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. High debt may be problematic
for other reasons (e.g. crowding out of private capital, default risk,
increasing distortionary taxation), but not because it must cause inflation.
This post is about explaining this conventional view. The two
ways of giving the answer reflect two different ways to describe the
conventional view, and I think that tells us something interesting - although
perhaps controversial - about the role of money.
In the textbooks, the conventional view starts by talking about
the demand for the medium of exchange, money. The amount of money in the
economy, it is assumed, is related to the amount of money created by the
central bank, but not the amount of debt issued by the government. The demand
for nominal money is proportional to the price level, which is what economists
mean when they say people demand ‘real balances’. So, if the stock of nominal
money does not change, neither can the price level. When economists talk about not
monetising the debt, they mean that the central bank keeps nominal money fixed.
There are two elements in this argument. The first has to do
with the relationship between the amount of money created by the central bank
(‘base’ or ‘high powered’ money), and what the financial institutions that
create money (private banks) can do. The second has to do with money demand,
which is what I want to focus on first. To do so, imagine an economy where the
only money is cash printed by the government.
It is trivial to show why there can be this tight and simple
link between cash and the price level. The economic system is all about real
variables: not just consumption and output, but also relative prices like real
wages. Furthermore people want money to buy some real quantity of goods, so the
demand function can be written as M/p = f(...) where (...) includes real output.
So, if the price level only appears on the left hand side of this equation and
nowhere else in the system of equations describing the economy, and the central
bank controls the supply of cash M, then this will lock down the price level.
This is the famous neutrality of money. Furthermore, the mechanism by which
this lock down works is intuitive: if the central bank creates more cash, we
have ‘too much money chasing too few goods’, so prices rise.
Once we allow private banks to create money, the story can get
much more complicated. The textbooks try and short circuit this by teaching the
money multiplier, which I think does a lot more harm than good. But we
could just assume there is some mechanism by which the central bank can control
the amount of money created by banks, and continue to tell our neutrality
story.
So according to this conventional view there is no worry about
government debt, as long as the central bank ignores debt when ‘fixing the
money supply’. Whether it always will ignore debt, or whether it always can, is
a separate issue for another post. The critical assumption I make here that
allows me to avoid this issue is that the fiscal authority does adjust its
taxes or spending to make the higher level of debt sustainable.
This story is missing a key ingredient, and to see why consider
the following. Let all government debt be nominal (not indexed). Suppose that,
just as there is a demand for real money, there is also a demand for a real
quantity of government debt: B/p = g(....). The government, by cutting taxes
for a period, raises the supply of nominal debt by a fixed amount. Suppose it
keeps nominal debt at this level. In that case, using an argument analogous to
the earlier one involving money, will the price level not increase, until the supply
of real debt matches the demand for real debt? If so, higher government debt
has raised the price level.
One argument here is to say that, as the government increases
the nominal quantity of debt, the demand for debt also rises in step, so there
is no need for prices to rise. This will happen if consumers are completely Ricardian,
because they believe tax cuts today mean tax increases tomorrow, and they save
to pay for those future tax increases by buying government debt. In this sense,
the supply of government debt creates its own demand, so we do not need
anything else, including the price level, to change.
Suppose, however, that this process is incomplete, perhaps
because some consumers are credit constrained, and so spend rather than save
their tax cut. Does that not mean prices will still have to rise a bit to match
the increase in the supply of nominal bonds? However, if we still have a fixed
nominal amount of money, then higher prices will raise the demand for money,
giving us a contradiction. What squares this circle is that interest rates
rise, which makes people economise on money, and also raises the demand for
government debt without the need for prices to increase. So higher debt might
raise interest rates, but it will not raise the price level if it is not
monetised.
Now an interesting feature of this story is that we could cut
out the stuff about money altogether. We could just talk about the supply and
demand for nominal government debt, and how the demand for debt is positively
related to interest rates and prices. If the government wants to borrow more,
the demand for nominal bonds needs to rise, and this can happen either because
interest rates rise or because the price level rises. If interest rates rise
sufficiently there is no need for higher prices. Loanable funds vs liquidity
preference and all that. [1]
It is a small additional step to just talk about the central
bank controlling interest rates to fix the price level. Nowadays this is how
many macroeconomists would explain why higher government debt does not raise
prices: the central bank changes interest rates to make sure it does not. This
explanation not only has the advantage of simplicity (we do not need to talk
about the demand for money, or how the central bank controls its supply), but
it also seems to match how central banks think.
Of course something about money is there in the background.
When we talk about interest rates being varied to control inflation, and why
therefore we can ignore the size of the stock of government debt as an
influence on inflation, we are assuming that the central bank has the ability
to control interest rates. This depends on the fact that the government can
issue money, or more specifically that the central bank’s “liabilities happen
to be used to define the unit of account”, to quote from the bible
Michael Woodford’s Interest and Prices (p 37). So money is there, but like the impresario of a play, it does
not need to appear on stage.
In terms of the question posed by the title, both ways of
describing the conventional view (with or without money) end up with the same
answer to the question about government debt and inflation, which is good.
However I remain puzzled about one thing. Do those who still tell the story
using money think that telling the story just with interest rates is equally
valid, or in some way misleading? When, with Campbell Leith, I first started
using ‘cashless’ models of the Woodford type, a frequent complaint was ‘where
was money?’. To appease potential referees we occasionally put money in, even
though this added nothing to the main points of the paper. Yet I think those
asking the question thought we might be missing something more fundamental, but
I never discovered what it was. I remain genuinely curious.
[1] Recall that I am assuming full employment in all this. In a
recession caused by people saving more, higher saving will raise the demand for
bonds, so even if the supply of bonds also rises following budget deficits,
interest rates or the price level could fall rather than rise.
