A significant portion of this debt was bought back by central banks who issued reserves in return - over 30% of GDP to the US Federal Reserve (Fed) and 60% to the European Central Bank (ECB).
So far, low interest rates have made it easy to refinance public debts. In addition, low inflation justified monetary support operations by central banks.
However, this situation is likely to end with the recent rise in inflation on both sides of the Atlantic. Some observers, especially in the United States like economist John Cochrane, or Larry Summers, former Secretary of the Treasury to Bill Clinton, are now worried about the ability of central banks to increase interest rates or reduce their reserves when necessary to achieve their goal of stability prices (an inflation rate close to 2% for the Fed and the ECB).
In the current debt environment, governments could indeed benefit from an accommodating monetary policy leading to a high level of inflation. Rising prices would erode the real value of public debts and therefore make them more bearable. They would thus have an interest in obstructing any tightening undertaken by central banks.
Such concerns highlight a risk of a shift from “monetary dominance”, in which the central bank faces no fiscal obstacles to achieving its price stability objective, to “fiscal dominance”, in which policy monetary policy first seeks to fix inflation to ensure the solvency of the tax authority.
With such a shift to fiscal dominance, inflation, which is currently considered transitory, may well become more persistent and, above all, more difficult to fight. This risk of budgetary dominance is moreover the object of dissension, in particular within the Eurosystem.
"The sissy game"
Usually, when the central bank tightens monetary policy, rising interest rates increase the debt burden on the government, which must then undertake fiscal consolidation in the form of tax hikes or cuts in government spending. Given their massive indebtedness, governments could instead be tempted not to reduce their deficits, or even increase their debt, to force the central bank to reverse its monetary tightening.
Should we believe in such a scenario today? In our recent research work, we analyze the incentives of a government to push towards fiscal dominance or, on the contrary, to comply with monetary dominance.
In the first case, this game has been described as a "sissy game" between the government and the central bank by the American economist Neil Wallace following his communication with his Thomas Sargent, Nobel Prize in economics in 2011.
This game is one where two drivers throw their cars against each other, the loser being the first to deviate from its path to avoid the collision: the government thus accumulates deficits while the central bank maintains its restrictive monetary policy until 'when one gives in, either through fiscal consolidation on the government side or through inflation on the central bank side. The crash scenario in which no one gives in corresponds here to sovereign default.
What we show, first of all, is that fiscal dominance in this sissy game requires the government to exhaust its fiscal capacity and make a default credible: it must no longer have funding margins, neither in terms of funding. reduction in expenses or in terms of additional taxes. Indeed, as long as the government has room for adjustment, monetary policy can force it into fiscal consolidation in order to avoid a default.
How can a government find itself in such a situation of exhaustion of its fiscal capacity? Shocks such as recessions or crises can lead to it through lower tax revenues or increased spending to support the economy.
We further show that the tax authority can also exhaust its fiscal capacity in such a way. deliberate. Instead of consolidation, the government may decide to run large deficits and flood the bond market.
The resulting large stock of debt will thus force the central bank to increase inflation in the future to erode the value of the debt and avoid sovereign default. This will happen all the more so when the public debt is initially high, when the interest rates are low and not very sensitive to the issuance of public debt, or if the future tax adjustment margins are low.
The paradox of preventive inflation
Does the central bank then have the power to tip the balance towards monetary dominance or, at least, to reduce the inflationary cost imposed by fiscal dominance?
Paradoxically, the central bank may have an interest in engaging in preventive inflation. By increasing current inflation, the central bank decreases the real value of past liabilities and thus makes the debt sustainable for the government again. Thus, this inflation makes costly and unnecessary a strategy of Pyrrhic victory of the uncontrolled issuance of public debt.
The choice for central banks is therefore between two options: either let inflation slip a little to loosen the fiscal stranglehold, or monetary orthodoxy at the risk of seeing governments react violently by thwarting their action by massive issues. of public debt used to repay past debt. This preemptive inflation strategy is not without risks: in particular, the central bank may give the impression of reneging on its objective of price stability.
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