditors demand rise (as they demand an inflation risk premium) in anticipation of the risk of hitting the ceiling. That means that the perceived risk of hitting the ceiling (once you are close to it) can become self-fulfilling."

Translation: Typically, once you hit the debt-to-GDP ratio that we have now, there is no escaping hyperinflation.

"...there is a clear risk now that a rise in global real interest rates could reverse their three decades of decline (which remains poorly understood), which would make even the current debt-to-GDP ratio very risky, especially given that large primary deficits are projected to continue and that spending cuts are hard because so much of government spending in the US is from entitlements (not subject to annual appropriations) or from military spending (which is unlikely to be reduced, given the current geopolitical landscape). Taxes could be increased, but it seems unlikely to think that a divided Congress today would be nimble enough to do that to stop an incipient inflation risk problem from emerging."

Translation: Look at how much welfare and military we have to pay for, along with the extreme political divide in Congress. We're screwed.

"What does a government that goes above the ceiling, or even gets too close to the ceiling, do to survive? It “prints money,” which you can imagine as using cash to pay for government bills rather than issuing new interest-bearing debt."

Translation: The only option we have left is to print money.

Limits of inflation taxation

"If the US were forced by debt-to-GDP math to fund itself by “printing money,” how would it do so and what are the limits to how much real government spending can be funded in this way? The real funding of spending from the “inflation tax” (the funding of its expenditures by printing money) is limited. There are two components to the inflation tax: expected inflation taxation and unexpected inflation taxation."

Translation: What are the limits to how much real government spending can be financed by printing money? First of all, there is a limit. It has two parts - expected inflation tax and unexpected inflation tax.

"The expected component of the inflation tax is limited by the real demand for zero interest government money... The real expected component of the inflation tax (the amount of real goods and services that can be paid for by printing money) has an upper bound because real demand for zero-interest money declines as inflation increases... That means that once a government exhausts its ability to fund with the inflation tax, it must reduce spending."

Translation: The expected component of inflation tax comes from people who hold cash or use it as money. This is limited because as inflation increases, the demand to use the money decreases. Eventually, once no more people are willing to hold cash, the government cannot buy real goods or services by printing money anymore.

"The government also may get another unexpected inflation tax related to the decline in the value of its outstanding bonds at the time the fiscal dominance problem arises. When fiscal dominance hits and leads to monetization, if this is not anticipated sufficiently far in advance, it also causes some or all existing bonds (long-term bonds with existing low coupons that aren’t indexed to inflation) to fall in nominal value. This is a one-time gain to the government because, going forward, the government will pay a market interest rate on all new debt issues that incorporates the future rate of inflation."

This is a beautiful little paragraph. Basically, when the government sells bonds and then surprise devalues them, they're essentially scamming people by selling bonds for more than they're worth. Each surprise devaluation yields a one-time gain because once the government does this, the market will price this new inflation rate into future bond purchases, paying less than they would otherwise for the same bond. More on bond pricing here.

"If the average duration of government debt is sufficiently long, and fiscal dominance is not anticipated years in advance, the government could benefit from a substantial capital gain from the unexpected inflation tax, which increases its real capacity to issue new interest-bearing debt by a similar amount."

Translation: If the government sells long dated debt, and the market is foolish for years before the devaluation, the government can scam bondholders by selling lots of overvalued bonds over many years before finally devaluing them, extracting much more money from unsuspecting bondholders than it would have been able to otherwise.

"This assumes that the public does not see the fiscal dominance problem coming; but in today’s world, that does not seem as far-fetched an assumption as it used to be. Still, the ability to surprise the market with an acceleration of inflation is always limited by the fact that market participants monitor political and economic news closely and have knowledge about the processes that give rise to inflation."

Translation: We think bondholders today are foolish and and will let us extract lots of money from them because they aren't foreseeing the inevitable money printing that is coming. However, there are limits to this because market participants do have brains and monitor the market situation to some extent.

"It is also worth noting, as Beckworth (2023) points out, that in recent months the market value of US Treasury securities has already taken a toll on bondholders (including banks), declining from 108 percent of GDP in 2020 to about 85 percent of GDP today, mainly as the result of inflation surprises since 2021. This unexpected inflation tax has already substantially expanded the ability of the government to issue debt. More surprises may be coming, although the ability to surprise savers will decline going forward: As the saying goes, you can’t fool all the people all the time."

Translation: We are already extracting money from bondholders in recent months. In fact, we have already extracted significant amounts of money from bondholders, which will give us a supposed justification of printing more money under the guise of a "reasonable debt-to-GDP ratio". We are going to continue extracting money from bondholders, although eventually bondholders will wise up to the fact that we're scamming them.

"What does printing money mean in practical terms? For the US today, the “tax base” for the expected component of the inflation tax does not include the $3 trillion dollars of reserves held by banks— because those pay interest. Of course, the Federal Reserve could change that policy (and perhaps would have to do so in the event of a fiscal dominance problem); but if it did not do so, the inflation tax would be earned only on the dollars in cash held by the public worldwide (about $2.2 trillion in nominal terms today). The big questions about fiscal dominance problems for the US, therefore, are (1) how much would the government gain from surprising outstanding bondholders with fiscal dominance, (2) what would be the tax base of the expected inflation tax, and (3) how much would real demand for zero-interest cash fall (thereby reducing the real tax base of the expected inflation tax) as the result of an increase in expected inflation? Answering these questions is important because it tells us how much inflation would be needed for the government to be able to fund the fiscal costs not funded by interest-bearing debt (as a result of hitting the fiscal dominance threshold). Indeed, it is possible that when answering these questions one might even conclude that it is not feasible for the projected real fiscal deficits to be funded by the inflation tax. In that case, some cuts to governments spending or increases in other taxation would be necessary."

Translation: There is only 2.2 trillion dollars in cash used worldwide, which is the tax base for the expected inflation tax. Therefore, we are going to have to print tons of money and completely default on our government debt. Even then, our tax base for the expected inflation tax (2.2 trillion) is going to shrink once inflation starts to increase, because once inflation starts to pick up, there will increasingly be less demand to hold and use that cash. Judging by all this, even if we print money and hyperinflate the dollar, we won't have enough money to fund our deficits. Therefore, we will have to reduce our spending or increase taxation in other ways.

Connecting the size of debt increases, money increases, and inflation

This section is more technical and attempts to mathematically model the situation.

If the government printed money one time equal to 5% of total US government debt, the paper predicts:

"Given the powerful inflation reduction that a large reserve requirement would imply (in our example, a decline from 16 percent to 8 percent), I think it is likely that a fiscal dominance shock would be accompanied by both the elimination of interest on reserves and a substantial reserve requirement (perhaps lower than 40 percent, but not so much lower that the implied rate of inflation would be permitted to rise too much)."

Translation: We are going to print money, eliminate reserves, and force banks to sell a bunch of their assets for cash.

"If fiscal dominance results in a large increase in the reserve requirement, that means that the real shock to the profitability of the banking system would be greater than the shock related to the elimination of interest on reserves alone."

Translation: If banks are forced to sell a bunch of their assets for cash, we are going to have a mass market meltdown and a ton of banks are going to go bankrupt because their balance sheets will be compromised.

Conclusions

"As the result of the high current US government debt-to-GDP ratio and continuing projected deficits, we face a possible dollar inflation uncertainty nightmare: Continuing deficits, if unchecked, eventually will lead to a fiscal dominance problem. This problem seems likely, given the way Congress has behaved in recent years."

Translation: We have too much debt, spend more than we earn, and have political issues in Congress, so now we're going to have to print tons of money.

"A significant rise in long-run real interest rates also seems quite possible, given that the three decades of decline in real interest rates are poorly understood and may reflect temporary demographic influences. Such an environment would hasten the triggering of a fiscal dominance problem, leading to a messy monetization in the US, with ramifications worldwide."

Translation: Bond markets are going to dump and real bond demand will only exist at significantly higher interest rates. This would force the US to print tons of money and buy debt securities, causing a global financial crisis.

"Many things would likely change in a fiscal dominance scenario to make the inflation tax base larger to facilitate the funding of continuing deficits with less of a rise in inflation. Interest on reserves would likely be eliminated—otherwise, monetization would do little to relax the constraint on the government. Inflation would rise, potentially by a large amount, if that is the only policy used to create inflation taxation. If the elimination of interest on reserves were accompanied by a new large reserve requirement, inflationary consequences could be much lower."

Translation: We are going to squeeze the private banking sector's cash flows, and force banks to sell assets and hold a bunch of cash.

"If the bond market does not anticipate a fiscal dominance shock sufficiently far in advance (where the definition of “sufficiently far” is determined by the duration of bonds held by the public), then bond investors would be caught with losses on high-duration bonds. All of these changes imply that the effects on banks and mutual funds and pension funds and others would be potentially quite dramatic."

Translation: If bond holders don't get out of the market now while they still can, bond holders are going to lose lots of money. Banks, mutual funds, pensions funds, and other financial institutions are going to go bankrupt.

"In the 1970s and 1980s, major financial disintermediation from banks accompanied the rise in inflation taxation because rising inflation reduced the real rate earned on bank deposits. Similar pressures to disintermediate banks could rise again as the result of a rise in inflation taxation. If that occurs, however, banks and their political allies will redouble their efforts to use regulation to protect the banking system from innovation and competition, as they have already been doing (see Calomiris, 2021)."

Translation: If all this happens, there will be bank runs. We are going to implement capital controls and prevent people from withdrawing their money from banks.

"Ultimately, the US may face a political choice between reforming entitlement programs and tolerating high inflation and financial backwardness."

Translation: We are going to face a choice between:

My personal closing thoughts

It's refreshing to see it all laid out like this. As non-insiders, this is as close to the truth we're going to get.

Some musings:

The truth is, the US has already been in fiscal dominance for a long time, AT LEAST since the 2008 GFC. This research report is simply a sober and politically correct recognition of the undeniable reality of what's coming and already here, by many measures. There is just too much debt held by the government and the public, and it all started from the parasitic bankers who stole and continue to steal from the people by creating money out of thin air.

We are past the point of no return. Buckle up!