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Budget Deficits and Crisis of Confidence

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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.

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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

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ARGENTINA BOLIVIA BRAZIL COLOMBIA MEXICO POLAND TURKEY U.S

1985 672.2 11749.6 226.0 24.0 57.7 15.1 45.0 3.5

1986 90.1 276.3 147.1 18.9 86.2 17.8 34.6 1.9

1987 131.3 14.6 228.3 23.3 131.8 25.2 38.8 3.6

1988 343.0 16.0 629.1 28.1 114.2 60.2 73.7 4.1

1989 3079.5 15.2 1430.7 25.9 20.0 251.1 63.3 4.8

1990 2314.0 17.1 2947.7 32.1 26.7 585.8 60.3 5.4

1991 171.7 22.4 477.4 29.7 22.7 70.3 66.0 4.2

1992 24.9 11.2 1022.5 26.8 15.5 43.0 70.1 3.0

1993 10.6 8.5 1927.4 22.4 9.8 35.3 66.1 3.0

1994 4.2 7.9 2075.8 22.8 7.0 32.2 106.2 2.6

1995 3.4 10.2 66.0 20.8 35.0 27.9 93.6 2.8

1996 0.2 12.4 16.0 20.8 34.4 19.9 82.3 2.9

1997 0.5 4.7 6.9 18.3 20.6 14.9 85.7 2.3

1998 0.9 7.7 3.2 18.6 15.9 11.8 84.6 1.5

1999 -1.2 2.2 4.9 10.2 16.6 7.3 64.9 2.2

2000 -0.9 4.6 7.1 9.3 9.5 10.1 54.9 3.4

2001 -1.1 1.6 6.8 7.8 6.4 5.5 54.4 2.8

2002 25.9 0.9 8.4 6.3 5.0 1.9 45.0 1.6

Country

Some Recent Episodes of High Inflation

Source: IMF (2003)—Annual Percent inflation (CPI)

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Financial Crisis in the 90’s

exc

ha

ng

e r

ate

sn

atio

na

l cu

rre

ncy

pe

r d

olla

r

Time series of recent collapsemonths

Jan90Dec90Dec91Dec92Dec93Dec94Dec95Dec96Dec97Dec98Dec99Dec00Dec01Dec02

Mexico

Thailand

Russia

Argentina

These crisis are a “crisis of confidence” of government policy

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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

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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

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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”

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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

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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

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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

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Austrian Budgets(In Millions of paper Crowns)

Receipts Expenditures Budget deficit Monetization**

1 Jan. – 30. June 1919 1339 4043 2704 67

1 July 1919 - 30 June 1920 6925 16873 10573 63

1 July 1920 – 30 June 1921 29483 70601 41118 58

1 Jan. – 31 Dec. 1922 209763 347533 137770 40

** Monetization is percentage of expenditures covered by new issue of paper money.

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Austria

• Market reaction: – rapid increase in prices

– flight from the Austrian Crown

– the exchange rate (Austrian Crown / USD) rose dramatically

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Austrian HyperinflationAustrian Hyperinflation

100

5,100

10,100

15,100

20,100

25,100

30,100Ja

n-21

Mar

-21

May

-21

Jul-

21

Sep-

21

Nov

-21

Jan-

22

Mar

-22

May

-22

Jul-

22

Sep-

22

Nov

-22

Jan-

23

Mar

-23

May

-23

Jul-

23

Sep-

23

Nov

-23

Jan-

24

Mar

-24

May

-24

Time

Pric

e le

vel

1,000,000

1,001,000,000

2,001,000,000

3,001,000,000

4,001,000,000

5,001,000,000

6,001,000,000

7,001,000,000

8,001,000,000

9,001,000,000

Mon

ey s

uppl

y

CPI Money supply

Money supply is Austrian Crowns in circulation.

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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

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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?

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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

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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

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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

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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

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Credible Regimes

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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

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Government Debt (GDP %) 1999

0

20

40

60

80

100

120

140U

nited

States

Japan

Germ

any

Fra

nce

Italy

Un

ited K

ing

dom

Canad

a

Au

stralia

Au

stria

Belg

ium

Den

mark

Fin

land

Gre

ece

Icelan

d

Ireland

Ko

rea

Neth

erland

s

No

rway

Po

rtug

al

Spao

n

Sw

eed

en

Source: OECD Economic Outlook

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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”

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Ratio of Federal Debt to GDP

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Ratio of U.S. Government Spending to GDP

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Ratio of U.S. Government Debt to GDP

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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