COMMENT: By Koichi Hamada
These old fiscal theories are like old wine in a new bottle, it often rewards those who are willing to taste it
In the fourth century, Japan’s emperor looked out from a small mountain near his palace and noticed that something was missing: smoke rising from people’s kitchens. While there were some faint trails here and there, it was clear that people were facing such harsh economic conditions that they could barely purchase any food to cook. Appalled at the circumstances of the Japanese people, who were largely peasants, the emperor decided to suspend taxation.
Three years later, the palace gates were in disrepair and the stars shone through leaks in the roof. But a glimpse from the same mountain revealed steady plumes of smoke rising from the peasants’ huts. The tax moratorium had worked. The people were so grateful to the emperor – who became known as Nintoku (Emperor with Virtue and Benevolence) – that they volunteered to repair his palace.
Almost two millennia later, the Japanese people are, again, under economic pressure. A steep hike in the consumption tax in 2014, together with another hike expected in the near future, has undermined household spending. As in the Nintoku story, it is the wealth of the people – not that of the government – that dictates consumption.
Of course, the wealth of the government does play a role in economic performance. But excessive concern about government’s solvency can cause the private sector to be reluctant to spend. That is what has happened in Japan.
Excessive government debt can be highly damaging. In inflationary periods, high outstanding government liabilities impair fiscal policy, because higher taxes are needed to finance the same level of real government spending. Making matters worse, governments can be tempted to inflate their debts away – a power that has been abused since the age of monarchs, resulting in a uniform inflation tax on asset holders.
But large public debts are not always bad for an economy, just as efforts to rein them in are not always beneficial. The focus on a balanced budget in the United States, for example, has led some elements of the Republican Party to block normal functions of state and even federal authorities, supposedly in the name of fiscal discipline. Likewise, the eurozone’s recovery from the 2008 financial crisis has been held back by strict fiscal rules that limit member countries’ fiscal deficits to 3% of GDP.
To understand the relationship between public debt and economic performance, we should look to the fiscal theory of the price level (FTPL), a macroeconomic doctrine that has lately been receiving considerable attention. In August, at the annual conference of central bankers in Jackson Hole, Wyoming, Princeton’s Christopher Sims provided a lucid explanation of the theory.