Budget constraints

For Auerback & Co the government budget constraint does not exist since governments can just print money to finance their spending

Many people are perhaps not good at obeying them but most are painfully aware of the budget constraints they face i.e. that spending may exceed income now via borrowing but then has to be reversed at some future date.

It is thus frustrating that some tend to neglect that governments also face budget constraints and some even dismiss them altogether. In the first camp you find the ones who ask for fiscal stimulus but with a budget deficit close to 10% of GDP i.e. government spending far exceeding government income (tax revenue) it is more than hard to see where the extra government borrowing should come from to finance this extra spending – just witness Greece’s problems raising extra borrowing or rolling other existing debt. In the second camp you find people like Marshall Auerback who occasionally rants against the IMF-EU package for Latvia since, among its many features, it makes Latvia live up to a budget constraint. For Auerback & Co the government budget constraint does not exist since governments can just print money to finance their spending: Apply a floating exchange rate and print money as part of fiscal policy; his paper cannot be read differently since he argues that eurozone governments have to “finance” every euro they spend (meaning have to borrow or raise via taxes) whereas “These funding constraints do not apply to the US government, which is sovereign in the US dollar and can never be revenue constrained”. In the Auerback world “financing” spending is not necessary – just print money (done by the government borrowing from the central bank which has the monopoly over the printing press). In the case of Latvia this would require abolishing Article 36 of the Law on the Bank of Latvia plus skipping the current independence of the central bank but that is a mere detail in the Auerback world I presume.

But why not apply this magic potion instead of “economic insanity” and “infernal devaluation” to quote Auerback? Government spending, whatever way it is financed, has to be paid by someone. Currently it is financed by taxes and borrowing, the latter implying future taxes. But who really pays when the government pays the salaries of the public servants with freshly printed cash? Well, once again the tax payers or, to be specific, those who have lats. As the amount of lats in circulation will increase dramatically with severe money financing of budget deficits a situation of “too much money chasing too few goods” will appear which will raise prices of goods and thus reduce the purchasing power of the money we hold and this concept is well-known in economic literature as inflation tax. Dramatic examples of this kind have appeared through history; most well-known is Germany’s hyperinflation in the 1920s and today’s extreme example is Zimbabwe where inflation runs in the billions of percent as ever larger amounts of paper money enters the economy. I am looking forward to seeing the 100 trillion Zimbabwe dollar note that my friend AE has. It does not, however, have to be this dramatic at all – I would argue that countries like Italy and Greece relied on the inflation tax on a much smaller scale in the 1970s and 1980s – excessive money creation helps erode the real value of government debt and thus makes it easier to repay. Excessive money creation is eventually followed by higher inflation and thus requires currency depreciation to maintain competitiveness which is why, if you remember, that also the Italian lira and the Greek drachma came in nominally big denominations. It is also why these countries find it hard to handle their government debt these days – in the eurozone they cannot print money and thus cannot inflate away the debt-to-GDP ratio.

Were Italy and Greece hurt by this mild inflation tax? Possibly not that much but with high inflation comes high interest rates and they certainly had much higher nominal interest rates prior to eurozone membership but not necessarily (much) higher real interest rates and then the discussion boils down the benefits versus costs of maintaining low inflation and low interest rates.

But I think there might be an additional element present here. Should an Auerback-type policy be advocated the proper response from you and I would of course be to move as much cash out of lats and into euro as possible and this is much easier to do these days than for Italians and Greeks some 30-40 years ago. The result would of course be immediate depreciation but also a low tax base (more technical…) for the inflation tax which would require inflation to be higher to erode enough purchasing power.

Auerback says (see the “Join the Discussion” part) that he’ll be in Riga at the end of this month, together with like-minded colleagues to advice the opposition (read Harmony Center).

Should their advice be adopted by some future government then I wonder what picture will be on the future 100 trillion lat note??? No (sort of) just joking but adherence to the Maastricht criteria must be expected to be dropped, eurozone membership will no longer be a goal and the 500 lat note may certainly see its real value reduced to a more human level. But who will care when we all hold euro anyway? Or will we even stay around to witness what will happen?

PS I wonder if Auerback & Co are also in broader agreement with the people they advice? For instance, do they agree with Jevgenija Zaiceva, (password may be needed), finance minister-to-be (?), that a) Karl Marx is the most relevant economist to read right now and b) that the “elections” in 1940 that made the USSR gobble up Latvia were free and fair???