The return of fiscal dominance

THE global economy is entering a more dangerous phase of adjustment.

As the gains from trade integration fade and geopolitical fragmentation deepens, governments are increasingly relying on domestic fiscal policy to sustain growth, manage structural transitions and respond to shocks.

Fiscal activism is no longer cyclical. It is structural.

This shift has profound implications for monetary policy. In a world of high and rising public debt, the central risk is the return of fiscal dominance – a condition in which monetary policy is constrained, explicitly or implicitly, by the need to ensure the sustainability of government finances.

The defining question today is no longer whether fiscal policy will be used aggressively, but whether central banks will retain the independence required to stabilise inflation, anchor expectations and act decisively in crises.

For much of the post-war period, trade integration supported growth and provided an external anchor for policy discipline.

The anchor has weakened

That anchor has weakened. Tariffs, industrial policy and strategic competition have replaced liberalisation as organising principles. As trade ceases to act as a reliable engine of demand, fiscal policy has become the primary macroeconomic lever.

But this transition is occurring at precisely the moment when public debt ratios are at historic highs. Fiscal space is constrained not only economically, but politically.

Central banks are increasingly expected to contain inflation, preserve financial stability and accommodate large-scale sovereign borrowing – often simultaneously. The risk is not a sudden loss of independence, but its gradual erosion through repeated accommodation.

The United States illustrates these tensions most clearly.

The retreat from trade began with withdrawal from the Trans-Pacific Partnership, deepened under tariffs imposed during US President Donald Trump’s first presidency, and was extended through large-scale subsidies under the Inflation Reduction Act and the Chips Act.

This turn towards fiscal-led growth has been reinforced by renewed tariff threats that openly challenge multilateral trade rules.

Downgrading US sovereign debt

These policies rest on deficits exceeding 6 per cent of gross domestic product and a public debt ratio heading towards 120 per cent, approaching the peak level reached in 1946.

While public debt started to come down after 1946, fiscal politics has now become increasingly dysfunctional – marked by debt-ceiling stand-offs, continuing resolutions and threats of government shutdowns, amid the reality of projected increases in public debt.

Rating agencies have downgraded US sovereign debt, and Treasury auctions have shown more uneven demand.

In this environment, the Federal Reserve operates under growing constraint. Higher interest rates raise debt-servicing costs and intensify political pressure for accommodation.

Markets increasingly assume that, in periods of stress, the Fed will intervene to stabilise Treasury markets – even if inflation risks persist. Fiscal dominance does not require formal subordination; it emerges when the costs of independent monetary action become politically intolerable.

Japan is often treated as an exception, but it may be a leading indicator. With gross public debt around 240 per cent of GDP, Japan has long tested the outer limits of fiscal sustainability without crisis. Stability was sustained through domestic savings, institutional cohesion and the Bank of Japan’s (BOJ) willingness to suppress yields.

That equilibrium is now under strain. The yen has weakened sharply, even as Japanese government bond yields have risen to levels not seen in decades.

Attempting to normalise policy

The BOJ is attempting to normalise policy, but doing so risks sharply increasing debt-servicing costs and destabilising markets. The result is a classic fiscal-monetary trap: exit accommodation and risk fiscal stress; maintain it and undermine currency stability and confidence.

What makes this moment different is market structure. Foreign investors and hedge funds now account for a large share of trading in Japanese government bonds, often through leveraged basis trades similar to those that destabilised US Treasuries in 2020.

Combined with the yen carry trade, this creates conditions in which stress could unwind rapidly. Japan highlights a paradox increasingly visible elsewhere: debt continues to rise, markets remain calm – until they do not.

Europe’s experience reflects a slower erosion of the monetary-fiscal boundary. Asset purchases and anti-fragmentation tools, initially justified as crisis responses, have become embedded features of the European Central Bank’s framework.

Fiscal adjustment remains politically contested, and monetary policy is increasingly expected to prevent sovereign stress even when inflation pressures persist.

China presents a different variant. There, monetary policy is already deeply intertwined with fiscal and quasi-fiscal objectives, particularly at the local-government level.

Credit provision, liquidity support and regulatory forbearance are routinely used to manage fiscal stress. While this has avoided abrupt crises, it has entrenched expectations that monetary policy will subordinate price stability to growth and stability objectives.

The consequences of rising fiscal dominance extend well beyond national borders.

One of the least discussed risks concerns the Federal Reserve’s role in providing US dollar liquidity to the world through swap lines. These arrangements rest not on treaties, but on credibility: the assumption that the Fed can act decisively, independently and without political interference to stabilise global US dollar funding markets.

Credibility erodes

If Fed independence is perceived to be weakened – by fiscal pressure, political interference or repeated market backstops – that credibility erodes.

In a future crisis, hesitation or politicisation of swap-line decisions would amplify global stress. Fiscal dominance at the centre would therefore transmit instability to the periphery.

Across the US, Japan, Europe and China, the pattern is consistent. High debt narrows policy choices. Political constraints delay fiscal adjustment. Markets assume that central banks will ultimately step in to prevent disorderly outcomes. Over time, that expectation itself weakens monetary independence.

Fiscal dominance rarely arrives through legislation. It emerges gradually, through repeated “exceptional” interventions that become routine. Stability persists – until it does not.

Today’s calm is deceptive. Debt continues to rise, yields are managed or suppressed, and investors give governments the benefit of the doubt. But when markets finally reassess sustainability, adjustment may be abrupt – a classic Wile E Coyote moment.

The 20th century was defined by trade. The 21st will be defined by fiscal constraints – and by whether central banks retain the independence to manage them. In this new era, central bank credibility is not a domestic technicality. It is a global public good.

The writer is distinguished fellow at India’s Centre for Social and Economic Progress and former Asia-Pacific director at the International Monetary Fund