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Flash Economics: Fiscal Dominance in OECD Countries (2018)

Core Content

This document analyzes the concept of fiscal dominance, which occurs when monetary policy is compelled to support fiscal solvency because fiscal policy has failed to do so. It assesses whether fiscal dominance still exists in the following OECD countries: the United States, the United Kingdom, Germany, France, Spain, Italy, and Japan, as of 2018.

The central argument is that fiscal dominance persists in France, Spain, Italy, and Japan, but not in the United States or the United Kingdom. The document highlights the risks associated with fiscal dominance, including the inability of the government to restore fiscal solvency, the central bank's inability to normalize monetary policy, and the negative effects of excess liquidity.

Main Points

Definition of Fiscal Dominance

• Fiscal dominance is when monetary policy ensures fiscal solvency instead of fiscal policy.
• This is dangerous because it incentivizes the government to maintain high public debt levels and prevents the central bank from tightening monetary policy without risking a sovereign debt crisis.

Dangers of Fiscal Dominance

• Sustained rise in public debt ratio: Governments may not feel the need to reduce deficits if the central bank is financing them.
• Inability to normalize monetary policy: Central banks may avoid raising interest rates for fear of triggering a debt crisis.
• Excess liquidity: Leads to asset-price bubbles and reduced risk premia.

Fiscal Dominance in OECD Countries

• France, Spain, Italy, and Japan are identified as still experiencing fiscal dominance in 2018.
• United States and United Kingdom do not exhibit fiscal dominance, as fiscal solvency would still be ensured even with a return to normal interest rates.

Key Information

United States

• A return to a normal long-term interest rate of 4.5% would increase interest payments by 1 percentage point of GDP, ensuring fiscal solvency.
• The central bank (Federal Reserve) is not under pressure to maintain low interest rates to support fiscal policy.

United Kingdom

• A return to a normal long-term interest rate of 3% would increase interest payments by 0.1 percentage point of GDP, and fiscal solvency would still be maintained.
• The Bank of England is not in a fiscal dominance situation.

Germany

• A return to a normal long-term interest rate of 4% would increase interest payments by 1.4 percentage points of GDP, but fiscal solvency would still be ensured.
• Germany is not experiencing fiscal dominance.

France

• A return to a normal long-term interest rate of 4% would increase the fiscal deficit by 2.3 percentage points of GDP, leading to a loss of fiscal solvency.
• France is in a fiscal dominance situation.

Spain

• A return to a normal long-term interest rate of 4.5% would increase interest payments and the fiscal deficit by 2 percentage points of GDP, eliminating fiscal solvency.
• Spain is in a fiscal dominance situation.

Italy

• A return to a normal long-term interest rate of 4.5% would increase interest payments and the fiscal deficit by 2.2 percentage points of GDP, resulting in a loss of fiscal solvency.
• Italy is in a fiscal dominance situation.

Japan

• A return to a normal long-term interest rate of 2% would increase the fiscal deficit by 2.4 percentage points of GDP, leading to a loss of fiscal solvency.
• Japan is in a fiscal dominance situation.

Conclusion

The document concludes that fiscal dominance is still present in France, Spain, Italy, and Japan, but not in the United States or the United Kingdom. This is based on the analysis that in these four countries, fiscal solvency would be at risk if long-term interest rates returned to normal levels.

The presence of fiscal dominance implies that monetary policy is effectively subsidizing fiscal policy, which can lead to long-term economic risks and reduce the central bank's policy independence.

Disclaimer

• The document is intended for professional and qualified investors only.
• It is strictly confidential and should not be disclosed to third parties without prior written consent.
• No liability is accepted for the distribution, possession, or delivery of the document.
• The views expressed are personal opinions of the authors and may differ.
• The information provided is not a personalized investment recommendation and does not take into account individual financial situations.
• No financial analysis is conducted in accordance with legal requirements for investment research independence.
• Natixis is not responsible for any differences in valuation methods or assumptions.