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Budget Deficits, Inflation, and Crisis of Confidence

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?

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Budget Deficits, Inflation, and Crisis of Confidence

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  1. Budget Deficits, Inflation, and Crisis of Confidence

  2. 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?

  3. 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.

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

  5. Budget Deficit • Government Budget deficit (nominal): Gt -Tt +Rt-1*Bt-1 • Government outlays are G • Tax collections are T • Interest payments are Government borrowing, B, times the interest rate, R

  6. Government’s Budget Constraint Change in Govt. Obligations = Govt. Budget Deficit [Bt –Bt-1] + [Mt –Mt-1]= Gt -Tt +Rt-1*Bt-1 • Two ways to finance the deficit: • Issuing more bonds, Bt –Bt-1 • Issuing more money, Mt –Mt-1

  7. 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 [Mt –Mt-1]= Budget Deficit • Inflationary financing of the deficit • Anticipations of this policy leads to “crisis of confidence”

  8. 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

  9. 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

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

  11. Austrian Hyperinflation Money supply is Austrian Crowns in circulation.

  12. 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

  13. Austrian Episode After price stabilization (Sep. of 1922) there was a period of falling prices (deflation) --- despite a rise in money supply. • 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 R A B Real money demand M/P

  14. 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

  15. 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

  16. U.S. Federal Debt

  17. Projected Budget Deficits

  18. The Baby Boom

  19. Social Security Trust Fund

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