The Politics of Fiscal Policy

The government budget constraint tells us that are three ways to fund spending: taxes today, the inflation tax, or debt (which means taxes at some future date). A government that has the best interests of its citizens at heart will decide on the best mix of these three. Optimists may believe that this is what governments try to do. Cynics might hold a very different view. Suppose—just suppose—that the leader of a government is more concerned with reelection than with sound economic policy and believes that her chances of reelection will be increased if she pledges not to increase taxes now or in the future. If this promise is credible, then the government budget constraint tells us that any increases in spending must be financed by money growth. The monetary authority again has no power to commit to avoid inflation. The fiscal side of the government has set the level of spending and decided, based on the wishes of the political leaders, to have low taxes. Faced with this fiscal package, the monetary authority has no choice: it must print money to finance the government budget constraint. This story relies on the belief that individuals in the economy do not understand that the government, by its fiscal actions, is causing inflation and thus imposing a kind of tax. A more extreme example arises when the government’s expenditures are so great that it simply cannot finance them with current taxation. This can occur in poorer economies where the tax base is low and the mechanisms for collecting taxes are often imperfect. Moreover, a government can finance its deficit through borrowing only if the public is willing to purchase government bonds. If a government is in fiscal trouble—if its tax and spending policies appear to the public to be unsustainable—it will have great difficulty persuading the public and the international investment community to buy government debt. Investors will demand a very high interest rate (including a risk premium) to cover the possibility that the government may default on its debt. Interest rates on debt will increase. At this point a government may find that the only option available to it is to finance its deficit through the printing of money. After all, no government wants to be in the position of being unable to pay its soldiers. The leaders of a country in such a position will decide to run the printing presses instead. The end result is inflation and, if the process gets completely out of control, hyperinflation. But from the government’s point of view, at least it buys it some time. Thus although moderate inflations are caused by poor monetary policy, hyperinflations are almost always originally caused by unsustainable fiscal policies. Regional Monetary Policy Figure 11.10 “The Price Level in Argentina” shows the price level in Argentina from 1988 to 2005. Argentina experienced hyperinflation in the early 1990s. Prices were then stable for about a decade and then increased again in the early years of the 21st century. In Argentina, different regional governments have significant power over the decisions of the central government. (It is as if a state government in the United States could appeal for funds directly from Washington.) These transfers from the central government in turn must be funded either from tax revenues or by printing money. If a region is sufficiently powerful relative to the central government, then it is as if the regional government has the power to print currency.