In their essay, "Inflation Is Not Always and Everywhere a Monetary Phenomenon" (Economic Letter, Federal Reserve Bank of Dallas, June 2014), Antonella Tutino and Carlos E. J. M. Zarazaga question Milton Friedman's famous dictum that "inflation is always and everywhere a monetary phenomenon" (Friedman 1970: 11). In doing so, they rely on the strong version of the fiscal theory of the price level (FTPL) as proposed by Christopher Sims (1994), which holds that "fiscal policy affects the price level and the path of inflation independent of monetary policy" (Carlstrom and Fuerst 2000: 23; emphasis added).
Tutino and Zarazaga (2014: 3) note that, given the strong assumptions of some FTPL models, hyperinflation can emerge when it is expected "even if the money supply is kept constant." That expectation results in an explosive rise in the velocity of money without any change in the money supply (see McCallum and Nelson 2005). The strong version of FTPL contradicts Phillip Cagan's monetary theory of hyperinflation, which holds that "variations in real cash balances mainly depend on variations in the' expected rate of change in prices"--which, in turn, depends on "a dynamic process in which current price movements reflect past and current changes in the quantity of money" (Cagan 1956: 27).
Current price movements also reflect expected future changes in the quantity of money (rational expectations). If individuals, from past experience or knowledge of past inflations, think monetary authorities will print money in the future to pay for government deficits, and lower the real value of public debt, they will increase their rate of spending today--before the inflation tax decreases the real value of their cash balances. Doing so will increase monetary velocity and cause inflation to exceed the current rate of growth of the money supply. This scenario is fully consistent with the quantity theory of money, even though Tutino and Zarazaga (p. 1) claim that the German hyperinflation of 1921-23, in which the rise in the general level of prices outpaced money growth, suggests that "something is wrong" with Friedman's dictum.
In this article, I examine the strong version of FTPL and contrast it with the weak version, which holds that fiscal policy drives monetary policy, which is assumed to be passive. The fiscal authority's deficit spending, however, cannot by itself cause a sustained rise in the price level unless accompanied by expansionary monetary policy--that is, monetization of the debt.
The key point that Tutino and Zarazaga (hereafter, TZ) make is that "hyperinflation is fiscal in nature because it can only happen if the fiscal authority--the central government--remains on the sidelines" (p. 3). They turn to the German hyperinflation in the 1920s for support of their argument, holding that the government ended runaway inflation by implementing "an active fiscal policy." In particular, TZ argue that it was the backing of the rentenmark by real estate revenues that ended the hyperinflation. The crux of their argument is that it was "the government's ability to raise revenues from the real estate market ... [that] successfully broke the link between mutually reinforcing lower fiscal revenues--implying higher fiscal deficits--and rising price levels" (pp. 3-4). I examine this argument by taking a close look at the German hyperinflation and stabilization. Evidence does not support the strong version of FTPL: fiscal policy cannot explain either the hyperinflation or the stabilization of the German currency. Passive fiscal policy did not usher in the hyperinflation, and activist fiscal policy did not end it. The article concludes by noting the importance of a proper understanding of monetary history in evaluating macroeconomic models such as FTPL.
Fiscal Theory of the Price Level
As noted, there are two versions of the fiscal theory of the price level: the weak version and the strong version. (1) The weak version holds that if the fiscal authority dominates the policy space, then fiscal deficits could be monetized by the central bank. This version is consistent with the quantity theory of money because inflation is ultimately determined by excess growth in the money supply. The second version of FTPL, the so-called strong version, holds that even if the money supply is held constant, inflation can occur if the fiscal authority is passive. All that is needed is for the public to expect prices to rise. People will then spend their given money balances at a faster rate--increasing the velocity of money--and prices will rise until expectations change.
Tutino and Zarazaga (2014: 3) note that the strong models of the FTPL can "give rise to hyperinflation quite easily, even if [the] money supply is kept constant," because "nothing in the internal logic of these models anchors the evolution of inflation." Rather, "the dynamics of inflation are entirely determined by household expectations." Thus, "if households anticipate ever-rising inflation, they will try to get rid of their money balances and exchange them for goods. The resulting increase in demand for goods accelerates inflation even further." The authors conclude: "This hyperinflationary process cannot be categorized as 'monetary' in the usual sense, because that would have required an equally explosive expansion of [the] money supply, which was kept constant."
This analysis ignores the reality that if the quantity of money is constant and people spend more of it on some goods, there will be less of it to spend on other goods, so the overall price level can't spiral upward. However, it is possible that if households expect the fiscal authority to cooperate with the monetary authority, and thus expect future...