The link between fiscal policy and financial stability from the perspective of the crowding out effect, under conditions of fiscal dominance, has become a topic of interest for both academia and macroeconomic policymakers, especially after the sovereign debt crisis in the euro area, which followed the financial crisis of 2007-2009. In a major paper on this topic, initially published in 2011 and then in 2016 at the NBER, a number of highly influential economists, such as Markus Brunnermeier, Luis Garicano, Philip Lane, Marco Pagano, Ricardo Reis, Tanos Santos, Stijn Van Nieuwerburgh, and Dimitri Vayanos, discuss problematic links between fiscal policy and financial stability, which they metaphorically call diabolic loops.

In the figure above, we find the example of two so-called diabolic loops, in the language of Brunnermeier et al. (2011), used to describe the interaction between the fiscal-budgetary situation and financial stability through the banking sector channel in the period 2009-2012, when a fiscal debt crisis occurred in the case of some eurozone countries. Thus, according to Brunnermeier et al. (2011), in eurozone countries, such as Greece, Ireland, Italy, Portugal, and Spain, the deterioration of the state’s financial credibility led to a significant depreciation of the value of government securities held by credit institutions. The aforementioned aspects further limited the capacity of credit institutions to finance the real economy. This led to contractionary effects, reducing tax revenues and further deteriorating the public finance situation, which triggered a new negative feedback mechanism in the real economy.

The concept of diabolic loop proposed by Brunnermeier et al. (2011) refers to the situation following a strong shock, in this case the financial crisis of 2007-2009. However, I would like to extend this vision of Brunnermeier et al. (2011) regarding a complicated link between fiscal policy and financial stability to macro-financial conditions characterized by the absence of such a major shock. In this regard, I would like to discuss the crowding out effect. The crowding out effect refers to that problematic relationship between fiscal policy and the real economic sector through the channel of private investment. More precisely, it refers to the fact that a high level of government spending affects the level of investment in the economy through different channels, as emphasized by Friedman (1978) or Ball, Elmendorf, and Mankiw (1998). At the intersection of government and private spending financing is the financial sector, dominated in many situations by the banking sector, as is particularly the case in emerging economies in Central and Eastern Europe.

At the same time, when analyzing the link between economic policies, it is important to see how they position themselves relative to each other. Sargent and Wallace (1981) are the first to emphasize that fiscal policy is in a dominant position relative to monetary policy, in the sense that if the government does not adjust its fiscal policy, then the room for maneuver of monetary policy inevitably becomes more limited. Uribe (2020) investigates the concept proposed by Sargent and Wallace (1981) from the perspective of financing large budget deficits in the case of an emerging economy as a result of the negative effects generated by the Covid-19 pandemic. On the other hand, Reis (2021) extends the concept proposed by Sargent and Wallace (1981) to show that fiscal policy is also in a dominant position relative to macroprudential policy, highlighting in this regard a new type of diabolic loop. Brunnermeier and Sannikov (2012) address the concurrent interaction between macroprudential, monetary, and fiscal policies, also highlighting a form of diabolic loop.

In light of the conclusions formulated in the aforementioned scientific works, the question I address here is: what does a problematic diabolic loop type connection between fiscal policy and financial stability look like through the crowding-out effect, under conditions of fiscal dominance? For us, it is particularly relevant to particularize this question for the case of emerging economies in Central and Eastern Europe, with a focus on Romania. As I mentioned in a recent article, titled Consolidated public debt above the level provided for in the Maastricht criteria: a new challenge for public finances, the IMF expects an increase in the public debt of Central and Eastern European countries. The most significant increases are expected to occur in the case of Poland and Romania.

In circumstances where the budget deficit on the primary balance will not decrease significantly, the increase in public debt with the related implications will put pressure on the state’s financing costs. This determines the amplification of the financing costs of credit institutions. Finally, higher costs for bank deposits have upward effects on loan rates. Specifically, as long as the new issues of government bonds offer, in the case of our country, yields of 7-8%, credit institutions will need to have competitive offers for savings products, so that they can finance the increase in lending. Here it must be taken into account that, unlike bank deposits, income obtained from investments in government bonds is exempt from taxes. The previously mentioned chain of causalities may be a form of crowding out through the deposit channel. Unlike the previously mentioned works, this form of crowding-out manifests itself across the entire spectrum of credit products, intended for both private investments and the population. However, it should not be forgotten that the financing attracted by the state in lei, from the local market, returns almost immediately to the banking system and, implicitly, to the economic circuit, in the form of liquidity. In summary, this article emphasizes that, under conditions of fiscal dominance, the increase in the state’s financing costs can generate a crowding-out phenomenon on the bank deposits channel, with negative effects on financial stability, and, ultimately, on the activity in the real economic sector.

In a context characterized by volatility, in which public debt increases significantly, the state accesses a significant part of the total financing available on the domestic market, and the pressures on borrowing costs are transmitted to the entire financial system. Thus, the increase in interest rates on government securities not only increases budgetary expenses for debt service, but also reduces the room for maneuver of credit institutions and private investments in the real economy, forced to compete with the state for the same financial resources. In fact, the pressure will be both for attracting bank liabilities in the form of deposits with high interest rates, and for the placement of bank assets, which, on the one hand, is influenced by the possibility of investing in government securities at high interest rates and, on the other hand, by the possibility of granting bank loans whose interest rates are increasing.

In the case of Romania, all of these influence the economic situation, pushing interest rates up and restricting lending to the real economy. If we also analyze the growth prospects of the Romanian economy for next year, according to which a demand deficit (negative output gap) of over 3% is expected, the crowding out effects may be amplified, with negative implications on the economic growth potential.