Fiscal Policy
Seignior Laffer, I presume?

Monetary, fiscal and financial policy and interdependent; this is one consequence of the familiar budget identities of the fiscal and monetary authorities and the associated solvency or present- value budget constraint of the public sector as a whole. In Discussion Paper No. 129, Research Fellow Willem Buiter discusses the implications of these constraints for fiscal and exchange rate policy in an open economy.

The budget identity of the public sector states that the excess of public sector outlays over revenues is financed by printing money, by running down foreign exchange reserves or by borrowing. Using the assumption that debt is eventually serviced through taxes or through seigniorage (the inflation tax), Buiter derives the public sector's solvency or present-value budget constraint, which stipulates that the present value of future taxes and money creation (seigniorage) should at least cover the government's outstanding liabilities plus the present value of its future spending.

Buiter first discusses the 'new conventional wisdom' concerning the fiscal roots of inflation. He argues that the velocity of circulation of money increases with the nominal interest rate and the expected rate of inflation. If this is so, then an increase in the government deficit (appropriately defined) may actually cause a fall in the long-run rate of inflation, even in the 'classical' rational expectations models of Sargent and Wallace. The response of velocity to the inflation rate also gives rise to what Buiter terms the 'seigniorage Laffer curve', in which the revenue from the inflation tax (seigniorage) first rises then falls with increases in the rate of inflation.

Buiter then analyses the implications of the public sector's solvency constraint in a managed exchange rate regime. He considers the case of a regime which is not viable, given spending and taxation plans: domestic credit expansion (DCE) exceeds the growth of money demand at the rate of inflation generated by the regime, so foreign exchange reserves are being lost continuously. The regime, it is assumed, will collapse when reserves fall below some given level; further borrowing to replenish the stock of reserves is ruled out, and the government is unwilling to change its spending and taxation plans.

The only way to ensure solvency in this case is to raise more revenue through seigniorage. This will oblige the government either to choose a different managed rate of exchange rate depreciation or to float the exchange rate and permit the economic system to pick a rate of inflation capable of generating the required seigniorage. The seigniorage Laffer curve again has surprising consequences: a high-inflation country may be forced to abandon a managed exchange rate, such as a crawling peg with a high rate of depreciation, and to adopt a free float with an appreciating exchange rate and a much lower rate of inflation!
Most analyses of exchange rate regimes assume that a foreign exchange crisis will be triggered if the stock of reserves falls below an exogenously determined lower limit. Economic theory, however, suggests only the public sector solvency constraint. This constraint does not imply a lower threshold for reserves, since a solvent government can borrow at home and abroad. Solvency limits only the ratio of net debt to GDP, but not the individual components of this debt, such as government bonds and reserves.

Such analysis, Buiter argues cannot rationalize a foreign exchange crisis (an attack on the currency) that is not at the same time a solvency crisis (a potential attack on the government's debt in general). Since the underlying problem is one of government solvency, the private sector's response will depend on its perception of which aspect of current policy will change. If the private sector expects a current and/or future spending cut or tax increase, the crisis is resolved without any need for a change in the exchange rate regime or a debt default.

An attack on the currency alone will only occur if the private sector believes that the government is willing to move to a freely floating exchange rate regime capable of generating enough inflation and revenue through seigniorage to restore solvency without changes in taxation and spending plans and without writing down the public debt. If the private sector is not convinced of this, there will be an attack on the government's debt as well as a foreign exchange crisis. But economic analysis of this process is still in its infancy, Buiter concludes.


Fiscal Prerequisities for a Viable Managed Exchange Rate Regime
Willem H Buiter

Discussion Paper No. 129, October 1986 (IM)