Sorting out the Fiscal Theories (having something to do with prices and inflation....)

Following John Taylor's papers about interest rate rules, there was much theorizing about inflation that essentially ignored fiscal policy, but that has changed rather decisively in the last decade or so.

The fiscal theory of the price level (FTPL) has gotten much attention lately (Planet Money interviewing John Cochrane for example), but there is another, older fiscal theory, from "The Unpleasant Monetarist Arithmetic" of Sargent and Wallace. Whether any fiscal theory explains any U.S. data is questionable. Turns out, we can make some sense of all this with one equation.

The equation:

real debt = fiscal surpluses + monetary seigniorages

The plural on surpluses and seigniorages is doing much work here. The right hand side is the present value of all future surpluses and seigniorages. (This is the PV equation in many FTPL papers.) The equation says a government has to pay its debt somehow, sometime in the future.

The fiscal surplus is the difference between tax revenue τ and government spending g. Monetary seigniorages are the benefit to the government budget from inflation π. There's a limit to this benefit as countries flirting with hyperinflation often discover, but that's not our focus here:  seigniorage s(π) increases with inflation. Finally, the real net debt is the amount of publicly held bonds B divided by the current price level P₀ .

The fancier, mathier version of the equation is......

(r/(r+1))B/P₀ = τ - g + s(π)

The stuff with the real interest rate r accounts for the present value. Note that there are no time subscripts on anything, so the right hand side values don't look very plural. This equation makes sense as a relationship between steady states, meaning average values over the very, very long fun.

Three theories about the long run connection between fiscal and monetary policy can be described with this equation. The difference is which values are controlled by the government and which adjust on their own.

For the unpleasant arithmetic, or the Fiscal Theory of Inflation (FTI, Section 7.2), inflation π does the adjusting. Lower fiscal surpluses (higher government budget deficits) mean inflation must rise to create higher seigniorages to compensate. The unpleasant arithmetic comes from a "big open market operation" (Sargent and Ljunqvist Section 23.3.4) where where the central bank sells some of its bond holding, increasing the net debt B, and requiring higher inflation. See the previous post for details.

For the FTPL, P₀ does all the work. If the government runs higher deficits, the current price immediately rises to lower the real debt.

I find the FTPL far less compelling than the FTI. The current price of oranges, for example, is set by the aggregate decisions of growers, wholesalers and retailers, none of whom have the slightest idea about the value of their government's real net debt.

But most governments would claim that none of the above describes their policies. Every government assures everyone that they have every intention of generating enough fiscal surpluses to service their debt. In econ-speak, their policies are Ricardian, where τ or g does the adjusting. If the present surpluses don't appear sufficient, they will be...someday....in the future.....

The FTPL papers usually describe an such a situation as monetary dominance where fiscal policy takes responsibility for paying the debt, and central bankers do central banker things to control inflation. These days, that usually means fiddling with interest rates.

FTPL advocates are more interested in the opposite fiscal dominance regime where folks don't trust that fiscal policymakers can handle the debt obligations and the price level must adjust. This is believable as a description of a debt driven hyperinflation. The real debt drives prices and inflation and the monetary policymaker is powerless. Countries like Argentina jump to mind, though Ivan Werning says its more complicated than that, and he ought to know.

Its probably true that trust in the ability of a government to pay its debt is a 0-1 proposition. As Patrick Swayze would say, "Be calm, until its time not to be calm." Government debt doesn't affect most people until a crisis is upon them.

In the case of the U.S., though, no one has seriously questioned the solvency of the country since Alexander Hamilton assumed the debts of the states after the Revolutionary War. Fiscal dominance is not relevant for U.S. data. Period.

Thinking through the FTI lens, it is possible government deficits could affect inflation, but only to the extent that they affect the steady state. The current U.S. deficit of 6.2% of GDP sounds bad, but it is plausible that it will drift back into the 2-3% range the CBO projects, meaning inflation is unaffected. Of course, political polarization can make it hard to control both spending a taxes, so there's that.

So fiscal theories are mostly for macro theory geeks, unless you're in a country in imminent danger of a crisis, or a country whose politics seem dis-functional enough to lead to a crisis....

Then....