From low taxes to economic fragility

The talk about fiscal dominance in the US is getting louder. An underappreciated consequence of this is that fiscal multipliers for government spending are rising, making the whole economy more dependent on politicians and their actions.

The Fed’s independence is under pressure from the White House. But even if the Fed withstands this pressure, there is a risk that it will face fiscal dominance. I simplify a little bit, but fiscal dominance describes any situation where the central bank has to conduct monetary policy in such a way as to accommodate fiscal policy to prevent a debt catastrophe or currency crash. Even though the central bank may be truly independent, it cannot set interest rates independently of the government’s actions anymore.

Fiscal dominance is usually associated with high inflation and poor economic performance. Many economists (and I am one of them) argue that during the 1970s, the US suffered from fiscal dominance because the central bank was unable to fight inflation. Central banks were under pressure to keep the economy afloat even if that meant letting inflation get out of control.

With the US running persistent deficits of 7% of GDP in the next five to ten years and long-term bond yields moving dangerously high, the risk of fiscal dominance in the US increases once again. There may come a point where the Fed will introduce yield curve control, not because it is ordered to do so by the White House, but because doing so is the only way to prevent a collapse of the US dollar and Treasury market.

The goal of the Fed in a state of fiscal dominance would be similar to the goal today: reduce cyclical economic fluctuations and prevent economic collapse. But an analysis by Zamid Aligishiev and Hamed Ghiaie indicates that this might no longer be possible. Yes, the Fed can prevent economic collapse (at least I think so, keep your fingers crossed), but it can’t smooth economic cycles anymore.

The research looked at fiscal multipliers in the US between 1949 and 2018. They find that the impact of fiscal shocks (expected and unexpected) on the economy varies over time. The chart below shows the fiscal multipliers of fiscal shocks directly after announcement (i.e. impact multiplier), as well as after one and two years. Note how this fiscal multiplier is higher in a recession (grey vertical bars) than in an expansion, but also systematically higher in the 1970s.

Fiscal multipliers in the US

Source: Aligishiev and Ghiaie (2025)

What this chart tells us is that when the central bank is busy keeping the economy afloat, its ability to smooth business cycles is reduced. Fiscal policy becomes the only game in town both during a recession and in times of fiscal dominance.

But that means that any change to fiscal policy – positive or negative – is transmitted much more directly to the economy. That is not a problem as long as fiscal policy is stable, but fiscal policy is never stable. Politicians always want to boost the economy through tax cuts or investment spending.

Today, the US is in the unenviable position where the government has cut taxes so much that not even the Republican Party can find enough cuts to government spending to balance the budget.

The result is that the country is on its way to fiscal dominance. This low tax dreamland, that Republicans are hoping for, is in fact a land of high economic volatility where deep recessions become more common and more frequent because every time the government decides to cut spending or increase taxes, the shock to the real economy will be transmitted without the Fed's damper.