The political economy of fiscal dominance: Evidence from the Chilean government of Salvador Allende

Abstract

This article examines the political economy of fiscal dominance during the Chilean government (1970–73) of Salvador Allende. Fiscal dominance appears when the monetary authority complies with the fiscal authority's demand to buy treasury bonds and monetise the deficit. It is argued that persistent fiscal dominance is inflationary, especially without robust fiscal and monetary rules. The Allende government financed the deficit with present taxes, debt (future taxes) and monetary issuance (inflation tax), causing the crowding-out effect and, together with other policies such as expropriation and price controls, collapsed the demand for money, triggering hyperinflation. The lessons of Chile clarify the fiscal trigger of the inflation, stagnation, and widespread poverty that has affected Latin American countries in recent decades.