Eric Leeper on the Interactions of Fiscal and Monetary Policy

Episode Summary

Executive Summary: Eric Leeper argues that inflation and debt stability are jointly determined by monetary and fiscal policy, not by the Fed alone. He explains fiscal dominance, the fiscal theory of the price level, and why today’s large debts and deficits may weaken monetary tightening unless fiscal policy supplies future backing through taxes or surpluses.

Main Topics: Fiscal dominance vs. monetary dominance (Priority: 5/5): Leeper distinguishes regimes where the central bank controls inflation and fiscal policy stabilizes debt from the reverse, where debt sustainability constrains monetary policy and can force seigniorage or accommodation. Active and passive policy framework (Priority: 5/5): He explains his 1991 active/passive formulation as a generalization of Sargent-Wallace’s ideas: one authority pursues its objective while the other adjusts to keep inflation and debt stable. Fiscal theory of the price level (Priority: 5/5): Leeper describes government liabilities as assets whose real value depends on expected future primary surpluses and the government’s taxing capacity, making fiscal backing central to the price level. Role of liquidity and convenience yields on government debt (Priority: 4/5): He discusses extensions showing Treasury securities provide liquidity services beyond backing by future surpluses, implying an asset-pricing framework must include convenience yields and financial plumbing. Current U.S. inflation and debt context (Priority: 5/5): Leeper warns that unlike Volcker’s era, today’s much higher debt-to-GDP ratio means disinflation via higher rates could require future tax increases; otherwise debt service becomes inflationary through wealth effects. International cases: Japan and the euro area (Priority: 4/5): He argues Japan’s net debt is lower than headline figures suggest and that low real rates are deflationary, while euro-area countries resemble a gold-standard-like setup where fiscal backing exists at the bloc level. Need for better fiscal discourse and institutions (Priority: 4/5): Leeper criticizes Congress, the CBO, and media for underemphasizing fiscal expectations and suggests stronger fiscal rules or technocratic constraints could improve macroeconomic stability.

Key Arguments: Monetary policy can only control inflation reliably if fiscal policy behaves in a circumscribed way and provides debt backing. Fiscal dominance arises when debt sustainability constrains the central bank, potentially forcing it to keep rates low or generate seigniorage. Sargent-Wallace unpleasant monetarist arithmetic is a special case of broader monetary-fiscal interactions, not the whole story. The fiscal theory of the price level treats government liabilities like assets whose value depends on expected future primary surpluses and taxes. If future taxes or surpluses are expected to rise, households save more today, bond demand increases, and the price level falls. Treasury securities may command liquidity premia, so present-value backing alone may understate their market value. The Fed’s balance sheet operations and QE/QT depend on financial-market plumbing and the role Treasuries play as safe/liquid assets. The U.S. benefited from fiscal support during Volcker disinflation, but today’s much larger debt burden makes that path harder to repeat. Japan does not invalidate the theory because much of its gross debt is offset by central-bank holdings, quasi-government holdings, and reserves. The euro area does not refute the theory because member states do not control monetary policy; fiscal backing can still emerge at the union level. Current public debate over inflation overweights the Fed and underweights Congress’s role in shaping expectations about debt and taxation.

Data Points: U.S. national debt increase: about $5 trillion - Beckworth cites the pandemic-era surge in debt before discussing fiscal theory relevance Debt-to-GDP ratio: about 100% - U.S. debt level described as roughly equal to annual GDP Recent inflation rate: 7.9% - Used to frame why monetary-fiscal interactions matter now Volcker-era debt-to-GDP ratio: about 25% - Compared with today to illustrate why disinflation is harder now Potential rate hike level: about 5% - Referenced via Larry Summers as a plausible anti-inflation policy rate Additional debt service from higher rates: about $1 trillion - Estimated increase in annual interest expense if rates rise substantially Japan adjusted debt-to-GDP ratio: about 50% - Leeper’s estimate after netting out reserves, quasi-government holdings, and BOJ ownership Post-1981 U.S. tax increases: five tax increases - Used as evidence that fiscal tightening supported Volcker disinflation Fed start date for Leeper: 1987 - He noted fiscal policy was taboo at the Fed when he began there CBO long-run projection change: from 50-year to 20-year projections - Leeper says his Jackson Hole paper led the CBO to shorten its projection horizon

Pivotal Quotes: "for monetary policy to successfully control inflation, fiscal policy must behave in a particular circumscribed manner" — Eric Leeper: His core claim at Jackson Hole about the hidden fiscal assumptions behind inflation control "I think of fiscal dominance as a special case of monetary and fiscal interactions" — Eric Leeper: Defining fiscal dominance relative to broader policy interactions "there's really only one theory of the price level" — Eric Leeper: He rejects a strict split between monetary and fiscal theories, arguing the price level reflects joint policy

Implications: Listeners should see inflation as a joint monetary-fiscal outcome, not a Fed-only phenomenon. Persistent deficits, debt service, and liquidity demand for safe assets can all shape the price level and constrain future disinflation.