Understanding Fiscal and Monetary Policy: Fiscal Dominance, Currency Debasement, and Inflation.

Let’s go back to basics with high-level definitions of monetary and fiscal policy.  Monetary policy is controlled by central banks, and their main tools are interest rates, banking reserve requirements, and quantitative easing or tightening.  The goal of the central bank is to manage inflation, keep the country’s currency stable, and support sustainable economic growth.  The mechanism works indirectly by affecting borrowing costs and credit availability and therefore investor sentiment.  As an example, central banks may lower interest rates to stimulate spending and raise them to slow inflation.

Fiscal policy is controlled by governments through the Treasury.  Their main tools are taxation, spending, and subsidies.   The goal of the Treasury is to influence economic activity, redistribute income, and fund public services.  The mechanism works directly by putting money into or taking money out of the economy via spending and taxes.  As an example, the Treasury may cut taxes, spend on infrastructure projects, or, in the developed world, issue stimulus cheques.

In summary, you could think of monetary policy as controlling the price of money, where fiscal policy controls the flow of money.

The current policy mix is pulling the developed markets (especially the United States) in two directions.  Tensions can arise when fiscal needs threaten to overshadow monetary prudence.  There is a lot of news flow in the US at the moment about Donald Trump wanting to fire Jerome Powell, who is the head of the Central Bank and therefore in control of monetary policy.   This struggle can shift the balance of risks – and opportunities – in global markets.   Fiscal dominance occurs when fiscal policy imperatives begin to dictate the course of monetary policy. In other words, central banks lose their autonomy, and their actions are guided—if not constrained—by the government’s fiscal needs.

This typically arises when a government accumulates substantial debts and relies on the central bank to finance deficits by purchasing government bonds or maintaining low interest rates. In such scenarios, the central bank’s primary focus—price stability and inflation control—can be sidelined in favour of supporting fiscal sustainability.

Fiscal dominance often emerges during periods of crisis. When economies falter and tax revenues plummet, governments may run large deficits to sustain public spending. What is unusual in this instance is that there is no clear crisis at present. If markets begin to doubt the sustainability of government debt, borrowing costs rise and fiscal stress intensifies.

Central banks may then be pressured—implicitly or explicitly—to “monetize” debt, purchasing government bonds to keep yields low. This can lead to a vicious cycle, where monetary policy is subordinated to fiscal needs, and inflation risks escalate.

The effects of fiscal dominance are profound. Autonomy of central banks is compromised, inflation targeting becomes secondary, and market confidence can erode. Investors may demand higher risk premiums, causing bond yields to rise and asset valuations to fluctuate unpredictably.

For emerging markets, fiscal dominance is particularly dangerous. Weak fiscal positions, limited monetary credibility, and shallow capital markets can trigger capital flight, currency depreciation, and external crises. Even advanced economies are not immune, as seen during the global financial crisis and the COVID-19 pandemic.

In the presence of fiscal dominance, markets become hypersensitive to signals from both fiscal and monetary authorities. A misstep can be costly, as the delicate balance between growth and stability is threatened.

Fiscal Dominance can lead to currency debasement.  In emerging markets, we have subtle experience of this as our currency fluctuates against developed market currencies and is quoted all the time against the world’s reserve currency, the US Dollar.  But how does the US Dollar become debased?   

Currency debasement is the reduction in the value or purchasing power of a currency over time, usually because more units of it are created without a corresponding increase in real economic output.  The terms come from history, when kings and governments would literally reduce the content of precious metals in coins (for example, by adding copper to silver coins) to create more money.  The modern version is to expand the money supply through printing more money or finance deficit spending by borrowing.  Debasement is about the long-term erosion of a currency’s value, often caused by policy decisions that dilute its worth.  This can eventually lead to inflation, or loss of foreign exchange value, or both.

Inflation, on the other hand, is the rise in the general level of prices of goods and services in an economy.  It is usually caused by too much money chasing too few goods, or the rising cost of inputs (like wages or energy) which drives up prices, or the expectation that prices will rise, so consumers spend more now.

A nice summary, and way to think about it, is that debasement is like watering down wine – the quality and value of each glass is reduced.  Inflation is when the price of the glass of wine goes up.

When governments run persistently high deficits, they need to issue more debt in the form of government bonds or treasury bills.  The central bank accommodates this and keeps interest rates low or creates new money to buy the continuously issued debt.  As the money supply expands faster than economic output, the value per unit of currency declines.  Over time, this is currency debasement, even if consumer inflation is not immediate. 

You could think about it like this: under fiscal dominance, the central bank becomes the government’s “credit card company” but one that prints its own money.  The result is a slow watering-down of the currency value, which is classic debasement.

History offers sobering lessons on the dangers of fiscal dominance and currency debasement. From Weimar Germany’s hyperinflation to more recent cases in Latin America and Zimbabwe, the loss of central bank independence and unchecked fiscal expansion have had devastating consequences.

In today’s advanced economies, the risks often manifest more subtly: asset price inflation, widening inequality, and creeping erosion of purchasing power. Recent episodes of extraordinary monetary accommodation—paired with sizeable fiscal deficits—have fueled debates about the return of fiscal dominance and the spectre of debasement.

The dance between monetary and fiscal policy is intricate, and never more so than when fiscal dominance looms. Currency debasement and inflation, while sometimes tools of necessity, are fraught with peril if not managed judiciously. For economies and markets, the lessons are clear: vigilance, coordination, and credibility are the anchors of stability. As the policy landscape shifts, those who understand these dynamics will be best positioned to navigate the uncertainty ahead.