Investing in the Age of Fiscal Dominance

Peter Warburton - 24 April 2020

This week, I recorded an Expert View interview for Real Vision, posted under this title. Fiscal dominance refers to an ordering of economic affairs in which monetary policy is assigned to the defence of the creditworthiness of the sovereign rather than to the achievement of an independent objective, such as low inflation or financial stability. As the government asserts control of a larger and larger share of national resources – for whatever reason – willing buyers of government debt depart, leaving the central bank to provide deficit finance. The challenge of investing in these circumstances is twofold: to protect against the ravages of inflation and the threat of nationalisation and to gain exposure to the expansion of public sector procurement and provision.

Fiscal dominance has been sitting on the subs bench for season after season, wondering if it would ever get a game. Suddenly, fiscal conservatism has suffered a dreadful injury and is ruled out for the rest of the season. Finally, fiscal dominance is beckoned into the limelight, is handed the captain’s armband and assured by the management that all necessary resources will be made available in the battle to avoid relegation.

At the outset, there is an alignment of interests: advocates of extensive public ownership and control are excited by the opportunity of an expanded role for public services, while advocates of free markets approve of radical expenditures to protect private enterprise from catastrophic failure and loss. Over time, this overlap of interests will diminish, with the first group insisting that it would be unwise and unsafe for support to be withdrawn or for activities to be transferred to private ownership. The second group are appalled at the extent of socialisation of economic activity and eager for the state to shrink back to its former size. The forces of inertia favour the continuation of a large public sector and a rising tax burden. 

Similarly, the central bank, having boosted the size of its balance sheet, is in no hurry to scale back, leaving excess balance sheet capacity in the financial system and a predisposition to inflation, and probably stagflation. The political consequences of adopting hawkish policies for the members of the monetary policy committee are too awful to contemplate. As with the previous rounds of QE, policy exit will be practically impossible and politically undesirable.    
The broad contours of the age of fiscal dominance will take shape over months, even years, but the likelihood is that the risk-adjusted real return on capital will be permanently lower, that dividends will be much harder to find and responsibility for financing fixed capital formation will lie predominantly in the hands of the public sector. The challenge for investors is to protect portfolios against rising, and more variable, rates of inflation while positioning to prosper from the expansion of public procurement and provision. Distant inflation swap prices responded well in 2009 and have much greater potential upside in 2020. 

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