Fiscal Dominance Part 2

Paul Hancock, CFP®    January 20, 2024

In my January article, I discussed why the recession many predicted in 2023 never arrived. My argument was that primarily fiscal actions by the US government played a major role in producing strong economic growth. My goal with this article is to explore “Fiscal Dominance” further and its effect on global growth and the bond market.

To Recap

Monetary Policy refers to actions taken by a country’s Central Bank to manage economic growth by lowering and raising interest rates, contracting or expanding its balance sheet, and influencing the number of bank reserves and base money (currency) in the system.

Fiscal Policy refers to the uses of government spending and taxation to influence the economy.

Fiscal Dominance refers to large and rising government debt and deficits creating inflationary pressures that “dominate” central bank monetary policy actions. This creates a “crowding out” effect and hampers the ability of the central banks to control the economy and inflation via interest rate actions.

Gold Standard to the Floating “Fiat” Standard

For the past two centuries, the US Dollar and most global currencies were pegged to gold. This provided a natural constraint on credit growth and spending by governments. If a country created too much debt and spent too much money abroad, gold would flow out of the country's central bank. Many countries abandoned the gold standard during World War I increasing debt to finance the war. Following World War I, Britain went back on the gold standard but finally gave in and went off in 1931. They created too much debt for World War I and didn’t produce sufficient economic growth to tame inflation. The United States would follow suit in 1934 confiscating US taxpayer's gold to fill a hole in their balance sheet.

The Bretton Woods system followed from 1944 until 1971 when countries fixed their currency to the dollar and central banks could still exchange dollar holdings into gold at a fixed exchange rate of $35 per troy ounce. The United States economy boomed during this period, but towards the end, spent above its means by running consistent balance of payments deficits with other countries. Not wanting to lose all of our gold, Richard Nixon finally severed the gold standard on August 15, 1971. Since then, all fiat currencies such as the US dollar have freely floated against one another and capital flows have become progressively deregulated. This was a critical event in monetary history.

Global Hegemon

For much of the past 80 years, especially since 1971, The United States has enjoyed a position unlike any other country. The demand for the US Dollar and the global thirst for debt in a pure fiat system has allowed the United States to wield its power. The United States has now fully shifted to consistently running “twin deficits.”

Government Deficit - Refers to the fact that the US spends more money than it receives in income via tax receipts. Therefore as we continue to run a deficit, the national debt is getting bigger and bigger (see Figure 1 below).

Trade Deficit - Refers to when the United States produces fewer goods at home but imports more goods from abroad. This creates a trade deficit. The US dollars that are created in the US thus get sent abroad.

When dollars are created this way, the United States government is the first entity that picks and chooses where to allocate those dollars. This has a crowding-out effect on private industries in the United States. This also crowds out any entity or country abroad that needs US dollars to service US dollar-denominated debt. This is a dominant position bestowed upon the United States. Only the United States can do this as it possesses the global reserve currency. This is how the system is designed with the United States now the Global Hegemon. The demand for dollars globally remains strong and although nations are beginning to “de-dollarize”, global reserve currencies have long lives.

Figure 1: US Total Public Debt

Source: Sound Money Capital AG

One Man’s Debt is Another Man’s Financial Asset

It’s important to remember that any debt or liability that is created becomes another man’s financial asset. For example, if you need a new car and borrow money from your local bank, the bank creates money or currency out of thin air. The loan is granted, money is created and the dollars are sent to your bank account. You then write a check to your local car dealer and receive a new car. Your asset becomes your car. The bank’s asset becomes your debt! The dealer also makes money in the process (probably using leverage!)

Extending this to the government bond market the reverse is true. If the US government needs funding, it sells debt to the market through a bond auction. Global investors buy government bonds and money flows into the US Treasury General Account, the “Government’s checking account”. Your asset becomes the US Treasury debt! As interest rates rise, the asset becomes more desirable to hold for new investors. The ability of the “Global Hegemon” to balance the level of interest rates vs. the amount of total debt becomes very important to global market stability. 

A Clearer View of the Monetary System

“More budget deficits mean more money-printing & currency debasement that causes inflation & other monetary problems, all of which hurt the economy & everyone’s standard of living.” James Turk.

The risk for the United States is once positive real interest rates (nominal rates minus inflation) get too high, this can set off a debt spiral. In this situation, the US simply can’t afford its interest obligations without printing money. Politicians generally choose not to cut spending (defense, entitlements) and would rather not raise taxes. The easy way out is to print the money. And if that Government happens to possess the global reserve currency, you can bet they’ll print money.

The US Treasury is primarily funded through the US Treasury bond market. In a world of risks, investors always look for ways to park short-term liquidity in the safest markets possible. The US Treasury market has long been the “safe haven” for global liquidity, especially very short-term liquidity. The demand for US dollars and the constant need to recycle dollars around the world enables this system to hum along even with the United States having high debt levels. 

Therefore, the Fed and the US Treasury now will go to any length to avoid any dysfunction in the US Treasury bond market. They have many ways to do this such as quantitive easing, yield curve control, special lending facilities, etc. The release valve for saving the bond market is the currency, in this case, the dollar. More liquidity means more dollar weakness. Not relative to other fiat currencies, but weakness relative to stocks, gold, real estate, and other real assets. More liquidity generally means more monetary inflation. But, the market still desires a short-term liquid safe asset. Given the strong global demand for US dollars and the lack of a credible liquid fiat alternative, short-term US Treasuries and the US dollar will continue to be a safe haven for global liquidity. Is this strategy and actions by the central bank and US Treasury good for everyone or even morally right? No. Is this the way the system works? Yes. My view of the monetary system became clearer once I came to this conclusion and began to see it for what it is rather than what I want it to be. 

References

• James Turk
• Sound Money Capital AG

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