Fiscal Dominance
When Prices Stop Telling the Truth
Markets are typically considered to be an informationally efficient reflection of the real economy. Growth, productivity, and private-sector risk-taking largely set the pace of income and profits, while markets processed that information into prices that guided capital to its best uses. However, this is not true in a world of politically normalized recurring deficits. Once investors believe the government will reliably fill the gap when private demand weakens, markets can flip upside-down: bad news can lift risk assets because it implies bigger support, while good news can threaten them because it implies less support.
The consequence is not just weird price action, but a slow degradation of market functioning: prices become less a signal about fundamentals and more a referendum on how far policymakers will go, while markets themselves become more brittle and susceptible to large drawdowns. This post is a summary of Upside-Down Markets: Profits, Inflation and Equity Valuation in Fiscal Policy Regimes.
The Limits of Monetary vs Fiscal Policy
Most investors are used to a simple mapping: stronger economic news tends to be bullish for stocks, weaker news bearish. An “upside-down market” is what happens when that mapping breaks; when good news behaves like bad news and bad news behaves like good news because the market is no longer trading the news itself, but the policy response the news is expected to trigger.
The classic version of upside-down markets is monetary: weak growth lowers rates; lower rates can boost asset prices. But monetary policy alone is usually a weak foundation for a lasting inversion, because rate cuts may buoy prices through portfolio channels without fully averting the underlying economic hit to fundamentals.
Fiscal policy, by contrast, can be much more direct. Imagine a regime where Congress, with Federal Reserve support, targets 5% nominal growth and commits to to hit it even if real growth fails and inflation has to do the work. Then imagine the economy is hit by a permanent social-distancing supervirus.
That would obviously be catastrophic for society and for real economic activity. But in this regime, Congress would inject enough fiscal stimulus to keep nominal spending growing at 5%, while the Fed cuts rates to zero (or below), making cash and bonds unattractive. In that world, the bad news doesn’t just become “less bad” for stocks; it can become perversely bullish because policy is explicitly insuring the nominal income stream of the corporate sector.
Corporate Profits as an Accounting Outcome
Fiscal stimulus works through government deficits: the government injects more income into the economy via spending than it withdraws via taxation, raising aggregate income, and corporate profit is a form of income that tends to rise in that process. In other words, profit generation is a macroeconomic phenomenon affected by aggregate saving and investment behaviors.
The Kalecki–Levy profit equation, loosely modified, shows that Corporate Profit = Corporate Investment + Dividends + Current Account Balance + Government Deficit Spending + Household Deficit Spending. We can show this via the following derivation.
Start with the GDP / National Income identity for an open economy:
where Y is income/output, C is consumption, I is investment, G is government purchases, X is exports, and M is imports. Then expand the income side into who receives income by split total income into households, corporations, and taxes:
Where YH is household income, Π is corporate profits (the thing we want), and T is net taxes (income received by the government). This allows us to solve for profits
We can introduce dividends as a flow from firms to households
Where SH is household saving including dividends D as income. We cna express C
Now, we substitute consumption into the profits expression
This can be re-arranged to
Which is the desired identify, showing that Corporate Profit = Corporate Investment + Dividends + Current Account Balance + Government Deficit Spending + Household Deficit Spending. (since the negative of SH is household deficit spending, government purchases minus taxes is government deficit spending, and exports minus imports is the current account balance).
The practical meaning is the important part: at the macro level, corporate profits are not merely a thermometer of corporate “value” or how “innovative” or “greedy” corporations are. They are instead mechanically shaped by whether the government is running deficits or surpluses, whether households are borrowing or saving, how much corporations are investing, and what the external trade balance looks like.
Bad News is Good News
Once profits are framed as the outcome of spending flows and sectoral balances, the “bad news can be good news” profit channel becomes easier to articulate. Household income and consumption normally move together because they fund each other (income funds spending; spending funds income). COVID or indeed any temporary economic disruption can therefore be seen as a kind of mismatch case: the economy was structured to supply activities people wanted (restaurants, travel, live events), but demand for those activities collapsed due to virus risk, leaving a painful gap.
In a normal market, bad news that worsens that mismatch would be bad for profits, because it prolongs the revenue hole. But in an upside-down dynamic, sufficiently bad news can force a stronger fiscal response in the form of bigger deficits; this raises the government deficit term in the profit identity. And if that deficit term is large enough to offset the deterioration in other terms (especially the collapse in investment and the rise in private withholding), profits can stabilize or even rise relative to what the underlying real-economy damage would suggest.
Inflation as Fiscal Constraint
Developed economies like the U.S. do not typically run explicit nominal income targets; they operate monetary regimes that target inflation, with fiscal policy available when political incentives align. However, if fiscal expansion ignites sustained inflation pressure, the central bank’s reaction function can change, and the upside-down dynamic can become dangerous.
Inflation as one of the least well-understood phenomena in economics; nonetheless, the most important mechanism for assessing fiscal inflation risk is demand-pull: inflation as a condition of “too much spending relative to productive capacity. The key question therefore becomes: will the fiscal response create a large, persistent increase in spending power that actually gets spent?
To make things less abstract, we consider the amount of financial wealth injected by deficits to the total wealth in the system. The fiscal response during COVID injected about $7.5T, and compares that to roughly $117T of household net worth, implying a total nominal wealth increase of about 6.4% over two years, or about 3.2% per year. In the prior decade, the weakest annual growth in household net worth from all sources was about 3.5% per year; at first glance, the wealth addition is not obviously inflation-explosive when viewed at the aggregate.
However, this aggregate comparison can mislead because wealth distribution is extremely uneven and the COVID injection is more targeted toward middle- and lower-income segments. If the bottom half owns only a tiny slice of wealth, an injection that looks small relative to total wealth can be enormous relative to the wealth base of the recipients, producing a large marginal propensity to spend.
Private Sector’s Withheld Demand
When fear rises, households and firms increase their desire to withhold; to strengthen balance sheets, hoard liquidity, pay down debt, or simply sit on cash rather than spend and invest. The problem with a shock like COVID isn’t only the initial decline in activity; it’s the potential for a negative multiplier spiral: layoffs reduce household spending, reduced spending reduces business revenue and profits, those profit declines cause more layoffs, and so on. The core Keynesian insight is that fiscal outlays can interrupt that spiral, but only to the extent they quench withholding demand and restart spending and investment.
Governments ought to pay attention not just to the size of outlays, but to where they land and how recipients behave. A significant portion of projected outlays during any crisis are typically expected to go into the corporate sector (either via corporate stimulus or via checks to consumers who then spend). But if those outlays merely sit idle as corporate withholding then they might not multiply into broader demand. Similarly, household outlays can turn into profit only if they exceed households’ withholding demand and get spent back into corporate revenues; if they don’t, they show up as idle income on household balance sheets.
To translate wealth injection into spending increase, we introduce wealth velocity as an improvement on the standard notion of money velocity. The core idea is that wealth, broadly defined and readily convertible into money, is the ultimate source of spending power, not narrow money itself. We define wealth velocity (for the purpose of calculation) as consumption spending per unit of wealth, operationalized as PCE divided by household net worth. Using that definition, as of year-end 2019, wealth velocity was about 12.6%, meaning households spent about 12.6 cents annually on consumption per dollar of net worth.
Inequality as an Inflation Sink
Lower earners have far higher wealth velocity than higher earners: the bottom 20% of earners spend an amount equal to about 65% of their net worth each year, whereas the top 20% spend about 7%. This reframes the familiar marginal propensity to consume idea in wealth terms. Using those velocities, if all the wealth were injected into the bottom 20%, spending would rise by 33.4%. If spread evenly across quintiles, spending would rise by 17.3%. If injected according to allocation estimates based on actual COVID legislation, spending would rise by 12.5%.
However, this estimate is incomplete. Even if the stimulus initially lands with people who will spend it, the money does not stay there. It gets re-filtered through the existing income distribution. In particular, the bottom income quintile earns less than 3% of total pre-tax income, which acts as an inflation sink. Low earners might spend the fiscal injection, but when they spend it, they receive only a tiny fraction back as income; most of the spending becomes income for high earners and corporations, which have lower propensities to spend. That higher-end withholding attenuates the multiplier and mutes inflation pressure.
As such, while the COVID response could be large enough to create real inflation risk in a recovered economy, structural features like inequality can dampen the sustained spending cycle that would be required for persistent demand-pull inflation.
How Deficits can Lift Prices Without Spending
Having considered what deficits do to spending and profits we now consider what deficits do to portfolios and asset prices. The central claim is that when a government runs a deficit, it adds financial wealth to the private sector. If the private sector prefers to spend that wealth, it shows up mostly in profits and inflation. If the private sector prefers to withhold it by storing it on balance sheets, it shows up in higher valuations of existing assets, especially equities.
That distinction matters because it explains why a society can experience severe real disruption while asset prices remain buoyant: the policy response can create a large quantity of financial claims that must be held somewhere, and if those claims are not being spent in the real economy, they can still bid up existing assets.
To explain how this happens mechanically, imagine a person receives a fiscal injection and decides to buy equities with it; that desire constitutes attempted buying flow. If enough such attempted buying flow hits a market with limited willingness to sell, prices must rise to clear the imbalance. Importantly, after such a repricing, prices do not necessarily revert just because the initial wave of buying ends; if holders are tight and equity supply is effectively locked up, the market can settle into a new equilibrium where higher prices are sustained.
For an equity claim that is a long stream of uncertain future cash flows, there is no single correct price in the immediate sense, and attempted flow imbalances can exert much stronger influence on prices. Equities are structurally more flow-sensitive than fixed-income instruments. In a world where fiscal deficits and central bank actions add large quantities of near-zero-yield assets to portfolios, the desire to escape those yields can push harder on equities than traditional valuation logic expects because the market lacks the crisp arbitrage anchor that exists for fixed-income instruments.
COVID deficits accumulated in the hands of savers, effectively becoming direct injections of cash and Treasury bonds into portfolios, raising allocations to cash/bonds and reducing allocations to everything else. If investors do not want their equity allocations reduced, especially with the Fed at zero, they have limited options. Short of creating new equity supply by investing in new companies or buying shares from diluters, the most straightforward mechanism for restoring desired equity allocations is to bid up the prices of the existing equity float.
Historically, equity is not scarce in the U.S. in a simple supply sense: before considering additional COVID issuance, equities were around 46.2% of the dollar-denominated asset universe, in the top 5th percentile of historical readings, meaning there had rarely been more equity supply relative to total assets. The deficit injection changes the mix. When the $7.5T of near-zero-yield instruments lands in portfolios, the realized allocation to equity was pushed down to about 42.2%, a forced reduction of roughly 4 percentage points. If investors resist that reduction, their collective behavior can push prices higher until the equity slice of the total pie expands enough, in market value terms, to restore the preferred allocation.
Under the simplifying assumption that investors display zero sensitivity to valuation and bid up equity purely to restore their pre-pandemic allocation preference, the market would have needed to rise by about 18%, from about 3327 to about 3900 in Q4 2019, implying a forward 2-year GAAP P/E around 26x.
There is No Alternative
Valuation should act in opposition to the reallocation process: if prices rise enough, investors should become less willing to allocate to equities. But valuation can have trouble gaining traction in a world where the alternative is an indefinite stretch of zero yields. The trade becomes awkward: positive-but-depressed earnings yields in equities versus zero yields in everything else.
Equities cannot rise to infinity just because bonds yield zero; as equities become more expensive, they become more needy, more dependent on continued buyer enthusiasm and narratives regarding future growth rates. Their dependence increases the potential for sharp losses if enthusiasm wanes (the precise mechanics of a bubble). Buying a perpetual $1 earnings stream at $10 (10% earnings yield) is forgiving; buying it at $100 (1% earnings yield) is not, because a re-rating from 100x to 20x implies an 80% drawdown and an absurd “wait” to earn your money back.
In other words, upside-down markets can be rational and still dangerous. Policy and portfolio mechanics can sustain high prices for longer than fundamentals, but the higher valuations climb, the more brittle the market can become because the entire equilibrium leans on the continuation of narratives and on willingness to keep paying.
Summary
Large deficits can support profits through the macro identity, especially if they offset private-sector withholding and help bridge utilization shocks. The inflation risk of deficits depends less on the deficit’s raw size than on the distribution of the injection, the marginal propensity to spend, and the economy’s capacity constraints, tempered by structural disinflationary forces like inequality that re-filter spending into low-velocity hands. Even if the injection is withheld rather than spent, it can still push equity valuations higher by injecting near-zero-yield assets into portfolios and triggering reallocation pressure into equities, amplified by the fact that equities are not like-for-like with cash and therefore are more vulnerable to flow-driven repricing.
However, if fiscal policy pushes hard enough, inflation eventually asserts itself as a problem; the downside repricing potential returns and with valuations elevated losses can be significant. Upside-down markets are therefore what you get when policy is powerful, credible, and asymmetric enough that markets price the policy reaction function more heavily than the underlying news. Fiscal policy is uniquely capable of producing that inversion because it can directly inject net financial wealth and stabilize nominal income streams. But the constraint that ultimately governs how far and how long the inversion can run is whether the resulting spending pressure becomes inflationary enough to force a policy reversal.
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Very timely. Really like inequality is becoming an integral part of economics - was denied for a long time as people were obsessed with averages - it is about the skew and the distribution if we want to gauge inflation right