Do budget deficits cause inflation? Let me be a little more specific: does raising the level of debt and keeping it there when the economy is at full employment raise the price level? The conventional answer is: not if the central bank controls inflation. Sometimes economists say the same thing in a different way: not if the debt is not monetised.
Pointer from Nick Rowe.
I was asked this question in 1975 on an Honors Exam given by William Poole (Swarthmore used outside examiners. Poole was then at Brown, I believe.) I said that if the government tried to use deficit spending to boost an economy that was already at full employment, this would cause ever-increasing inflation. “Wrong. I didn’t go to the University of Chicago for nothing,” Poole harrumphed. “If the central bank doesn’t increase the rate of money growth, inflation will not go up.”
A few years later, Sargent and Wallace wrote a paper that said that, in effect, that I was right, at least in a rational-expectations world. The reason is that when the government runs such deficits, it creates the expectation that they will be monetized, and because people anticipate that, prices start to rise.
In terms of the way Wren-Lewis asks the question, it seems to me that a textbook answer would be that it depends on the central bank’s reaction function. If it uses a Sumnerian NGDP target, then you get 100 percent crowding out of private investment, presumably because the long-term real interest rate goes up. With other reaction functions, you get some monetization of the debt. If the reaction function is to fix the money supply, then it is plausible that velocity goes up a bit, which gives you more inflation.
Truth be told, I think the sort of monetarist analysis in the preceding paragraph or that Rowe is reaching for is bunk. I am more inclined to think of money in financial terms, as just one of many forms of government debt. My thinking is that small changes in central bank policies get overwhelmed by other factors in financial markets and in the economy. To cause a shift in the inflation regime, the central bank has to be really determined.
Suppose we ask an opposite sort of question. What happens if the government is balancing its budget and the central bank wants to go on an inflation binge? On the one hand, it is certainly true that the central bank can find assets to buy (old government debt, private debt, foreign currency), so it ought to be able to cause inflation. On the other hand, has this ever happened? In practice, is high inflation always a fiscal phenomenon?
Real World Circumstance Question:
If an economy is running at true full capacity, can any stimulus, be it fiscal, monetary, or external, NOT cause inflation or one sort or another?
Bryan Willman:
I’ll offer a resounding “YES” answer to your question.
The justification being, monetary and/or fiscal stimulus currency can (and does) readily flow out of an economy to form foreign investment, foreign investment returns, foreign reserves, and in some cases currency-of-choice for foreign economies. Such is the case with the U.S. dollar right now, and it has been the case for many years.
About a decade after your exam, Poole said of his Friedmanite thinking in the ’70s: “I think it’s fair to say that those of us who have developed strong theories tried to fit the world into the theory rather than the other way around.” (from Greider’s Secrets of the Temple.) Maybe you could have the exam re-graded?
“What happens if the government is balancing its budget and the central bank wants to go on an inflation binge? On the one hand, it is certainly true that the central bank can find assets to buy (old government debt, private debt, foreign currency), so it ought to be able to cause inflation. On the other hand, has this ever happened? In practice, is high inflation always a fiscal phenomenon?”
One could argue that something like this has happened during the Clinton years. The budget was in surplus. Interest rates were possibly lower than they should have been, since we got a stock market boom, falling savings rates, and the growth of foreign reserves — all of which seem to be things that are not strictly price inflation and things that loose monetary policy can cause. So, maybe that is a hint at an answer. But I suspect that it says nothing about the presence of absence of a balanced budget. We got a similar result from the housing boom, which happened in the presence of a large deficit. Or perhaps the signal from those episodes is simply hidden by the noise.
Max
In your question gov’t wants to keep its budget balanced, but the central bank wants to make an inflation binge. So the central bank creates a trillion dollars and drops it in the form of numerous gift cards to people walking in the doors of Walmart and Target. Retail spending explodes, more employment there and eventually more spending in other areas like services.
Over on the gov’t side, the budget was nice and balanced but now all in the sudden the Treasury is reporting tax receipts are flowing in, applications for unemployment, welfare etc. are going down. The gov’t is now in surplus. So now we must ask what does gov’t want to do in regards to this rogue central bank? If it simply believes in balancing its budget it must lower taxes or raise spending dramatically to kill the surpluses. In essence the Central Bank would be forcing a stimulative fiscal policy. That would be essentially the same as Congress going on a spending binge (or supply-side tax cutting binge or both) and the Central Bank playing along by printing money.
On the other hand, if the gov’t let’s the surpluses grow it can neutralize the money printing being done by the Central Bank. It seems for every dollar the bank prints, the gov’t can neutralize by taxing that very dollar back out of the economy. If debt is entirely paid off the gov’t could simply store dollars in a big safe.
On the other hand, has this ever happened? In practice, is high inflation always a fiscal phenomenon?
Well there’s Spain when the New World opened up. You have to consider the Central Bank to be Mother Nature in that case. A currency like Bitcoin may generate inflation if something unexpected (like quantum computers that can ‘mine’ new coins much faster than planned.
Has Central bank hyperinflation happened? I bet not but maybe you could make a case the inflation of the 70’s was such a case. The inflation that drove Carter out of office was not matched by huge Federal spending or deficits (esp. compared to Reagan). Perhaps that was a case where the Central Bank didn’t want to get aggressive on inflation but the gov’t wasn’t willing to pound the austerity button hard enough to do the job.