Monday, September 3, 2012

A hypothesis of Guam's stagnation and relative inflation

I have recently read an interesting paper that was written by renowned (to economists, at least) macroeconomist Michael Woodford called "Public Debt and the Price Level" (1998).  What I believe is interesting about the paper is that it discusses the effects of fiscal policy (taxes and government spending) on inflation, leaving aside accommodative monetary policy.  To me, this sounds like it has potential implications for small economies which lack their own monetary policy apparatus (like Guam, or just about any of the small U.S. states).

In the paper, Mr. Woodford discussed "Ricardian" and "non-Ricardian" budget policy.  Basically, the idea is that if a government is acting in a Ricardian fashion, the government will pay for deficits through higher taxation or lower spending in the future, so that the present discounted values of the debt and future contractionary policy are equal.  Under such a scenario, there should be no direct effect on inflation (upward or downward).  Under non-Ricardian policy, the government could have too much or too little expected future contractionary policy to offset current deficits.  Here is how he explains the mechanism:

The way that fiscal disturbances aff ect the price level is through a wealth e ffect upon private consumption demand. A tax cut not balanced by any expectation of future tax increases would make households perceive themselves to be able to aff ord more lifetime consumption, if neither prices nor interest rates were to change from what would have been their equilibrium values in the absence of the tax cut. This would lead them to demand more goods than they choose to supply (both immediately and in the future). The resulting imbalance between demand and supply of goods drives up the price of goods, until the resulting reduction in the real value of households' fi nancial assets causes them to curtail demand (or increase supply) to the point at which equilibrium is restored.

Much of this seems to align closely to what has actually occurred in Guam.  During the mid-nineties on, the government of Guam has faithfully delivered deficits year after year, both in the form of the "accumulated deficit" that is talked about by officials and the increased amount of bonds issued.  At the same time, Guam's CPI has, on average, tended to rise more quickly than the U.S. CPI and it doesn't seem to become undone (if we believe the official statistics).  I have considered this quite a puzzle, since I was under the impression that purchasing power parity is basically operative in open economies.

It seems that such an operative force needs to be counteracted by "fiscal consolidation" to use the phrase that is still in vogue, but such a move would tend to be contractionary, which creates a bit of a puzzle.  Here's a thought: maybe what the government of Guam needs for this is not the implementation of contractionary policies immediately, but the credibility that such policies will be forthcoming.  That might be a little irresponsible, but it's taken us this far, right (snicker, snicker)?  Maybe the bigger issue is that people won't believe the policy will actually happen.  Another idea might be to undertake fiscal consolidation alongside a new fully-funded program (unemployment insurance?) or just a balanced budget increase in government spending.  As Simon Wren-Lewis recently pointed out, the balanced budget multiplier is about 1 and is fairly robust, especially when there are "buy local" policies in place.

I'm not totally bought in on the hypothesis I just presented.  I think lack of demand, which are external to local policy, could be a serious issue, too.  I hope to go into this at some future point.

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