I’ve been watching the Fed raise interest rates while the size of the national debt keeps rising. The dangerously high national debt is so high now that the annual debt payment is itself dangerously high. Interest expense may soon be the biggest annual federal expenditure. At the same time, inflation is still too high and the Fed won’t reduce interest rates until inflation is back to the Fed’s 2% target. Interest rates can’t come back down until inflation is slain, but interest rates have to come back down to save the national budget. It sounds like an impossible quandary.
It turns out there are a couple of terms that explain where we probably are now and what may happen next. The first term is Fiscal Dominance. That’s what happens when a central bank doesn't get to make its own decisions any more, it loses its autonomy, because the government is running huge deficits and needs interest payments to be kept low. The government has let debt get out of control and has no easy ways to pay it off. The Fed then has to do what’s necessary to keep the government solvent no matter what it otherwise would have done in the face of inflation.
The second term is Fiscal Repression, which is what happens when interest rates are kept artificially below inflation. That leads to negative real interest rates which means debt will be paid back in cheaper future dollars. That is good for borrowers (the government) and bad for lenders (anyone who buys treasuries). The government borrows a dollar, but they can pay it back when that same dollar is only worth fifty cents. Over time, today’s government debt will become lower and lower in inflation-adjusted terms.
It’s pretty easy to see why fiscal repression might be an attractive solution to excessive government debt. It doesn’t require legislators to make painful and controversial choices or pass tax increases or make program cuts. Fiscal repression is somewhat painless and almost invisible. Nobody has to vote on it, or even acknowledge it. It’s the “get out of jail free” card in Monopoly.
The cost of this great benefit is absorbed by the bond holders. So why would bond holders ever agree to accept negative real interest rates? Losses in purchasing power are stealthy and easy to miss. In nominal terms bond holders are still making a return. It’s only after factoring in inflation that the return is negative. Governments can intervene in lots of ways that force or encourage the purchase of negative interest rate bonds. The Fed and the government can use capital controls to force banks and pension funds and insurance companies to hold a certain amount of government debt because it is “safe”. They can create situations that keep banks from paying high interest rates to depositors so those depositors will purchase treasuries instead for a better return.
Fiscal repression requires that interest rates be not just low, but also below inflation. The greater the gap between the interest rate and the inflation rate, the faster the debt will “melt” away. Eliminating inflation completely can’t be tolerated, but hyperinflation isn’t a goal either because that will scare everyone into paralysis. The ideal is to create a little inflation, “stealthy” inflation. Enough to have an impact but not so high that it will shut down the economy or keep people from purchasing treasuries.
Fiscal dominance and fiscal repression are not terms I had ever heard, but it turns out these both have happened in the past. One of the most interesting and probably appropriate examples is right after World War II. The government spent a huge amount of money fighting the war and by the end of the war the national debt was over 100% of the gross domestic product (GDP). Inflation surged for a few years but interest rates were tightly capped at a very low rate, and banks were limited in the amount of interest they could pay. Fiscal repression worked. The national debt dropped from 116% of GDP in 1945 to 66% in 1955, and it kept dropping after that.
Our national debt today is the highest it has ever been since WWII, and many things about the current shock are similar to what happened then. The money spent in the pandemic to keep the economy going was as enormous as the war spending in WWII. The war shut down supply chains and made many products impossible to get, as happened in the pandemic. The post WWII period was a reopening similar to our post pandemic reopening, and the surge in demand led to similar surges in inflation post WWII as the ones we have seen in the last couple of years.
There is a big debate right now about what is happening to inflation. Is it down and ready to stabilize? Is it about to go back up again? Are we instead headed for deflation? There are plenty of reasons to think any of those could be about to happen. But if for some reason we are headed for deflation, the impact on the national debt would be even worse. Deflation would make the national debt even higher as percentage of GDP. Fiscal repression in a time of deflation would require massively negative interest rates, rates so low that nobody could be fooled into thinking they are still making money. The Fed will need to be sure that we never end up with deflation.
I see little likelihood that we will reduce the national debt by making difficult and painful reductions through cooperative, bi-partisan, legislation. And I don’t think the Fed can allow us to go into deflation. In the absence of that, it looks like we could expect to see fiscal repression, with low(er) interest rates and high(er) inflation for many years to come.
Resources
Some articles that were really helpful:
Fiscal Dominance, Lyn Walden, July 2023
Terms You Should Know, T. Rowe Price, 8/11/2020
Fiscal Dominance and the Return of Zero Interest Bank Requirements, St. Louis Federal Reserve, 6/2/2023
Fiscal Repression, Then and Now, Carmen Reinhart and Jacob Kirkegaard, 3/26/2012