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?

Charles W. Calomiris is Henry Kaufman Professor of Financial Institutions Emeritus at Columbia Business School, and Dean of the Center for Economics, Politics and History at UATX. The author thanks Peter Ireland, Peter Stella, the referee, the editor, and participants in the Alamos Alliance 2023 meetings for helpful comments on earlier drafts.

"Under current policy and based on this report's assumptions, [government debt relative to GDP] is projected to reach 566 percent by 2097. The projected continuous rise of the debt-to-GDP ratio indicates that current policy is unsustainable." 

—Financial Report of the United States Government, February 16, 2023

INTRODUCTION

The above quotation from the Treasury's Financial Report admits that the current combination of government debt and projected deficits is not feasible as a matter of arithmetic because it would result in an outrageously high government debt-to-GDP ratio. But when exactly will the US hit the constraint of infeasibility, and how exactly will US policy adjust to it? This article considers whether fiscal dominance is a serious possibility for the United States in the near future and discusses how various policies (especially those related to the banking system) likely would change if fiscal dominance became a reality.

Fiscal dominance refers to the possibility that the accumulation of government debt and continuing government deficits can produce increases in inflation that "dominate" central bank intentions to keep inflation low. The article begins by showing that the prospect of this occurring soon in the United States is no longer far-fetched. 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. 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.

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). To be specific, here is how I imagine this occurring: When the bond market begins to believe that government interest-­bearing debt is beyond the ceiling of feasibility, the government's next bond auction "fails" in the sense that the interest rate required by the market on the new bond offering is so high that the government withdraws the offering and turns to money printing as its alternative.  

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. 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. 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.

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. 

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.

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.) 

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. For example, under one illustrative example, I will show that requiring banks to hold 40 percent of deposits as zero-interest reserves, under reasonable assumptions, would reduce the annual inflation rate to fund likely deficits from an inflation of about 16 percent to only about 8 percent. For that reason, imposing high reserve requirements for zero-interest paying reserves may seem quite attractive to a policymaker interested in reducing the inflationary consequences of fiscal dominance. 

The history of inflation taxation around the world has shown that when governments become strapped for resources, they often use zero-interest reserve requirements to tax banking systems and remove their spending constraints. For example, in Mexico during the 1970s and early 1980s, inflation taxation of banks became increasingly relied on as government expenditures rose; eventually, as fiscal problems mounted, the government expropriated first bank depositors and then bank equity holders by nationalizing the banks (Calomiris and Haber, 2014, Chapter 11). The general problem of impecunious governments taxing banks with the inflation tax, credit controls, or other means—which can have major adverse consequences for efficient capital allocation and growth—is the theme of a very large literature, which goes back at least as far as Gurley and Shaw (1960) and includes such landmark contributions as McKinnon (1973), Fry (1988), and Acharya (2020).

Taxing banks with reserve requirements and zero-interest reserves is convenient for two reasons. First, instead of new taxes enacted by legislation (which may be blocked in the legislature), reserve requirements are a regulatory decision that is generally determined by financial regulators. It can be implemented quickly, assuming that the regulator with the power to change the policy is subject to pressure from fiscal policy. In the case of the US, it is the decision of the Federal Reserve Board whether to require reserves to be held against deposits and whether to pay interest on them. 

Second, because 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.  

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. Such financial disintermediation from banks occurred in the US in the 1960s and 1970s as a result of high inflation and regulations (including both zero-interest reserve requirements and ceilings on deposit interest rates) that limited the interest rates banks could pay to depositors. 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. (This would be a continuation and acceleration of recent political trends to limit Fintech bank chartering, as discussed in Calomiris, 2021.)

An alternative policy path, of course, with less inflation taxation, would be for the government to decide to reduce fiscal deficits and thereby avoid the need for rising inflation and its adverse consequences for the banking system. This may be a hard policy to enact, however, given that the main contributors to future deficits are large Medicare and Social Security entitlement payments. Also, defense spending seems likely to rise as the result of increasing geopolitical risks related to China. Increased income taxation is another alternative, but this too may be unlikely, not only because of the lack of political consensus about taxation but also because it would reduce growth in income, which would partly offset any deficit reduction coming from projected increases in the ratio of taxes to income. Ultimately, it seems likely that the US will either have to decide to rein in entitlements or risk a future of significantly higher inflation and financial backwardness.

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