A few days ago I was reading an article in the Economist about structural problems in Brazil, caused by a combination of many years of wildly imprudent fiscal policy and the collapse of the oil and iron ore boom (soybeans, too) that had been preventing legislative craziness from having immediate bad consequences.

Those consequences have since arrived, in the form of deep recession, high inflation and a collapsing currency.  The policy situation in Brazil is grim enough to be described as one of fiscal dominance, a term that has slipped into the economic lexicon without my noticing it (by the way, the Bundesbank has an interesting discussion of its relevance in the EU).

What does fiscal dominance mean?

It’s a situation where a country’s finances are so unstable—high, and rising, government deficit + large outstanding, and also increasing, government debt–that any attempt to raise interest rates runs the risk of driving the government into default.  Investors quickly figure out the extra interest expense that will be needed to roll over existing debt and issue new bonds to fund the continuing deficit.  They know the point where the government will simply be unable to pay.  They don’t wait for that point, of course.  They run for the hills as soon as they reckon this is a real possibility.

As a result, in a fiscal dominance situation money policy can play no role in either stabilizing the currency or fighting inflation.  Fiscal policy, which in Brazil’s case has caused the parlous circumstances it now finds itself in, is the only policy tool available.