For decades, economists have warned about the risk of fiscal dominance. Over the past year, the topic has graduated to news headlines. At first glance, the US’s deteriorating fiscal situation appears to be the culprit.
Kevin Warsh sees it differently: fiscal dominance is an outgrowth of Federal Reserve actions that enabled profligate federal spending, led the Fed to stray from its monetary mission, and ultimately undermined Fed independence.
In other words: the problem of fiscal dominance is actually one of monetary policy run amok.
The usual fiscal dominance story goes something like this. In normal times, a central bank should adjust its interest rate target as needed to deliver low and stable inflation. Under fiscal dominance, however, a profligate government forces the central bank’s hand. Rather than adjusting its interest rate target to maintain low and stable inflation, the central bank must accommodate government borrowing. Inflation inevitably rises because the central bank is effectively committed to monetizing government debt.
Economists have proposed a host of institutional constraints to guard against fiscal dominance, including central bank independence, conservative central bankers, optimal contracts, and monetary rules. These institutional constraints all function to insulate monetary policy decisions from the influence of short-term politics — that is, to preserve monetary dominance.
That, at least, is the conventional view. But Kevin Warsh, President Trump’s nominee to chair the Federal Reserve, has flipped the script.
In a talk delivered at the International Monetary Fund last year, Warsh said, “monetary dominance — where the central bank becomes the ultimate arbiter of fiscal policy — is the clearer and more present danger.” Rather than restraining fiscal excess, he argues, the modern Fed has enabled it. And, in doing so, it has undermined its own legitimacy.
Warsh on Monetary Dominance
Warsh traced the roots of today’s predicament to the 2008 financial crisis, when the Fed cut rates to zero, engaged in emergency lending, and pioneered large-scale asset purchases. He accepted that the Fed might use these tools to stabilize markets and prevent collapse in exigent circumstances. “But when panics subside,” Warsh said, “the Fed is duty-bound to retrace its steps.”
The problem, in his telling, is that the Fed never fully retreated. “Since the panic of 2008, central bank dominance has become a new feature of American governance,” Warsh observed. Crisis management hardened into a permanent practice, with the Fed maintaining a nearly $7 trillion balance sheet today. Warsh noted it was “nearly an order of magnitude larger” than when he joined the Fed Board back in 2006, and has made the Fed “the most important buyer of US Treasury debt — and other liabilities backed by the US government — since 2008.”
By suppressing borrowing costs, Warsh argued, monetary policy quietly subsidized fiscal expansion. “Fiscal policymakers…found it considerably easier appropriating money knowing that the government’s financing costs would be subsidized by the central bank,” he said.
The predictable result was more debt.
Independence as Shield and Sword
Warsh also offered an important corrective on central bank independence, which is usually cast as a safeguard against fiscal dominance. “Independence is not a policy goal unto itself,” he said. “It’s a means of achieving certain important and particular policy outcomes.” Its purpose is instrumental: to deliver low and stable inflation.
In practice, however, central bank independence has become a rhetorical sword, enabling the Fed to cut a path well beyond its remit. “‘Independence’ is reflexively declared when any Fed policy is criticized,” Warsh said.
That approach is ultimately self-defeating. When the Fed strays beyond its congressionally assigned mandate — venturing into climate policy or social justice — it weakens its claim to independence in monetary policy. And when it dismisses legitimate oversight as political interference, it further erodes the credibility it depends on.
Perhaps even more damaging to the cause of independence is the Fed’s recent performance on inflation. The “intellectual errors” that contributed to high inflation over the last few years — overconfidence in models, complacency about inflation risks, and downplaying the contributions of monetary and fiscal policy to high inflation — have exposed the limits of technocratic authority. The widespread recognition of those limits, in turn, has left the case for independence on shakier ground.
Warsh said independence is “chiefly up to the Fed.” It must be earned through competence, restraint, and accountability. When outcomes are poor, “serious questioning” and “strong oversight” are not threats to independence. They are prerequisites for its survival.
The Case for a Narrow Central Bank
If monetary dominance and abuse of independence are the disease, Warsh’s prescription is institutional modesty. He called for a narrow central bank focused relentlessly on its core mandate.
The Fed, Warsh argued, has come to resemble “a general-purpose agency of government.” A narrow Fed, in contrast, would eschew fashionable causes, limit discretionary interventions, and operate within well-defined and clearly-articulated frameworks. It would abandon performative transparency — shifting metrics, maintaining data dependence, revising forecasts, and offering forward guidance — in favor of quiet consistency.
“Our constitutional republic is accepting of an independent central bank, only if it sticks closely to its congressionally-directed duty and successfully performs its tasks,” he said.
A Test of Conviction
Warsh has sketched a high-level vision for reforming the Federal Reserve. Whether his vision can be transformed into a coherent plan that survives contact with power is unclear.
Congress has learned to rely on accommodative monetary policy. Markets have grown accustomed to a Fed that intervenes early and often. Reversing course will not be painless.
If confirmed, Warsh will face a choice between rhetoric and resolve. He believes the Fed has weaponized the argument for central bank independence and drifted well beyond its mandate, thereby setting the stage for fiscal folly. But restoring genuine accountability and restraining Fed action will require resisting precisely the temptations he thinks led the Fed astray.
If Warsh is serious about narrowing the Fed, his tenure could mark a genuine turning point. If not, monetary dominance will continue to run amok.
