Investing during an era of Fiscal Dominance

As the Street parsed Powell’s Jackson Hole speech and obsessed over whether the Fed would raise an additional quarter-point, the annual Fed symposium at Jackson Hole is meant for central bankers to consider Big Ideas which reflect the concerns of the day.


The centrepiece of such ideas was usually an academic paper. As an example, the Big Idea in 2020 was “flexible average inflation targeting” and the now quaint problem of persistent low inflation. A paper by University of California at Berkeley academic Yuriy Gorodnichenko argued that the Fed needs clear, simple and transparent communication to create the link between higher inflation expectations and actual spending behaviour.


The Big Idea in 2023 is fiscal dominance, or the problem of big government deficits and skyrocketing debt around the world.



How should investors position themselves in an era of persistent deficits, rising sovereign debt, and fiscal dominance?



Living with high public debt

The Big Idea paper was presented by Barry Eichengreen, another Berkeley academic, called “Living with High Public Debt”. The paper made the case that “high public debts are not going to decline significantly for the foreseeable future. Countries are going to have to live with this new reality as a semi-permanent state of affairs.”


The paper makes for grim reading. Eichengreen went on to lay out possible solutions, none of which are very feasible in the current circumstances.
  • Grow out of it.
  • Implement austerity programs and run primary surpluses.
  • Inflate out of it.
  • Financial repression.
In addition, Eichengreen highlighted global financial stability problems as emerging market and developing economies are far more vulnerable to high debt than advanced economies.


Let’s explore each of these solutions, one at a time.



Growing out of debt

From a policy perspective, the most painless way to get out of debt is to grow out of it. Eichengreen characterized this as the r – g, where r = real interest rate, g = real growth rate. A country can grow its way out of debt if g > r.


From a big picture viewpoint, the U.S. debt situation isn’t as dire as the standard debt-to-GDP and other ratios depict. The nonpartisan Congressional Budget Office estimates that federal interest payments are still manageable. They are projected to rise to 3.3% of GDP by 2032, but the federal government saw similar levels of interest burden in the 1980s and early 1990s. What happened? It grew its way out of debt.



Here’s what’s different this time. The U.S. economy enjoyed a significant tailwind in productivity and demographic growth during that period, but growth potential has declined and is expected to remain low in the future



Other papers presented at Jackson Hole this year addressed the problems of productivity. Charles Jones documented that productivity growth had mostly flatlined since 2005.



Yueran Ma studied the link between monetary policy and innovation. She concluded, “Monetary policy can influence innovation activities by changing aggregate demand and correspondingly the profitability of innovation, and by changing financial market conditions…Our findings suggest that monetary policy may affect the productive capacity of the economy in the longer term, in addition to the well-recognized near-term effects on economic outcome”

In short, Eichengreen pointed out that it’s difficult to find a more favourable r – g environment today and further improvements would be challenging to achieve.



The challenges of austerity