Fiscal Policy and the Inflation Constraint

Modern Monetary Theory (MMT) makes clear that, for currency-issuing governments, the macroeconomic constraint on fiscal policy is resource availability, not revenue. This is sometimes summarized as “the constraint on fiscal policy is inflation” in recognition of the link between resource availability and the macro impacts of spending. So long as there are available workers, materials, plant and equipment, it is possible to produce more. Under these circumstances, extra spending on goods and services can initiate or encourage production without necessarily affecting prices. Although this point is elementary, recent public debate suggests that it is not obvious to everyone. Some appear to believe that inflation will result whenever there is: (i) money creation; (ii) spending; or (iii) fiscal deficits. These concerns are addressed in turn.

Money creation and inflation

Policymakers no longer pay much attention to monetary aggregates when considering inflation, and with good reason. Monetarist attempts to control such aggregates (for a short period from the late 1970s to early 1980s) failed badly and were quickly jettisoned. But monetarist-type thinking still appears to have a hold over many people. With this in mind, it is perhaps worth considering money creation as it pertains to inflation.

In doing so, it is important to be clear on what is meant by the terms “money” and “inflation” in the present discussion.

The term “money” is used in different ways in different contexts. In the present context, “money” is taken to mean currency plus deposits. This appears to be the concept people usually have in mind when fearful that money creation must necessarily result in inflation. Money, in this sense, is created every time government spends or a commercial bank lends. Equally, money is destroyed every time someone makes a payment to government or pays down a private bank loan.

“Inflation” refers to a persistent rise in the general level of prices for goods and services. It is a continuous rise in prices, on average. It is not, say, a rise in the price of coffee relative to the price of tea. Nor is it a rise in asset prices. The latter can be a serious problem, especially when driven by speculative behavior that creates bubbles and an unsustainable build up in private debt, but is a separate topic. Eliminating harmful speculation, to the extent that this is possible under capitalism, would require some combination of public banking, narrower limits on banking activities, improved incentives, stricter regulation, enhanced oversight and firmer deterrence of bad behavior. The present focus, however, is on inflation as conventionally defined, which concerns general movements in the prices of goods and services.

For money creation to be implicated in inflation, several conditions would have to be met.

First, there would need to be an actual increase in the quantity of money. Unless the rate of money creation exceeded the rate of money destruction, there would be no net increase in the amount of money in existence.

Second, the money would have to be created for the purpose of spending on goods and services. Money created for other purposes has no direct impact on the level of demand for output. (As already noted, it might have other bad effects, such as asset speculation, which will require specific measures to address them.)

Finally, supposing there has been net money creation, with the money created to spend, the impact on prices will depend on the state of the economy. In particular, the impact will depend on whether the extra spending can be met with a quantity response rather than price adjustments.

Even in cases where money creation does happen to enable spending in excess of the economy’s capacity to produce, it will not really be the creation of money, as such, that is the source of the problem. The source of the inflationary pressure will be the excess demand. Money creation will accommodate or enable the process, but not drive it.

The same can be said in the case of price pressures originating on the supply side, acting through costs of production. Money creation can enable cost-push inflation, but the real source of the problem will be the cost pressures themselves.

Demand, quantities and prices

Most prices for goods and services do not just – or even mostly – reflect the level of spending (or demand). Especially in the manufacturing and services sectors, prices are largely cost-based. So long as businesses in these sectors are operating with spare capacity, wage and material costs per unit of output are more likely to remain constant (or even fall), rather than rise, as output is increased. Roughly speaking, it is more realistic to assume constant, not rising, average variable costs as the typical situation. This implies that many firms will face falling unit costs, because fixed costs are spread over more output when production expands.

A firm’s price will typically be set as a mark up over the unit cost (or, alternatively, average variable cost) that applies when capacity is utilized at its normal (or expected average) rate. Under competitive conditions, stronger demand – whether public or private – will tend to be met with an expansion of supply whenever the availability of workers, materials, plant and equipment makes this feasible.

If, as a result of additional demand, a business is confronted with more customers than before, it will make extra sales. This will cause its stocks to deplete. In response, it is likely to place more orders with its suppliers. If its suppliers have the capacity to meet the orders, they are likely to do so. The business will sell more output. Inside capacity and resource limits, there is little reason to expect much impact, if any, on prices.

A burger joint/hair salon/newsagent/convenience store/car manufacturer/hotel will face demand for burgers/haircuts/newspapers/soda/cars/accommodation that fluctuates somewhat unpredictably over time. It would make little sense to alter price with every variation in the number of customers walking through the door. Instead, the business will vary the quantity it sells of burgers/haircuts/newspapers/soda/cars/accommodation at given prices to cater to demand. These given prices will largely reflect cost.

The tendency for prices primarily to reflect cost applies even more strongly over longer time frames than shorter ones, because additional time gives producers a chance to respond to trends in demand by investing in new capacity.

It is true that, at a certain point, stronger demand can temporarily translate into higher prices for particular goods and services, but this is most likely to occur when a business or one of its suppliers is already operating at full stretch.

At the macro level, price effects of rising demand will only begin to dominate quantity effects once the economy as a whole nears full employment and full capacity.

Full employment, in the sense relevant here, means more than just official full employment, which can occur while some workers who are willing to work longer hours are only employed part time. One reason inflation pressures have been slow to emerge in recent decades, despite official rates of unemployment at times being fairly low, is that the proportion of part-time workers has increased significantly. Many of these workers would choose to work longer hours if the extra employment were on offer. This means that there is usually more slack in the economy than the official unemployment rate suggests, and so more scope for firms to expand production in response to stronger demand.

Clearly it is the level and composition of demand in relation to supply-side factors that matters so far as the inflation threat is concerned.

Demand effects are unlikely to be problematic so long as there is: (a) spare capacity; and (b) an absence of bottlenecks.

Spare capacity. Most firms intentionally operate with margins of spare capacity. For the US economy as a whole, the rate of capacity utilization has ranged from about 67 to 89 percent since records began to be kept in 1967. Utilization rates have averaged around 80 percent. Average utilization rates of 80-85 percent also appear to be typical in other developed economies.

This is not by accident. Firms have reason to maintain larger capacities than they use on average. Planned spare capacity allows them flexibility to respond to unexpected peaks in demand rather than risk losing market share to competitors. For the same reason, if utilization rates rise persistently above normal, firms have an incentive to expand their operations through investment in an attempt to restore more normal utilization rates.

The maintenance of spare capacity ensures that rising demand can usually be met with quantity adjustments rather than higher prices.

When capacity limits are tested, there may be some inflation, but the tendency of firms to invest in additional capacity can address the situation, given time.

Bottlenecks. There can be shortages of certain types of labor-power or natural resources that are needed as inputs into the production of other goods. These bottlenecks can result in price pressures even while the economy is below full employment and full capacity.

Bottlenecks are best handled by specifically addressing the supply-side issue. Ideally, the possibility of bottlenecks will be anticipated ahead of time, and measures taken to address them before they become problematic. Shortages of particular kinds of workers can be tackled through education and training. Deskilling of roles is another strategy typically employed by capitalist firms. Shortages of raw materials can be countered through investment or, in the case of non-reproducibles, through the development of alternatives.

In cases where bottlenecks do occur, it can take time to address them directly. In the meantime, fiscal tightening may be required. Direct controls or restrictions may also be appropriate to prioritize access to necessities. These temporary measures would allow time for the supply-side problem to be resolved at its source.

Implications for fiscal policy

The implications for fiscal policy are clear. The level and composition of public spending and taxation should be in sensible relation to the level and composition of demand and the economy’s capacity to adjust output in a timely manner at given prices.

Significantly, a lot of the macro-level management of demand occurs without any need for an active change in policy. This is due to the functioning of automatic stabilizers. Once government has set policy, it is mostly the private sector that determines the size of the government’s fiscal balance.

Consider a government that spends an amount G over the course of a year. For given tax rates, the amount T that gets taxed back over the year will depend on the spending behavior of households, businesses and non-residents. Stronger private and foreign spending will translate into higher income and tax payments, automatically narrowing the government deficit. Weaker private spending will result in lower income and tax payments, automatically widening the deficit.

So, by design, the automatic stabilizers cause the deficit to narrow when the risk of demand-side inflation is pronounced, and widen when the risk is largely absent.

Implementation of a job guarantee along the lines proposed by Modern Monetary Theorists would strengthen automatic stabilization by introducing a significant endogenous element to government spending. Booms would see spending on the program promptly withdrawn as some workers transitioned to employment in the broader economy.

Despite all efforts to anticipate and handle issues before they arise, occasionally it will still be necessary to make discretionary changes to policy. A very weak economy will require injections of spending. A booming economy might call for cuts to discretionary public spending, higher tax rates or new taxes in combination with other measures such as temporary controls on the pricing or usage of key resources.

To some extent, it is possible to build flexibility into discretionary programs. For example, public sector projects can be structured into stages in which work is decelerated during booms, when extra labor-power is required elsewhere in the economy, and accelerated when the economy is relatively weak.

Through a combination of automatic stabilization and discretionary measures, the government’s fiscal balance will vary countercyclically, moderating inflationary and deflationary forces.

To a currency-issuing government it is of no particular consequence, in itself, what the fiscal balance turns out to be so long as the situation remains consistent with strong employment outcomes and low, stable inflation.

UPDATE – March 2, 2019

Over the past twenty-four hours, Modern Monetary Theorists have explicitly addressed the topic of fiscal policy and inflation in high-profile venues.

This article by Scott Fullwiler, Rohan Grey and Nathan Tankus emphasizes institutional design, automatic stabilization, anticipation of bottlenecks and more.

FT Alphaville – An MMT Response to What Causes Inflation

This short segment with Stephanie Kelton explains the MMT view of the fiscal balance with particular emphasis on the job guarantee as automatic stabilizer.

CNBC – Modern monetary theory takes on Wall Street and Washington

In commenting on these two contributions, Pavlina Tcherneva tweets:

MMT talks about inflation as a function of the prices paid by the government. As a currency monopolist, it is also a price setter, whether it effectively employs this power or not. This is implied in the previous 2 links even if not explicitly stated in these terms.

For an academic treatment of this point, see:

Tcherneva, P. R., ‘Monopoly Money: The State as a Price Setter’, Oeconomicus, Vol. 5, 2002, pp. 124-143. (pdf file)