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28 Sep 2022


Jonathan Portes looks at whether fears of ‘fiscal dominance’ – where the central bank can’t, or won’t, raise interest rates enough to offset the impacts of the government’s budget deficit – are behind the fall in the pound.

‘Fiscal dominance’ sounds like something that goes on after a few too many drinks after the closing panel session at the Royal Economic Society. We should be so lucky. In fact, it’s the biggest open question about UK macroeconomic policy.

Since at least the early 1990s, the ‘division of labour’ in macroeconomic policy in the UK, and in almost all advanced economies, has been that the government is in charge of fiscal policy – tax and spending, debt and deficits – and pursues them with a view to achieving its economic and social objectives, including growth and redistribution. Meanwhile, the role of monetary policy is to control inflation, usually with an independent central bank with an inflation target.

So what happens if the first conflicts with the second? That is, if the government’s fiscal policy threatens to push inflation up (or indeed down)? In the standard framework, the central bank simply adjusts monetary policy to take account of the government’s actions. So, if the government loosens fiscal policy a lot, raising demand and pushing inflation up, the central bank will respond by tightening monetary policy. In other words, while the government has flexibility to set tax and spending policy as it likes, the central bank still controls demand (and hence inflation) overall: monetary dominance.

One important, and somewhat counterintuitive, consequence of this is that a sudden, large increase in the government’s budget deficit ought to push the currency up, not down, at least for an advanced economy like the UK that borrows on international markets. The larger deficit requires higher interest rates, which makes the currency more, not less, attractive, and there is no default risk for a country that borrows in its own currency. Indeed, this is what happened in the Reagan era of very large US budget deficits financed by foreign borrowing. So why then has the pound fallen sharply rather than risen since the UK ‘mini-budget’?

The answer, in large part, is the opposite of ‘monetary dominance’ – fiscal dominance. This is what happens when the central bank can’t, or won’t, act as it is supposed to under the standard framework; that is, it can’t raise interest rates enough to offset the impacts of the government’s budget deficit. There are two main reasons – which overlap to some extent – that this might be the case.

The first is economic, or rather arithmetic. Raising interest rates pushes up the cost of government borrowing; at some point, depending both on the scale of government borrowing and the level of interest rates, this becomes self-perpetuating, since higher interest rates raise the cost of government debt and hence the deficit, requiring yet more borrowing. Ultimately, this becomes unsustainable, unless the government is willing to cut spending or put up taxes. The second is political: higher interest rates hit – by design – businesses and households. But even independent, inflation-targeting central banks face constraints on just how much pain they can or should inflict in pursuit of price stability.

Under fiscal dominance, then, the central bank doesn’t raise interest rates enough to deal with inflation – instead, it allows inflation to erode the value of government debt (or, in extreme circumstances, the government defaults, although this is not realistic in the UK context). Under this scenario, the currency falls rather than rises.

Could fears of this scenario be one explanation of the fall in the value of the pound? Yes, as Paul Krugman notes, if the tax cuts were so large as to call into question the Bank’s ability to counteract them with interest rate rises. This is certainly what underlies the IMF’s almost unprecedentedly blunt rebuke to the government, which stated that ‘it’s important that fiscal policy not work at cross purposes to monetary policy’.

We’re not there yet – market interest rates have risen a lot already, and the Bank of England has said publicly it remains fully committed to setting monetary policy to hit the inflation target. Well, they would, wouldn’t they? And already we have seen the Bank reverse its earlier commitment to ‘quantitative tightening’ and instead commit to buy still more gilts (UK government bonds). While they’ve justified this because of recent market turbulence – rather than to help out the government with its borrowing – there’s obviously a fine line here.

So where does this leave us? Caught between a rock and a hard place. If the Bank resists fiscal dominance and does indeed stick to its mandate, the pound should stabilise; but the costs will be substantial. As I’ve noted elsewhere, the price of Kwarteng’s tax cuts for the better off will be paid by homeowners, businesses, and all those who rely on public services. But if it doesn’t, the pound will continue to fall, and inflation will stay higher and longer, and the UK will become a steadily less attractive place to invest. Again, we will all pay the price.

In other words, instead of facilitating what Truss’s advisers thought was a welcome rebalancing towards looser fiscal policy and tighter monetary policy, the mini-budget has destabilised the whole macroeconomic policy framework. As Michael Caine put it (not long after Harold Wilson devalued the pound – to $2.40!) ‘You’re only supposed to blow the bloody doors off.’

By Jonathan Portes, Senior Fellow at UK in a Changing Europe.


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