This research piece on fiscal dominance in the United States was compiled and written by Sam Callahan, and commissioned and advised by Lyn Alden.
Published: January 2025
Executive Summary
• Structural fiscal deficits have surpassed private sector lending and monetary policy as the primary drivers of economic activity and inflation, marking a fundamental shift in the economy’s liquidity dynamics.
• Debt-to-GDP projections reveal the impact interest rate policy could have on fiscal sustainability. At a fixed 5% rate, debt-to-GDP would steadily increase over the next decade, while a 2% fixed rate would lead to a decline. However, this measure can be misleading, as nominal GDP growth driven by fiscal deficits increases, masking the extent of nominal debt accumulation and inflation in various forms.
• The Department of Government Efficiency is unlikely to make meaningful cuts to federal spending as only 14% of the budget is non-defense discretionary, while 87% of nominal spending growth over the next decade is projected to come from mandatory programs and interest expense.
• Stabilizing factors such as the global demand for U.S. dollars and debt denominated in its own currency suggest an era of fiscal dominance in the U.S. that’s less dramatic than alarmists predict but more persistent and intractable than optimists hope. The deficit problem is unlikely to be resolved this decade, running structurally hot with steady nominal growth and ongoing currency debasement.
The Fiscal Backdrop Today
In September 2022, the UK gilt market crashed, nearly toppling the country’s pension system. It all began with then-Prime Minister Liz Truss’s controversial “mini-budget,” a fiscal package that consisted of unfunded tax cuts and increased government spending. This came at a time when UK CPI inflation was running above 10% YoY, and its debt-to-GDP was sitting at levels not seen since the 1960s.
The market plummeted on the news. Investors viewed the new budget plan as fiscally reckless, and a massive sell-off in the gilt market ensued. Consequently, pension funds—deeply tied to the gilt market through leveraged strategies—faced a wave of margin calls that threatened their solvency.
This crisis couldn’t have come at a worse time for the Bank of England. It had been raising interest rates and implementing Quantitative Tightening (QT)—selling government bonds and allowing maturing assets to roll off its balance sheet—to combat inflation. It had plans to tighten further, but the market’s violent reaction to the government’s fiscal agenda forced the central bank to temporarily abandon its plans. Instead of continuing with its inflation-fighting mandate, the Bank of England had to intervene by purchasing gilts to stabilize the market and prevent a financial meltdown.
This episode revealed how fiscal policy can constrain a central bank’s independence. The Bank of England’s inflation-fighting efforts were temporarily undermined by the need to address financial instability—a clear example of fiscal dominance. Moreover, the recent introduction of a new liquidity tool for financial institutions during periods of stress suggests that underlying vulnerabilities in the gilt market remain.
The Bank of England’s struggle is not unique. Governments worldwide continue to run massive fiscal deficits, even as debt burdens reach historic highs. This trend shows no signs of stopping, with government spending forecasted to increase further in the coming decades.
This backdrop creates significant challenges for central banks attempting to combat inflation and produces an environment ripe for fiscal dominance.
In the U.S., debt-to-GDP is still hovering at levels not seen since World War II. But one big difference today compared to the last forty years is that interest rates are no longer structurally falling.
Since the late 1980s, interest rates have steadily fallen, making it easier for the government and Federal Reserve to manage and expand the debt burden. However, debt management gets complicated when interest rates start moving in the other direction.
Over the past four years, the federal funds rate has increased fivefold, while public debt has grown by more than 30%.
As interest rates spiked, so did the Treasury’s interest expense on the national debt.
Net interest represents the federal government’s true cost of servicing its debt after subtracting offsets like income from trust funds like Social Security and Federal Reserve remittances. It excludes intragovernmental interest payments, such as those made to Social Security and Medicare trust funds, which are considered internal transfers.
As such, net interest reflects the government’s true out-of-pocket expense to external creditors, excluding any ‘self-payments’ that cycle back to the Treasury. Since these external payments must be financed by taxes or new debt, net interest reflects the cost that taxpayers ultimately bear.
When looking at the last fiscal year, net interest was the second largest government expenditure, behind only Social Security. The chart below shows how net interest has nearly tripled since 2020 as interest rates have risen:
This massive debt burden—along with the associated refinancing costs—comes at a time when the government is projected to continue running large fiscal deficits for the foreseeable future. Together, these factors explain why fiscal dominance has become an increasingly relevant topic today.
Defining Fiscal Dominance
There have been many definitions of fiscal dominance over the years, but one that explains it well comes from Daniel J. Ford:
Fiscal dominance is an economic condition that occurs when a country’s debt and deficit levels are sufficiently high that monetary policy ceases to be an effective tool for controlling inflation. In fact, persistently high interest rates in an environment of perpetually large deficits actually risk exacerbating inflation.
We also propose a complimentary definition:
Fiscal dominance occurs when fiscal deficits become as significant as, or more important than, private sector lending and monetary policy in driving economic activity.
To understand fiscal dominance, it’s essential to understand how money is created in the economy. Broadly, there are two main mechanisms:
Private Sector Lending: includes lending from banks and private credit markets (non-bank institutions). Commercial banks and non-bank institutions create new money whenever they issue a loan. By crediting the borrower’s account with a deposit, these institutions essentially create money out of thin air, backed by the borrower’s promise to repay.
Monetized Government Deficits: When governments spend more than they collect in taxes, they borrow to cover the gap. If the central bank funds the government spending by purchasing this debt, directly or indirectly, it expands the money supply.
In cases like those of Argentina and Venezuela, central banks have directly financed government deficits by purchasing government debt outright, a practice known as direct monetization. In the United States and Eurozone, policies like Quantitative Easing (QE) allow central banks to buy government debt from financial institutions in secondary markets, injecting liquidity into the financial system without directly funding deficits.
Over the last four decades, fiscal deficits have become a more powerful force in shaping the economy. Historically, private sector lending has played a leading role in driving economic activity alongside central banks through interest rate policy.
However, as government spending has persistently outpaced revenue collection in recent decades, fiscal deficits have grown more influential on the economy and will likely continue to be a major factor moving forward.
Part of this shift stems from the sheer size and structure of the government debt. With over $36 trillion in outstanding debt and an increasing reliance on short-duration borrowing, higher interest rates now rapidly increase the government’s interest expenses.
Think of this interest expense as payments flowing from the Treasury to bondholders in the private sector. The term “bondholders” here is broader than it sounds, consisting of households, money market funds, banks, pension funds, corporations, hedge funds, and other institutional investors.
These interest payments provide income for the bondholders, which flows into the economy and asset prices. In this way, it can be viewed as a form of economic stimulus. Even as the Federal Reserve raises rates to constrain private sector lending, higher interest payments inject liquidity into the economy. This creates demand and counters the Fed’s tightening efforts.
This dynamic leads to an inflationary feedback loop: rising rates increase government interest payments, which widen deficits and stimulate economic activity, keeping inflation elevated.
At the same time, much of the private sector’s debt is fixed and long-term, making it less immediately sensitive to higher interest rates. In this environment, fiscal deficits become the dominant force driving economic activity and inflation, and traditional monetary policy tools, like interest rate hikes, lose their effectiveness—a hallmark of fiscal dominance.
Ironically, in this environment, Federal Reserve interest rate hikes increase inflationary pressures rather than reduce them.
The Wrong Tool For the Job
If we are indeed in an era of fiscal dominance, then the Federal Reserve is relying on the wrong tool (interest rate policy) for the job (bringing down consumer price inflation).
This mistake could stem from the Fed simply employing strategies that have worked in the past without fully accounting for the structural changes driving inflation today.
The charts below are from Lyn Alden’s previous report on this subject and deserve to be highlighted again because they are critical to understanding how our economy is structurally different today compared to the last time inflation reared its ugly head.
The charts highlight the year-over-year change in bank loan creation and corporate bond issuance alongside the year-over-year change in the fiscal deficit. In other words, they show how much of the economic activity is being driven by the private sector versus government spending. The first one shows that for most of modern financial history, private sector debt creation was a larger force than the public deficit and associated public debt creation:
However, the chart below demonstrates that the opposite is true today. Over the last 15 years, the fiscal deficit has grown much more rapidly than private sector credit creation, even during non-recessionary periods, as shown in the green boxes on the chart below:
The chart illustrates how fiscal deficits’ annual growth has far outpaced the private sector’s ability to create credit organically. In addition, the Federal Reserve indirectly monetized a percentage of this deficit through its QE programs, which led to money supply growth.
Government spending has taken the lead, driving liquidity, economic activity, and inflation in today’s economy. The main takeaway is that private borrowing is a less critical metric in the current cycle because it’s been crowded out by government borrowing and spending.
These insights clarify why the Fed’s interest rate hikes are unlikely to curb inflation like they did in the early 1980s. When former Fed Chairman Paul Volcker famously raised interest rates to nearly 20%, inflation was largely driven by private sector credit creation. Perpetually large fiscal deficits drive today’s inflation. This structural change limits the effectiveness of rate hikes.
Since inflation is not primarily driven by private-sector lending in the current environment, making borrowing more expensive will not significantly cool the economy. The structural drivers of inflation require a different approach.
Structural Fiscal Deficits Lead to Persistent Inflationary Pressures
We should stimulate when the economy is weak and rein in when the economy is strong. It’s not the idea of stimulus or deficits that’s dangerous—it’s the failure to turn off the tap.
– Nobel laureate Paul Samuelson
Below is another chart from Lyn Alden that highlights how fiscal deficits have become structural rather than cyclical in nature. It shows how we are continuing to run massive deficits despite the unemployment rate being near multi-decade lows. The green boxes below again highlight periods when the government ran large fiscal deficits even when the economy in a reasonable state:
Historically, deficit spending was a countercyclical tool—used to stimulate the economy during downturns and scaled back during periods of growth. In stronger economic conditions, governments were supposed to run surpluses, reduce debt, and balance the budget. But this is no longer the case.
Today, structural deficits are driven by systemic factors: an aging population requiring higher entitlement spending, rising healthcare costs, and compounding interest payments on decades of accumulated debt. Said differently, these deficits are no longer a matter of choice but a byproduct of systemic obligations. This is what we mean when we call them “structural.”
The problem is that these structural deficits, when combined with money supply growth, lead to increased inflationary pressures. However, inflation doesn’t just show up in consumer prices measured by the CPI—it operates on a broader spectrum.
If there are no significant supply constraints in energy, raw materials, or other commodities, during periods of fiscal dominance, liquidity injected through government spending often flows into financial assets rather than consumer goods, driving up prices for stocks, real estate, gold, and bitcoin. In other words, asset prices can surge in periods of fiscal dominance, even if consumer prices are stable or even declining.
This trend has become increasingly evident since CPI peaked in mid-2022, while most asset prices (except bonds) have soared.
This divergence highlights a frustrating reality for households. While inflation may appear under control according to the CPI, surging asset prices erode purchasing power and make them increasingly unaffordable for many. Asset price inflation favors high-income earners and those who entered the period already holding significant assets, exacerbating wealth concentration and deepening social divisions.
Ultimately, the Federal Reserve’s rate hikes may suppress demand in certain sectors, but they cannot address the root cause of today’s inflation: structural fiscal deficits. These deficits are now the primary driver of liquidity and inflation, rendering the Fed’s traditional tools ineffective. Worse yet, keeping rates elevated will only exacerbate the fiscal imbalance, increasing interest costs and widening deficits even further.
As we’ll see in the next section, higher sustained interest rates have far-reaching implications for fiscal sustainability and the future inflationary outlook, underscoring how deeply the current economic environment is entrenched in fiscal dominance.
Where Could the Public Debt Go From Here?
Net interest expense has emerged as one of the largest expenditures for the U.S. government, surging 34% over the last year alone as the Federal Reserve raised interest rates at one of the fastest paces in history.
To put things into perspective—net interest spending last fiscal year exceeded both Medicare and Defense for the first time ever.
This sharp increase in borrowing costs has further ballooned the deficit, creating a feedback loop of additional inflationary pressures. The question now is: What happens to the public debt burden over the next decade if interest rates remain at these levels?
To answer this, we first must define “public debt.” The total public debt currently exceeds $36.2 trillion, but it’s essential to distinguish between its two main components: marketable and non-marketable debt.
Marketable debt – is the portion of debt that trades on secondary markets, including T-bills, notes, and bonds. The interest costs of these instruments fluctuate based on market conditions.
Since marketable debt is typically held by private investors, foreign governments, pension funds, etc., the interest payments flow outside the government, representing a direct cost to taxpayers. This is why it’s frequently labeled “Debt Held by the Public.”
Non-marketable debt – is the portion of debt that includes instruments like savings bonds and trust fund holdings (such as Social Security and Medicare trusts), which have fixed terms and aren’t influenced by market fluctuations. These obligations are largely unaffected by market interest rates, with payments classified as internal transfers.
Non-marketable interest payments simply reshuffle funds from one government account to another, so they do not create an additional taxpayer burden like interest on marketable debt does.
This is why, for the purpose of this analysis, we will focus on the Debt Held by the Public, as its refinancing costs are borne directly by taxpayers and tied to prevailing interest rates.
As of December 2024, the total Debt Held by the Public stood at $28.79 trillion.
To assess how different interest rate scenarios could impact the national debt over the next decade, we need to consider two variables: 1.) interest expense on existing and future debt and 2.) the projected non-interest annual fiscal deficit.
To accurately estimate the interest expense, the composition of existing marketable debt is key to understanding how quickly rising interest rates impact the government’s borrowing costs. Different instruments have unique maturity structures and rollover rates, dictating how often they must be refinanced at prevailing rates.
Below is the breakdown of Debt Held by the Public by debt instrument type:
The maturity profile of existing debt matters because different instruments have unique maturity structures and rollover rates, dictating how often they must be refinanced at prevailing interest rates. The higher the rollover rate, the greater the share of that portion of the debt that needs to be refinanced each year.
Here are the different instruments with their annual rollover rates:
– Treasury Bills (100% rollover): Short-term instruments maturing within a year, requiring a 100% annual rollover. Their short duration exposes them fully to any change in interest rates, making them the most sensitive segment of debt.
– Treasury Notes (26.18% rollover): Medium-term instruments with maturities ranging from 2 to 10 years and an average maturity of 3.82 years. This means that roughly 26.18% of the outstanding notes will require refinancing each year.
– Treasury Bonds (4.93% rollover): Long-term instruments with maturities of 10 to 30 years and an average maturity of 20.27 years. Only 4.93% of bonds roll over annually, offering short-term insulation from rising rates but creating a longer-term vulnerability as rates remain elevated.
– TIPS (12.76% rollover): Treasury Inflation-Protected Securities have an average maturity of 7.35 years and an annual rollover rate of 12.76%. The interest expense on these instruments is calculated using the inflation-adjusted principal. For this analysis, we used various fixed CPI inflation rates.
– Floating Rate Notes (65.79% rollover): These notes are short-term instruments with an average maturity of 1.65 years. This means that 65.79% of these notes required refinancing each year, making them highly sensitive to prevailing interest rates. These notes typically match market interest rates such as the SOFR, but we used fixed rates for the purpose of this analysis.
Today, the maturity profile of the public debt skews short-term. The government’s recent reliance on short-term instruments like T-bills exposes it to significant refinancing risks. In the next year alone, $6.7 trillion in debt will need to be refinanced at higher rates, amplifying the fiscal strain. While longer-term instruments provide some insulation, they, too, roll over into elevated-rate environments over time, compounding borrowing costs.
Beyond refinancing existing obligations, we also need to consider the new debt the government must issue annually to fund operating deficits. These non-interest fiscal deficits, representing the gap between spending and revenue excluding interest payments, are projected annually by the Congressional Budget Office (CBO), which we will take at face value for this analysis.
These projections provide us with a baseline estimate of the amount of new debt the government will need to issue each year to cover its operating expenses. For simplicity, we will assume the maturity composition of new debt will mirror the current structure of marketable debt–meaning the percentage of debt that will be issued as bills vs. notes vs. bonds will stay the same.
The chart below shows the CBO’s annual non-interest fiscal deficit projections along with the estimated percentage of each instrument that will comprise each new issuance for the next decade:
With a clearer picture of the interest expense on both existing and future debt, along with the projected fiscal deficits, we can now evaluate how varying interest rate policies influence the trajectory of the national debt over the next decade.
To assess the potential impact of interest rate policies, we modeled the growth of the public debt under fixed interest rate scenarios of 2%, 3%, 4%, and 5%. The results reveal noticeably different trajectories for debt growth depending on the rate environment.
Under a fixed 5% rate scenario, the Debt Held by the Public grows by $6 trillion more than it would under a 2% rate. This difference highlights how compounding interest accelerates debt expansion over time:
This divergence becomes more apparent when viewed through the lens of debt-to-GDP ratios:
At a fixed 2% rate, debt-to-GDP declines below 95%, suggesting more manageable borrowing costs and improved fiscal health. In contrast, a fixed 5% rate pushes debt-to-GDP above 108%, highlighting the fiscal strain created by higher interest rates.
However, debt-to-GDP has limitations that are often overlooked. While much attention focuses on the “debt” side of the equation, the “GDP” component can distort the picture. Large monetized deficits can fuel nominal GDP growth, artificially stabilizing or even reducing debt-to-GDP ratios despite significant underlying inflation and nominal debt accumulation.
Let’s look at Turkey as an extreme example of this dynamic. In mid-2021, its fiscal deficit became unstable and began to balloon:
Yet, despite its deficit blowing out, Turkey’s debt-to-GDP ratio actually declined during this period, falling from 40% in 2021 to 27%:
This may initially seem counterintuitive until one considers the parabolic nominal GDP growth that occurred fueled by rampant inflation and deficit spending:
Annual inflation surged above 80% year-over-year, eroding the Turkish lira’s purchasing power while boosting nominal GDP figures:
On the surface, Turkey’s debt-to-GDP metrics appeared reasonable, but these figures masked a deeper issue: the fiscal deficit was driving currency debasement, which in turn inflated nominal GDP. This dynamic created the illusion of fiscal stability, even as nominal debt and inflation spiraled out of control.
The U.S. may experience a muted version of this dynamic in an environment of fiscal dominance. As nominal GDP and inflation run hot, debt-to-GDP ratios may appear stable or even decline, masking the extent of nominal debt accumulation and inflation in various forms.
These findings illustrate the intricate relationship between interest rate policy and fiscal sustainability. Lowering rates could meaningfully reduce interest expenses, making it one of the simplest levers for policymakers to pull to alleviate fiscal pressures. However, doing so risks stoking inflation and undermining central bank independence. Conversely, maintaining elevated rates to curb inflation exacerbates fiscal deficits, increasing the debt burden through rising interest costs and potentially compounding inflationary pressures.
This analysis underscores the paradox facing central banks in an era of fiscal dominance. Higher rates strain government finances and worsen deficits, while lower rates invite inflationary pressures and fiscal complacency. Striking the right balance with this is one of the greatest challenges facing policymakers today.
Who Will Buy the Debt?
The sustainability of the U.S. fiscal outlook hinges on identifying the buyers willing to absorb the surging issuance of debt as structural fiscal deficits continue. It’s important to remember that while the Federal Reserve controls short-term interest rates, long-term rates are determined by the market. If investors lose confidence in the fiscal path, then bond prices could crash, and yields could spike. This creates a vicious cycle: rising yields increase borrowing costs, which widen deficits and amplify inflationary pressures. This dynamic can quickly spiral into a full-blown crisis for highly indebted nations—similar to the UK gilt crisis.
This is precisely why it’s vital to consider: who will be buying U.S. debt if structural fiscal deficits are expected to persist for the foreseeable future?
Over the past two decades, domestic institutions and households have increasingly picked up the slack and financed government deficits.
This shift raises questions about the capacity of domestic institutions and households to continue absorbing such large volumes of Treasury debt in an environment of rising rates and persistent deficits.
Banks have become increasingly constrained by post-Global Financial Crisis regulations like the Liquidity Coverage Ratio, which requires them to hold significant amounts of Treasuries for financial stability purposes. While this has boosted Treasury demand, it also caps the banks’ ability to take on more, especially in a rising rate environment where fixed-income assets lose value.
Insurance companies and pension funds have been key buyers of Treasuries because they help them match their future payouts with stable, predictable income. However, in a rising interest rate environment, they may prefer shorter-term Treasury instruments because they carry less interest rate risk and allow for more frequent reinvestment at higher yields, especially during periods of rate volatility. This dynamic could limit their future appetite for long-term bonds.
Similarly, U.S. households—who indirectly hold Treasuries through retirement accounts and mutual funds—are sensitive to broader economic factors like income growth and inflation. If we enter a period of persistently high inflation, this diminishes real returns, reducing the attractiveness of investing in long-term Treasury bonds.
If U.S. domestic institutions and households reduce their Treasury buying, some believe foreign investors might step in to fill the gap. Recent headlines have highlighted record-high foreign ownership of Treasuries, but this is misleading.
These figures reflect the nominal size of their holdings, which have naturally increased alongside the massive growth in Treasury issuance over the past three decades.
A different story emerges when you break down the percentage of Treasury debt held by foreign investors. Over the last 15 years, foreign share of U.S. debt has declined from 47% to 30%.
This decline reflects several factors, including geopolitical tensions, diversification away from Treasuries, and concerns over the U.S. weaponizing the dollar as a policy tool. The freezing of Russian reserves served as a stark reminder of these risks, accelerating a shift toward neutral reserve assets like gold, which has seen record central bank purchases in recent years.
Now, some believe that the private sector will continue to be able to help finance the growing deficits and absorb the new issuance. One reason there’s hope is a new buyer has recently emerged: stablecoin issuers. Former House Speaker Paul Ryan recently said that stablecoins could be the solution to stave off a debt crisis, saying that they have become “an important net purchaser of U.S. government debt.”
As stablecoin supply has skyrocketed, so has their appetite for T-bills. When looking at the latest Treasury data on foreign holdings of Treasury debt from July 2023, Tether was the ninth-largest holder of T-bills compared to other foreign countries.
Since then, Tether’s holdings of T-bills have exploded to $84 billion, up more than 400%.
This means that, as of today, Tether is likely right outside the world’s top five holders of T-bills.
But while stablecoins are filling some gaps in short-term demand, they do not address the long end of the yield curve, which is critical for the U.S. government’s funding needs.
When asked whether Tether would consider adding long-duration Treasury debt to its reserves, CEO Paolo Ardoino dismissed the idea. He explained, “The single most important thing for stablecoins is that we need to be able to liquidate our reserves immediately and pay out our users.” Ardoino further noted that holding long-duration government debt poses significant liquidity, geopolitical, and financial risks, emphasizing his preference for holding bitcoin as a long-term reserve asset instead.
The growth of stablecoins is a promising development for Treasury officials, but it will not fix all their problems (a lack of demand for long-duration bonds). For that, they may need to turn to the Federal Reserve.
As foreign ownership in Treasuries has steadily declined over the 15 years, the Federal Reserve has almost doubled its share, mainly through QE programs post-Global Financial Crisis. And that’s where all of this is likely headed. Should global appetite for Treasuries continue to wane, it’s the Federal Reserve that will likely end up as the buyer of last resort to stabilize the bond market—just as the Bank of England did two years ago to save the gilt market.
We’re already seeing hints of this: after implementing QT in 2022, the Fed meaningfully slowed its pace of balance-sheet reduction by mid-2024. If demand for Treasuries continues to falter, the Fed’s role in stabilizing the market will likely deepen, even if doing so runs counter to its stated goal of combating inflation.
However, such interventions have significant costs: purchasing Treasuries through QE programs expands the money supply, injecting liquidity into the financial system. This ultimately results in asset price inflation and the erosion of purchasing power in the dollar.
As structural deficits persist, the Treasury faces a shrinking pool of buyers. Foreign investors have significantly reduced their share of U.S. debt holdings, and domestic institutions are approaching capacity due to regulatory and market constraints. In this environment, the Federal Reserve increasingly becomes the buyer of last resort—a role that has profound implications for financial stability and the currency’s purchasing power.
The sustainability of this system hinges on either a dramatic fiscal reform or a reconfiguration of global capital flows. Without such changes, the Treasury’s reliance on a shrinking pool of buyers raises significant risks for the U.S.’s long-term fiscal and inflation outlook.
Can Private Credit or DOGE Save the Day?
Until now, we have focused on the structural nature of fiscal deficits and why the Fed’s current monetary tools are insufficient to address the underlying drivers of inflation today. The potential solutions for overcoming fiscal dominance are limited and come down to two basic options: 1) the private sector grows to become the dominant force driving economic activity, or 2) fiscal deficits are meaningfully reduced.
One sector that some believe could help shift the balance of power back toward the private sector is private credit. This market, consisting of loans from non-bank institutions like private credit funds, hedge funds, private equity firms, and insurance companies, has experienced significant growth over the past two decades.
However, if you zoom out and view private credit in the context of the broader economy, it remains a relatively small player, comprising just 2% of the total non-financial debt market.
When considering this, it becomes clear that private credit is likely too insignificant today to fundamentally alter the structure of fiscal dominance.
Of course, the more promising solution lies in addressing the root cause: government spending. If the government can cut spending and reduce its fiscal deficits, then perhaps it can change the nation’s fiscal trajectory and move away from this period of fiscal dominance.
This is the goal of the newly proposed Department of Government Efficiency (DOGE) led by Elon Musk and Vivek Ramaswamy. This is an advisory commission rather than an official government department. Musk has famously vowed to cut “at least $2 trillion” in federal spending—roughly 30% of last year’s federal budget.
Although this sounds good on paper, achieving such a target will be quite challenging, given the composition of government spending. Last year, the government spent $6.75 trillion, with $4.1 trillion (61%) classified as mandatory spending.
Mandatory spending includes entitlement programs like Social Security, Medicare, and Medicaid, which are legally required to provide benefits to eligible recipients. Even if DOGE wanted to, this spending can’t be cut. To change these programs’ funding, eligibility, or benefits, Congress must vote to amend the laws, a daunting task in the current polarized political climate.
Compounding the issue, President-Elect Trump recently stated his unwillingness to touch Social Security or Medicare. In addition, the Republican Party included protecting these programs as one of twenty promises in its 2024 GOP Platform.
If the incoming administration follows along party lines, that leaves discretionary spending (26%) as the only realistic target to trim spending.
The problem is that defense spending makes up nearly half of all discretionary spending, and given the rising geopolitical tensions and Congressional pushback, it’s unlikely that DOGE will be able to cut meaningful defense spending from the budget. The same 2024 GOP Platform mentioned above promises to “strengthen and modernize” the military, and, in fact, the CBO projects that defense spending will continue to rise over the next decade.
That realistically leaves only 14% of the total federal budget–non-defense discretionary spending–available for DOGE to focus its efforts on to implement cuts.
But even if the department cut the entire $948 billion of non-defense discretionary spending, it would still fall well short of Elon Musk’s $2 trillion budget cut goal. Furthermore, if Musk meant that he would cut at least $2 trillion over time, even if they managed to cut 25% of this annual non-defense discretionary spending, achieving their objective would take more than 8 years.
The bigger issue is that the mandatory spending portion of the annual fiscal deficits is poised for rapid growth over the coming decade as a greater portion of the aging population becomes eligible to receive benefits and interest expenses compound.
According to the CBO’s projections, interest expense, social security, and health care will account for 87% of the nominal spending growth over the next decade.
This means that no matter how much government officials cut the discretionary portion of government spending, the growth in mandatory spending will likely offset the cuts and keep fiscal deficits perpetually high.
Even if the government implements material spending cuts or tax hikes to address the deficit, the structural reliance of U.S. tax receipts on asset prices creates a challenging feedback loop. In a highly financialized economy like the U.S., asset prices are critical to federal tax revenues, with a significant portion coming from taxes on capital gains and dividend income. If spending cuts lead to a decline in asset prices, and the resulting drop in tax receipts is larger than the savings from reduced spending or increased taxes, the deficit can actually widen instead of narrow.
The chart below, originally created by Lyn Alden, highlights how correlated Federal tax receipts have become to the equities market performance. It shows how, in 2021, a booming stock market drove a significant rise in 2022 tax receipts. Conversely, the market downturn in 2022 caused a decline in 2023 receipts, while the market recovery in 2023 fueled a rebound in 2024 revenues:
Despite low unemployment throughout this period, the stock market—not labor markets—has become the dominant driver of federal tax revenues.
This dynamic puts the U.S. in a tougher position than countries like Canada in the 1990s or Germany in the 2010s. Canada addressed its deficits with reforms on a tax base less reliant on financial markets, while a strong manufacturing and export economy supported Germany’s austerity. The U.S. economy, however, is deeply tied to the stock market, creating a strong incentive for policymakers to support equities rather than risk a drop in revenues from falling asset prices.
The result is a fragile cycle: fiscal spending drives asset prices higher, rising asset prices increase tax receipts, and those receipts sustain further spending.
All of this boils down to one simple truth: discretionary spending cuts alone cannot resolve the deficit problem. Without significant reforms to entitlement programs and fundamental changes to the tax system, structural fiscal deficits will persist, dominating economic activity and serving as the main driver of inflation. As long as these mandatory programs remain untouched and asset price performance and tax revenues remain entangled, the fiscal dominance train will continue to barrel forward at full steam.
Navigating Fiscal Dominance
The world is engulfed in an era in which fiscal policy, rather than monetary policy, is the dominant force driving economic activity and inflation. Unlike the countercyclical deficits of the past, today’s fiscal deficits are structural in nature and rooted in systemic obligations like entitlement spending, rising healthcare costs, and compounding interest on decades of accumulated debt.
Central banks today face the difficult task of trying to manage inflation while addressing the escalating costs of sovereign debt. As this report highlights, interest rate cuts could offer a meaningful path to fiscal sustainability by reducing the government’s interest expenses. However, this threatens central bank independence, which could lead to a loss of confidence in the currency.
Meanwhile, the structural nature of fiscal deficits means that even well-intentioned initiatives like DOGE are unlikely to put a meaningful dent in government spending. In an era of perpetually high deficits and persistent inflation, central banks’ traditional tools become ineffective at combating inflation, creating an increasingly uncertain economic backdrop.
At the same time, there are several mitigants that suggest the fiscal dominance train is likely to run hotter and longer than many analysts expect without derailing outright.
The global demand for U.S. dollars, largely driven by trillions of USD-denominated debt worldwide, provides a stabilizing force that can “keep the wheels on the track” for a lot longer than people think. In addition, the U.S.’s debt is denominated in its own currency, giving it flexibility unmatched by many other nations. Lastly, the size and diversification of the U.S. economy enable it to absorb and disperse this debt over time.
While federal debt is growing at a 7–8% annual rate, this is significant but not yet at levels associated with major fiscal crises. Historically, severe currency crises tend to occur when a nation is dealing with extreme impairments, such as war, economic collapse, or large external obligations it cannot print its way out of—conditions that the U.S. does not currently face.
This combination of factors points to a fiscal dominance era that is less dramatic in any given year than alarmists might predict but also far more persistent and intractable than optimists might hope. The deficit problem is unlikely to be resolved this decade, nor is it likely to culminate in a sudden collapse. Instead, it will run structurally hot, punctuated by occasional moments of drama, while nominal figures steadily rise amid ongoing currency debasement.
In this environment, holding hard, scarce assets such as real estate, equities, gold, and bitcoin offers a pragmatic way to preserve purchasing power and navigate the pressures of fiscal dominance. These assets provide a hedge against the gradual yet persistent erosion of purchasing power in an era where fiscal policy rules the economic landscape.
