Budget Deficits, Inflation, and Crisis of Confidence

Issues What is the relation between Government Debt, Budget Deficits, and Inflation? What is a “crisis of confidence” and what is a credible Government Policy? How can a crisis of confidence lead to a financial crisis? How can credibility be achieved?

Consequences of Crises of Confidence: Hyperinflation Price Level in December 1919 is 803, in December 1924 it is 131*10 12 ; that is, prices rose is by a factor of about 131 billion.

Episodes of High Inflation in Latin America Source: IMF (2003)—Annual Percent inflation (CPI)

Budget Deficit Government Budget deficit (nominal): G t -T t +R t-1 *B t-1 Government outlays are G Tax collections are T Interest payments are Government borrowing, B, times the interest rate, R

Government’s Budget Constraint C hange in Govt. Obligations = Govt. Budget Deficit [B t –B t-1 ] + [M t –M t-1 ]= G t -T t +R t-1 *B t-1 Two ways to finance the deficit: –Issuing more bonds, B t –B t-1 –Issuing more money, M t –M t-1

Do Budget Deficits Lead to Inflation? Consider a government which has –significant nominal debt, and –cannot borrow from the private sector anymore Consequently, it chooses to finance its budget deficits by borrowing from the Central Bank Monetization regime [M t –M t-1 ]= Budget Deficit Inflationary financing of the deficit Anticipations of this policy leads to “crisis of confidence”

Monetization Budget deficits are –financed through money creation –budget deficits can last forever Implications of this regime –Rampant Inflation –Inflationary expectations will rise Holders of Govt. Debt incur huge losses as the real value of their bond holdings fall All episodes of high inflation are of this nature

Austrian Episode After WW-1 Austria owed the reparation commission substantial sums –Substantial Govt. Liabilities To finance budget deficits, Austria –ran large budget deficits financed via monetization –Between March 1919 and August 1922 money increased by a factor of 288

Austrian Budgets (In Millions of paper Crowns) ** Monetization is percentage of expenditures covered by new issue of paper money.

Austrian Hyperinflation Money supply is Austrian Crowns in circulation.

Austrian Episode In August 1922 prices stabilized rapidly Reasons: –International loan of 6.15 Million gold Crowns to Austria. –Fiscal reform: limit budget deficits –Austrian government promised a new independent central bank –Bound itself not to finance deficits via monetization. –The liabilities of the Austrian central bank (i.e. currency) became 100% backed by gold and foreign assets. Summary: move from a “monetization regime” to a “credible regime” In essence Austria moved to a gold standard The mechanics of ending all other hyperinflations are very similar

Austrian Episode After price stabilization (Sep. of 1922) there was a period of falling prices (deflation) --- despite a rise in money supply. Real money demand R A B M/P Point A: high expected inflation, high nominal interest rates, low real money holdings Point B (post reform): expected inflation falls, nominal interest rates fall, holdings of real money increase –If no change in money supply, then prices have to drop for the economy to reach higher holdings of money balances at point B –However, we see stable prices due to the rise in money supply, which avoids the deflation

Gold Standard Gold standard: –Currency backed by gold –Fixed rate of exchange with gold –(Consequently) fixed exchanges rates across currencies that are on gold standard –Bretton Woods Gold standard is a commitment by the central bank not to underwrite debt issued by the government Modern Incarnation of a Gold Standard –Currency board: government pledges to redeem on demand all government notes for foreign currency –Currently used by Hong Kong –The currency board is a commitment device to be a credible government Many currencies (such as the US) are not on any standard –Fiat money –Backed up only by the credibility of the government

The Credible Regime Polar extreme of monetization regime Government does not rely on central bank to finance its budget deficit –No undue rise in money supply –No inflation risk In the credible regime---debt is sold (and bought) by the private sector Budget deficits are not inflationary in the “credible regime” Budget deficits are temporary, why? –Current budget deficits are financed by the promise of future budget surpluses –More importantly the markets believe that the govt. will not resort to monetization

U.S. Federal Debt

Projected Budget Deficits

The Baby Boom

Social Security Trust Fund