1. 1 Budget Deficits and Crisis of Confidence

2. 2 Issues What is the relation between Government Debt, Budget Deficits, and Inflation? What is “crisis of confidence” and what is credible Government Policy? Crises of Confidence can lead to Financial Crisis (e.g., currency crisis, capital flight). Several arrangements are designed to achieve credibility –fixed exchange-rate regimes –requirements for joining the Euro etc.

3. 3 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. 4 Some Recent Episodes of High Inflation Source: IMF (2003)—Annual Percent inflation (CPI)

5. 5 Financial Crisis in the 90’s Mexico Thailand Russia Argentina These crisis are a “crisis of confidence” of government policy

6. 6 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

7. 7 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

8. 8 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”

9. 9 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

10. 10 Government Debt, Default and Hyperinflation Why might large Government Debt be a source of Concern? –Can create incentives for default by the Government How do governments default on local currency debt? Mostly via inflation –They shift from the “credible regime” to the “monetization regime” –The central bank finances the government by purchasing the nominal debt issued by the government As discussed earlier, this is the basis of all hyperinflations

11. 11 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

12. 12 Austrian Budgets (In Millions of paper Crowns) ** Monetization is percentage of expenditures covered by new issue of paper money.

13. 13 Austria Market reaction: –rapid increase in prices –flight from the Austrian Crown –the exchange rate (Austrian Crown / USD) rose dramatically

14. 14 Austrian Hyperinflation Money supply is Austrian Crowns in circulation.

15. 15 Other Historical Hyperinflations Germany: 1919 - 1924. Price level rose by a factor of about 130 billion In Hungary and Poland (1921-1924) price level rose by a factor of about 10,000

16. 16 Common Features of All Hyperinflations Large and persistent budget deficits financed through money creation Hyperinflations end suddenly due to drastic fiscal and monetary reform There may be an increase in money supply after the hyperinflation has ended, but this is not inflationary. Why?

17. 17 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

18. 18 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

19. 19 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 An alternative to the gold standard is unbacked currency, like currently in the US Gold standard is a commitment by the central bank not to underwrite debt issued by the government

20. 20 Modern Incarnation of Gold Standard: Currency Board 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

21. 21 Credible Regimes

22. 22 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

23. 23

24. 24 Credible Regime 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 –This is a “credible government”

25. 25 Ratio of Federal Debt to GDP

26. 26 Ratio of U.S. Government Spending to GDP

27. 27 Ratio of U.S. Government Debt to GDP

28. 28 Summary Lessons from Poland, Austria, and Germany –“crisis of credibility” leads to financial crisis Similar issues arise in many other economies, two of these –South East Asian Currency Crisis and Argentina –we will discuss in our FX discussion Many Developed economies have large Govt. Debt to GDP ratios –these economies are “credible” as risks of monetization are very small