Confidence, Credibility and Macroeconomic Policy

Richard Burdekin, Farrokh Langdana

• Publisher: Routledge
• Year: 2003
• eBook ISBN:
  9781134851232
• Topic: Commerce
• Subtopic: Commerce Général

The results of macroeconomic policy are often unpredictable. One of the major reasons for this is the importance of confidence and expectations in economic affairs. Confidence, Credibility and Macroeconomic Policy explores this interaction between confidence and expectations, and the credibility of the government's financial policies. The volume is divided into three parts. * An overview of the inter-relationship between fiscal policy, credibility and inflation * Empirical research on the importance of public confidence and expectations to the success of fiscal and monetary policy. * The definition and functions of consumer confidence as it is measured today. Confidence, Credibility and Macroeconomic Policy will be an invaluable guide for all those interested in macroeconomic policy.

Part I Credibility in practice and in experimental testing

Chapter 1
Fiscal policy, credibility and inflation
The critical role of confidence factors*

A Government can live for a long time, even the German Government or the Russian Government, by printing paper money…. It is the form of taxation which the public find hardest to evade and even the weakest Government can enforce, when it can enforce nothing else. Of this character have been the progressive and catastrophic inflations practiced in Central and Eastern Europe, as distinguished from the limited and oscillatory inflations experienced for example in Great Britain and the United States.

(John Maynard Keynes, 1924)¹

[A]n effective prohibition of creating new money to cover deficits of the government or state enterprises, and…a guarantee to redeem rubles for gold at a price above the current market rate …is technically feasible…. And it could even be effective if anyone believed it. Yet the trouble with this, or any other plan relying on Russia’s politicians and central bankers, is that it would be quite difficult to establish credibility and trust.

(Alan Reynolds, 1993)²

INTRODUCTION AND OVERVIEW

Keynes’ (1924) characterisation of inflationary deficit finance in Central and Eastern Europe seems remarkably applicable to the problems facing countries like Russia, the Ukraine and the former Yugoslavia in the early 1990s. During both the hyperinflations of the 1920s and those of the 1990s, resort to inflation finance led to a flight from the currency as the public sought to unload the depreciating currency to minimise their exposure to the inflation tax. The European hyperinflations of the 1920s were ended by drastic fiscal reform and stabilisation of the exchange value of the currency (Sargent, 1993, chapter 3). Reynolds (1993) points out, however, that such reforms cannot succeed in Russia today unless the government is able to gain the confidence of the public. If the public expects the government eventually to revert to the money-financing policies that have characterised the early post-Soviet era in Russia, then inflationary expectations will remain high and so will the actual inflation rate.

As evidenced by such inflationary episodes as the American War of Independence, the American Civil War and the French Revolution, the ultimate effects of money-financed deficits were seemingly well-established even before the twentieth century (see Burdekin and Langdana, 1992, chapter 3; Tallman, 1993). In reviewing the interrelationship between the fiscal policy regime and confidence factors in the inflation process, it may, therefore, be appropriate first to consider why governments have continued to resort to inflation finance in the first place. The alternatives to money financing are either to reduce the deficit by cutting spending or raising taxes or else to finance the deficit by bond issuance. This latter option is exemplified by the 1979–1993 US experience, which shows that it is possible to run substantial budget deficits with only single digit inflation provided that there is a ready market for the government’s bonds.

Figure 1.1 The US federal deficit as a percentage of GDP

Figure 1.2 US federal debt as a percentage of GDP

The ratio of total federal debt to gross domestic product (GDP) in the United States reached 69.1 per cent in 1993 and the deficit/GDP ratio was more than 4 per cent. The debt/GDP ratio has, in fact, been continuously rising since 1981 and the 2.7 per cent deficit/GDP ratio in 1981 remains the low point for the post-1979 period (see Figures 1.1 and 1.2). Nevertheless, the perception of the US dollar as a ‘safe haven’ has continued to encourage foreigners, particularly the Japanese, to purchase a significant portion of die debt. Despite the explosive debt growth since the end of the 1970s (Figure 1.3), the share of the publicly-held debt accounted for by foreigners has declined only slightly from 22 per cent in December 1979 to 20 per cent in September 1993 (see Figure 1.4).³

The US situation contrasts sharply with developments in countries like Russia, where the lack of developed financial markets compounds the (justifiable) lack of confidence in the stability of the rouble, thereby severely limiting the market for Russian bonds. Indeed, while Russia’s monetary base rose from 1,450 billion roubles in December 1992 to 7,450 billion in September 1993, government bonds outstanding increased only from 15 billion to 20 billion over this same period—and in September 1993 government bonds accounted for less than one tenth of 1 percent of Russia’s 25,300 billion M–3 money supply measure (Lewarne, 1995, table 2). Central bank credit creation accounted for 40 percent of Russia’s GDP in 1992. While there has been some progress in establishing a nascent market for short-term treasury bills since 1993, even the greatly expanded June 1994 auctions could not bring government treasury bills outstanding to more than 3 per cent of the anticipated $35.7 billion deficit (Rosett, 1994, p. A10).

Figure 1.3 Total US public debt held by private investors vs. non-foreign holdings

Whatever the actual state of a government’s finances, the critical issue remains the perceptions of that government’s future prospects of balancing its budget or at least of avoiding the necessity of repudiating its monetary and debt obligations through inflation. A recent example of the importance of expectations and confidence factors is given by Slovakia’s experience after its ‘divorce’ from the Czech Republic. Despite inheriting the near balanced budget pursued in 1991 and 1992 by the now-defunct Czechoslovak Federation, the Slovak koruna was already exchanging at a discount relative to the Czech koruna in early 1993 (PlanEcon Report, 1993e). This reflected the fact that the loss of the transfers previously received from the Czechs, and perceived structural problems hampering the Slovak economy’s international competitiveness, fuelled expectations of future deficits—even though the actual Slovak deficit, at that time, remained quite low.⁴

There are also many earlier historical examples of the role played by confidence factors in influencing a currency’s exchange value. Consider the US experience with the non-convertible ‘greenback’ legal tender notes issued in the midst of the 1861–1865 Civil War. The greenbacks were authorised at a time of financial crisis whereby the banks had suspended specie payments at the end of 1861 and the government, facing rapidly mounting war expenditures, was already in arrears. On 8 January 1862, Congressman Elbridge G. Spaulding wrote of the need for ‘at least $100,000,000 during the next three months, or the Government must stop payment’ (Mitchell, 1903, p. 47). Although some bankers urged that the government rely on bond financing rather than money financing, it was feared that this ‘might depress the price of bonds to the point of bankrupting the owners of earlier issues’ (see Hammond, 1961, p. 7). Notwithstanding the government’s promise that the greenbacks would eventually be redeemed in gold, the greenback quickly depreciated to an average of 62.3 per cent of par in February 1863. At the greenback’s low point on 11 July 1864 the currency had declined to 35.09 per cent of its par value in terms of gold (Mitchell, 1903, pp. 423–424).

Figure 1.4 The percentage of US public debt securities owned by foreign and international subscribers

Declines in the greenback’s gold exchange value were often linked with Confederate military successes that decreased the North’s prospects of redeeming the notes at par (Mitchell, 1903, Chapter III; Calomiris, 1988b; Guinnane et al., 1993). Similar, but inverse, fluctuations in the price of gold were evident in the South (Schwab, 1901, chapter IX). Distant as these events may seem now, they should remind us that under a fiat money system, money and bond issues are backed only by the public’s confidence in die government’s ability to redeem its debt obligations without resorting to the inflation tax. Rapid declines in the exchange value of the Russian rouble following the 1994 resignations of pro-reformers Fyodorov and Gaidar provide an example of how today’s markets, like those of the past, react to events that are thought to increase the likelihood that the government will resort to inflation finance.

Lack of faith in a government’s fiscal soundness has not only severely limited the scope for its bond issuance but also led to rejection of the national currency itself in many instances. During the German hyperinflation of the 1920s, for example, foreign bank notes increasingly took the place of the domestic currency as instruments of payment. In their anxiety to unload the rapidly depreciating mark, some German merchants even mistakenly accepted Confederate dollars at the prevailing US dollar exchange rate (The Numismatist, 1920). A number of Russians were apparently victimised in the same way in the midst of the chaotic monetary conditions of 1921 (The Numismatist, 1921). While there is no sign of Confederate currency re-emerging in post-Soviet Russia, it is evident that the rouble is also being increasingly shunned by the Russian public today. As early as November 1992, the estimated value of the US dollars circulating in Russia stood in excess of $10 billion (C.Goldberg, 1992).

The German government of 1923 had made a number of increasingly desperate attempts to combat the use of foreign exchange, culminating in the Decree of 7 September 1923, that permitted government agents to ‘seize foreign currencies wherever they were to be found…People’s houses and cafés were searched, letters opened, bill-brokers’ transactions scrutinized’ (D’Abernon, 1927, p. 20). Notwithstanding these activities, the real value of the foreign bank notes held in Germany at the end of 1923 was still estimated at around 1,200 million gold marks—while total Reichsbank notes in circulation at that time were equivalent to only about 497 million gold marks (Young, 1925, pp. 402, 529).⁵ In contemporary Russia, concerns with the flight from the rouble have once more led to government attempts to interfere with the domestic circulation of foreign currency. Indeed, the use of the US dollar for transactions purposes was outlawed by the Russian government in 1994.

Even when a government takes concrete steps to put its finances in order, this has not always been enough to eliminate inflation. There is the question of whether or not the public is confident that the new-found fiscal and monetary restraint is sustainable. Participants in the experiments described in Chapters 2 and 3 evidence considerable concern on this score, and the postwar Latin American experience is itself replete with cases where even drastic fiscal tightening has not prevented inflation from remaining at double digit levels. Notably, public reluctance to hold the new Bolivian currency after that country’s 1985 stabilisation was instrumental in keeping inflation at the 20 per cent level. In contrast to the experiences of Germany and other European countries after the termination of the 1920s hyperinflations, Bolivian real money balances remained below the pre-hyperinflation levels because of ‘a general mistrust in Bolivian political institutions and in the stability of property rights’ (Bernholz, 1988b, p. 766).

THEORETICAL PERSPECTIVES ON DEFICIT FINANCE

As a way of framing the issues involved, it is useful to consider the relationship between deficits and issuance of bonds and currency that is required under the government’s intertemporal budget constraint. In order to remain solvent, governments must raise sufficient revenue from current debt and money issue to cover today’s budget deficit plus interest payments and principal payments due on past debt issue. If the government continues to run deficits, the rising debt burden can be offset, for a time, by ‘rolling over’ the debt and issuing new debt to pay off the old debt. However, if there is no prospect of the government levying future taxes or cutting spending to reverse the progressive build up of debt, this rolling over of the debt must eventually be regarded as a non-sustainable Ponzi scheme.⁶ At this point, no one will be willing to hold the government’s debt, leaving monetisation of the debt (money finance) as the only remaining option.⁷

The government’s dynamic budget constraint can be expressed as follows:

P_t(G_t-T_t)+D_t-1=D_t+M_t (1)

where P_t is the price level, G_t is real government spending, T_t is real tax revenue, D_t is current debt issuance, D_t-1 is the cost of servicing past debt issue, and M_t is current base money issuance.

While the form of this budget constraint is uncontroversial, the sustainability issue is not. At what point will domestic and foreign individuals refuse to hold government bonds, and render the deficits non-sustainable by forcing the government to monetise the debt—that is, to inflate it away? The answer to this question will vary from case to case, depending upon public perceptions of the government’s willingness and/or ability to avoid resorting to the money financing option. Or, alternatively stated, the answer is a function of the credibility of the fiscal and monetary authorities’ commitment to combat inflation-inducing monetisation of the debt. Nevertheless, we can safely say that, unless the public believes that current debt will eventually be redeemed out of future taxes, then bond issuance has inflationary effects today because of money issue expected in the future (see Langdana, 1990, chapters 11–15; Sargent, 1993, chapter 2; and Chapter 2 of this volume).⁸

There are instances, such as cases of war-induced temporary deficits, where confidence in the government’s ability to redeem its obligations through future taxes and/or cuts in government spending has made reliance on bond financing feasible on a massive scale in the short run.⁹ Following the outbreak of the Second World War, for example, the US debt/GDP ratio grew from 53.1 per cent in 1940 to a peak of 127.5 per cent in 1946 while the deficit/GDP ratio peaked at 31.1 per cent in 1943 before moving into surplus in 1947 (Economic Report of the President, 1994, table B–79). From June 1942 until the end of the war in mid-1945, the annualised growth rates of the public debt and the monetary base averaged 50 percent and 20 per cent, respectively (Toma, 1991, p. 472). Nevertheless, the Federal Reserve and Treasury were able to keep the yield on 25year Treasury bonds below 2.5 per cent over this period.

Toma (1991) calculates that the public would rationally purchase the US war bonds at the 2.5 per cent interest rate ceiling provided that there were expectations of a sufficiently high level of postwar tax financing.¹⁰ For example, if the war duration expected in 1942 is set equal to the actual value of 3 years, all expenditures and interest payments would have to be financed from future taxes in order for the 2.5 per cent interest rate to be sustainable. This would imply zero postwar growth in the monetary base, which in reality did grow at only 1.7 per cent between 1945 and 1949 (see Toma, 1991, p. 475). Given the prior US record of temporary wartime deficits that had been repaid out of future taxes (Trehan and Walsh, 1988; Jones and Joulfaian, 1991), expectations that such a strategy would be followed after the Second World War may have been reasonable at the time.

The US situation can be compared to those of the Southern Confederacy of 1861–1865 and Germany during the First World War. In each case, difficulties in marketing the government’s bond issues went hand in hand with the state’s declining military and financial situation. The Confederacy was unable to successfully float any major loans subsequent to the $50 million loan approved by Congress on 16 May 1861. Even the cotton-backed £3 million Erlanger loan (equivalent to approximately $15 m...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Figures
• Tables
• Foreword
• Acknowledgements
• Introduction
• Part I Credibility in practice and in experimental testing
• Chapter 1 Fiscal policy, credibility and inflation: The critical role of confidence factors
• Chapter 2 Bond-financed deficits, taxation and expectations: An experimental test of the Ricardian equivalence theorem
• Chapter 3 Monetary credibility and national output: An experimental verification of the Lucas ‘islands’ explanation of business cycles
• Part II Confidence and credibility factors in historical perspective
• Chapter 4 Public confidence and public finance during the American Civil War: Lessons from North and South
• Chapter 5 Deficit finance, expectations and real money balances: The operation of the inflation tax in Germany after the First World War
• Chapter 6 Does exchange rate pegging foster monetary credibility?: The European Monetary System and the 1980s disinflation
• Part III Consumer confidence and macroeconomic stabilisation in the 1990s
• Chapter 7 Consumer confidence in today’s macroeconomy: Definition, measurement and potential importance
• Chapter 8 Consumer confidence and the optimal timing of effective monetary stabilisation
• Chapter 9 Consumer confidence and domestic fiscal stabilisation
• Notes
• Bibliography