First published: October 2015.
The fiscal theory is one of these theories that would leave my mother speechless. No way I can make it convincing. No way she will understand it. I can’t blame her, nobody understands it. Nobody? A little village is resisting, this village is governed by an old wise man, Chris Sims. The fiscal theory of the price level is a revolutionary theory, really.
There is the key to the mystery: while most of the economic tradition has attributed the determination of the price level to monetary policy, the fiscal theory tells you that when taxes and expenditures don’t respond to keep the government solvent, the price level is determined by the government’s ability to repay its debt. As a result, if the government is expected not to be able to meet its obligations, inflation will have to erode away part of the nominal value of the debt. In a nutshell, the price level adjusts so that the government remain solvent, or in other words, so that it meet its intertemporal budget constraint. Why does it “have to”? And what is the economic mechanism behind it?
Why does it ‘have to’? In Sims’ world, the government fully repays its debt, so that if it were to become insolvent, something in the economy would have to adjust to bring public debt back onto a sustainable path. This something could be taxes or expenditures, but by assumption they don’t react strongly enough. So prices and inflation have to adjust. That’s as simple as that.
What is the economic mechanism? The key ingredient consists in assuming that people deeply believe the government will always remain solvent and will repay its debt – in other words it cannot default on its debt. We also assume the public knows more or less the amount of taxes that will be collected and the amount of expenditures in the future. Therefore the public knows how much it will be taxed and by how much the total amount of tax exceed the amount of debt. Imagine now a situation in which the government is accumulating too large a stock of debt to be repaid and that it is not going to increase taxes. Because the public believes debt will be repaid, and because it knows the future amount of tax, it will consider the part of the debt that cannot be repaid as net wealth, will feel richer and crucially will consume more. In a world of flexible prices, the latter will raise prices, thereby inflating away the debt.
Notice the schizophrenic thinking of consumers. They know the government is about to be insolvent because they know the future path of taxes as well as the current level of debt. Yet, they still buy the debt, believe it will be repaid, feel richer because of the gap between current assets and future liabilities and therefore consume more. And we dare call these people rational…
This is often the difficulty with macroeconomic models: equilibrium paths are exactly the sequence of states that makes compatible all the relationships that constitute the system. As for our example, the price increase is the only outcome that makes compatible the fact that the intertemporal budget constraint of the government holds and is believed to hold, that the government is insolvent and that it is not expecting to raise taxes in the future and that people anticipate future liabilities (taxes) rationally and compare it their current asset when choosing upon consumption. If prices didn’t increase, then one of these relationships would have to break down: for example the government could be forced to default or the consumer don’t believe anymore that the government budget constraint has to hold.