First published: December 2015
In a 1999 paper, Buiter argues that the fiscal theory of the price level is a fallacy.
Two years ago (so in 2013), before joining the resisting village governed by the wise Chris Sims, I would have naively agreed with the assertion of the title without even feeling the need to endure the pain of reading his paper. The Fiscal Theory of the Price Level looked so much unrealistic to me, so far-fetched, that there must have been a fallacy somewhere into the foundations of the intellectual construction. No need to check it.
Surprisingly enough, I find now myself in the position of defending it, not because I have come to the idea that the theory captures some interesting dimension of reality – I hope Chris Sims wouldn’t disagree with me on this point, for I fear his wrath – but because I think it is misunderstood by many people.
The criticisms of Buiter are of 4 types but only the first one is really serious.
1) The first criticism is about the key underlying economic assumption: “only those models of a market economy are well-posed, in which, if default is ruled out, budget constraints (including the government budget constraint), must be satisfied for all admissible values of the economy-wide endogenous variables [and not only in equilibrium].”
As we explained in a previous post, models of Fiscal Theory assume that the government doesn’t adjust its taxes and spending to meet its budget constraint and can’t default on its debt so that the prices have to move to make the real value of the debt equal to the expected discounted stream of future revenues.
I agree with Buiter that this assumption doesn’t make sense from an economic point of view. If only this was the first time economists make unreasonable assumptions…
2) Because the level of prices should remain positive, there are some restrictions on the admissible set of debt and sequence of revenue and spending.
Well, this is true. For example, if tomorrow, the debt of the French State becomes negative – i.e. if the government becomes a net creditor – , the price level should become negative to maintain its intertemporal budget constraint. It is not a serious criticisms, because for most realistic parametrizations, the price level would remain positive.
3) The theory of the price level can determine the price of money in a model without money.
This is not exactly true. Without money, the price level remains the relative price between the nominal unit of account/numeraire and real goods and the numeraire becomes the public bond.
4) Buiter then gives many instances where a non-Ricardian fiscal rule gives rise to overdeterminacy of the price level: in finite-horizon with a monetary rule for the government, in finite-horizon with a taylor rule and price rigidities, in infinite horizon….. This over-determinacy is easy to understand: when one adds additional restrictions on the dynamic system, the price level is determined both by the intertemporal solvency condition and the other parts of the model.
Well, this is obviously true, but I really don’t see how this criticism – which can be made to any model – weaken the intellectual construction of the fiscal theory of the price level.
To conclude, only the first criticism is really serious: the key assumption that the government doesn’t adjust its taxes and spending to meet its budget constraint and can’t default on its debt so that the prices have to move, an assumption on “fiscal benign neglect”, is not realistic at all. But again, remember, if one makes the government Ricardian, then the price level becomes undetermined unless the monetary authority becomes active…
Buiter’s paper can be found here: http://www.nber.org/papers/w7302