Fiscal deficits – the myth of debt and inflation

Posted by Anis Chowdhury on 19 October 2009

Fiscal deficits – the myth of debt and inflation

Anis Chowdhury[1]

UN-DESA, New York and University of Western Sydney, Australia

Neil Hart

University of Western Sydney, Australia

In our previous commentary, we tried to debunk the myth about fiscal deficits. Historically, fiscal deficits have been an essential tool not only for counter-cyclical macroeconomic policy, but also for driving structural change and infrastructural development in developing countries. There is nothing inherently good or bad about fiscal surpluses or deficits as long as they serve their ends, i.e. maintaining full employment and achieving structural change and infrastructure development. This is the key message of “functional finance”, that government’s fiscal stance should be evaluated based on its impact on the economy.

However, a lingering concern is the financing of the deficit. The first recourse for the governments is to borrow domestically. This raises the spectre of “crowding out”; i.e. government borrowings driving up interest rates and adversely affecting private investment. This, however, ignores the consequences (e.g. low profitability, bankruptcies etc.) of a depressed economy in the absence of increased government spending. Inaction by the government for the fear of crowding out will not help private investors. The action by the government is necessitated in the first place by inadequate private spending; what is being done through fiscal deficits is the maintenance of total spending needed for full-employment with price stability. Thus, empirical evidence finds only small interest rate effects of
government debt.[2]

Government borrowings will, of course, be counterproductive if they lead to declines in private spending. There is another channel through which this is claimed to happen. It is known as “Ricardian equivalence” hypothesis. That is, individuals save more in anticipation of higher future taxes needed to pay off larger government debt. There is very scant evidence supporting this hypothesis, especially in developing countries.[3] Furthermore, the notion that government deficits will need to be ‘financed’ through higher taxes in future periods is spurious as revenues rise with an expanding economy.

It is also a myth that government expenditure must always be financed by raising tax, so that government budget remains in balance. As Abba Lerner pointed out more than half a century ago, “taxing is never to be undertaken merely because the government needs to make money payment.”[4] Just as government expenditure, taxes must also be judged from their impact on the economy. Higher taxes have two immediate impacts: (a) taxpayers will have less money to spend and (b) the government will have more money. Hence, at the time of economic slowdown, raising government spending through raising taxes will not be able to achieve its goal of maintaining full-employment.

Therefore, it is much easier to raise government’s spending capacity by simply printing money (borrowing from the central bank). Printing money is the only option for most developing countries in the absence of a well-developed capital market. The immediate financial implications of expansionary fiscal policy action when the central bank uses interest rate – in a world of ‘endogenous money’ – is to add to the cash reserves of the private sector banks in which the government checks are deposited. This in turn increases (net) liquidity in the cash market where the central bank discount rate is established and defended, assuming that the central bank did not implement offsetting market operations (buying and selling its own or government short-term securities, or associated derivatives such as re-purchase agreements). Under these circumstances the actual central bank discount rate should tend to decrease, causing downward pressure on retail interest rates. This conclusion is contrary to the conventional belief, and therefore should encourage instead of crowd out private investment.

The immediate revulsion to the option of borrowing from the central bank comes from the supposed link between printing money and inflation. However, this fear again arises from the lack of appreciation of the root cause of the problem, i.e. insufficient spending. Printing money in a depressed economy should not cause inflation. The first principle of functional finance is to keep the total rate of spending “neither greater nor less than that rate which at the current prices would buy all the goods that is possible to produce.”[5]

Furthermore, the effect of an increase in the money base on monetary aggregates depends on portfolio decision that influences the willingness of financial institutions to lend, and the propensity of spending units to borrow. If expansionary fiscal policy achieves its intended purpose of boosting output and employment, the increased money supply will match increased demand for money needed for a higher level of transactions. Expansionary fiscal policy would only fuel inflationary pressures in the economy and place upward pressure on interest rates if the accompanying increases in demand pushed the economy close to, or beyond, full capacity output.

However, that does not depend on the mode of financing deficit. Instead, price rises would be due to normal frictions within an expanding economy. As James Tobin argued, “a little inflation helps oil the wheels of the economy”.[6] One should not fear a break away inflation just because some prices rise as the economy undergoes structural change and expands. Historical records of hyperinflation do not lend any support to this.[7]

Finally, the fear of inflation wracking the economy is also unfounded. After reviewing a mass of evidence, Michael Bruno and William Easterly arrived at the following answer to the question “Is inflation harmful to growth?”, Bruno and Easterly (1998, p. 3), “The ratio of fervent beliefs to tangible evidence seems unusually high on this topic.”[8] This is consistent with the observation of the guru of monetarist school Milton Friedman (1973, p. 41), “Historically, all possible combinations have occurred: inflation with and without [economic] development, no inflation with and without [economic] development.”[9]


[1] Views expressed here do not reflect the views of the UN or any of its agencies

[2] Noriaki Kinoshita (2006), “Government Debt and Long-Term Interest Rates”, IMF Working Paper, WP/06/63

[3] Nadeem Ul Haque and Peter J. Montiel (1987), “Ricardian Equivalence, Liquidity Constraints, and the Yaari-Blanchard Effect: Tests For Developing Countries”, IMF Working Paper No. 87/85. The study notes: “Empirical tests of the model for a sample of developing economies do not support the equivalence proposition owing to the prevalence of liquidity constraints.” In evaluating the theoretical case and empirical evidence from developed countries, Douglas Bernheim notes, “the theoretical case for long-run neutrality is extremely weak, in that it depends upon improbable assumptions that either directly or indirectly falsified through empirical observation. …even in [the case of short-run], behavioral evidence weighsheavily against the Ricardian view” (pp. 263-64), Douglas Bernheim (1987), “Ricardian Equivalence: An Evaluation of Theory and Evidence”, NBER Macroeconomics Annual 1987, Volume 2, edited by Stanley Fischer

[4] Abba Lerner (1943) “Functional finance and the federal debt” Social Research, vol. 10, No. 1, pp. 38-57 [p. 40; emphasis original]

[5] Abba Lerner, op cit. p. 39.

[6] James Tobin (1972), “Inflation and unemployment”, American Economic Review 62 (1972), pp. 1–18

[7] Only in a handful of cases inflation rate did accelerate and output stagnated or declined in the past, and these cases could be attributed to unusual circumstances (e.g Iran or Nicaragua in the 1980s following dramatic fall of the regimes). Like-wise, the great German hyperinflation occurred in the aftermath of the devastation of WWI.

[8] Michael Bruno and William Easterly (1998), ‘Inflation Crises and Long-run Growth’, Journal of Monetary Economics, vol. 41, pp. 3–26

[9] Friedman, M. (1973), Money and Economic Development, Toronto: Lexington Books