Threat of fiscal dominance?

BIS Papers No 65
May 2012

The massive expansion of central bank balance sheets to contain the worst financial crisis in living memory raises questions about the theory and practice of monetary policy. The persistence in many advanced countries of large fiscal deficits and the prospect of high public debt/GDP ratios for many years is likely, at some point, to create policy dilemmas not only for central banks but also for public debt managers. Some countries have already had to cope with higher sovereign risk.

Worries about both "fiscal dominance" and "financial repression" have certainly gained ground. Whatever view is taken of this, the boundary between monetary policy and government debt management has become increasingly blurred. Policy interactions have changed in ways that are difficult to understand. The current delineation of policy mandates may need to be reassessed.

The aim of this BIS-OECD workshop was to better understand these issues. Theoretical perspectives draw on a long and rich body of monetary theory, but the theory is far from settled. Analysis of the history of fiscal/debt/monetary policy interconnections shows how such linkages have varied across countries and over time - there is no "one size fits all". And careful review of empirical studies shows that precise estimates of the impact of large-scale central bank purchases of government bonds need to be treated with caution.

There is great uncertainty about the impact of increased government debt on inflation, on interest rates and on future growth. Much will depend on future policies. Do monetary policies need to be better coordinated with other macroeconomic or financial policies? Could government financing decisions and financial sector regulation drive the long-term interest rate too low, at least in the short-term? What medium-term risks could this create? What could be the implications for the efficiency and stability of the financial system?

The papers and discussions in this volume do not, of course, converge on simple answers to any of these questions. Indeed, opposite views are expressed. The aim rather is to stimulate discussion about the complex interactions between fiscal deficits, government debt management and monetary policy in unusual macroeconomic circumstances. Some of these interactions are new, but many would be very familiar to an earlier generation of central bankers faced with heavy government debts and thin financial markets.

JEL classification: E43, E44, E63, E61


Threat of fiscal dominance? - workshop summary

Financial crises and monetary policy

Government debt management and monetary policy in Britain since 1919
Keynes's monetary theory of interest
Thoughts on policies and the policy framework after a financial crisis

Macroeconomic theory

Sovereign debt management as an instrument of monetary policy: an overview
Monetary policy and the natural rate of interest

Sovereign debt management and economic theory

Is the standard micro portfolio approach to sovereign debt management still appropriate?
Sovereign debt management and fiscal vulnerabilities
Debt management and optimal fiscal policy with long bonds
Interactions between sovereign debt management and monetary policy under fiscal dominance and financial instability

Recent balance sheet policies

The effectiveness of the Federal Reserve's Maturity Extension Program - Operation Twist 2: the portfolio rebalancing channel and public debt management
The financial crisis and the changing dynamics of the yield curve
The financial market impact of UK quantitative easing