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Sunday, September 27, 2020

Understanding The Non-Existence Of Financial Constraints

The idea that there is no financial constraint on a floating currency sovereign bothers some people. However, it makes sense when we realise that a constraint is a limitation that is always binding. For a floating currency sovereign, it appears to be well accepted that it is not bound all the times by financial concerns. This is unlike a household, that has to remain within its spending capacity (as determined by its resources and ability to borrow) at all times.

In mathematics, a constraint is a mathematical statement (loosely speaking, an equation) that is added to a model to help pin down a solution. That is, there can be an infinite number of potential solutions, but the addition of a constraint pins it down to a single solution. The grand-daddy of financial constraints -- the inter-temporal governmental budget constraint -- meets this technical definition.

Otherwise, we have non-mathematical definitions, e.g., the inflation constraint, as described by Modern Monetary Theory (MMT). Although constraint in this context is less clearly defined, I would argue that a key property is that it is always binding, and must hold.

The received wisdom among Canadian elites at present is that although it would be a mistake to tighten the Federal fiscal stance now, tightening should be done later (e.g., these comments). (This folk wisdom is probably showing up in other developed countries, but not as repetitively.) These elites might not refer to a "financial constraint" on the Federal government, but it is clear that they are not worried now about the alleged negative effects of issuance. That is, if a financial constraint did exist, it can be ignored in recessions, but it pops back into existence later. It is clear that this does not meet any reasonable definition of "constraint," it is a non-biding guideline of some sort.

This is unlike a household or a sovereign that borrows in a foreign currency, that always has to keep in mind the restrictions placed on it by creditors. (Yes, a floating currency sovereign has to meet existing debt obligations-- which might be viewed as a constraint -- but we are interested in the ability to add new debt.)

In summary, if we accept the premise that the government can wait for after a recession to worry about its finances, then we can say that it does not face a financial constraint. Given that the former appears to be a consensus view, the non-existence of financial constraints is not particularly radical.

Completely Obscure Technical Appendix on the Inflation Constraint

If one is unhappy with the mathematical status of the "inflation constraint," we can operationalise it mathematically as follows.

Property (name to be determined): An economic model has the (as-yet unnamed) property if at any time, a sufficiently large "loosening" shock to fiscal policy (G-T sufficiently negative) results in the price level (spot or forward) rising above some threshold relative to the model solution in the absence of the shock.

That is, loosen fiscal policy enough, prices go up.

All we need to is:
  1. Demonstrate that models we like have this property.
  2. Demonstrate that models that do not have this property display pathological behaviour.
This is a model property, and might not meet the usual mathematical definition of a constraint. (Although it is a constraint on the class of models considered.) However, it is a limitation on fiscal policy that holds at all times, so it meets my criticism about "non-binding guidelines." 

(c) Brian Romanchuk 2020


  1. Brian,
    I seldom disagree with you. floating currency? It is often said that Japan has a debt ratio roughly 230%. But Yen remains the world's strongest currency in the long long-run. This is of course another weakness of mainstream macro. Both MMTers and mainstreamers have yet to explain why.

    1. I'd imagine some MMTers have actually explained why, though I can't actually cite any off the top of my head. Anyway, the explanation is quite simple: it's that there is plenty of demand for Japanese debt, particularly from inside Japan (i.e. the demand comes from Japanese households, pension funds etc).

      I'd imagine the US is slightly different in that a bigger proportion of demand for US debt will come from OUTSIDE the US.

    2. Japan is a major exporter, and has an inflation rate of 0%. It should have a currency that appreciates against currencies with higher inflation.

      I assume you are relating this to the “inflation constraint.” It’s not saying that inflation is proportional to the fiscal deficit. It’s saying that a sufficiently large fiscal change will cause inflation. Japan’s policy obviously was below that threshold. It’s not a linear relationship that allows you to do a regression analysis.

  2. I explained this 3 years ago: Basically, money, even physical bills and coinage, is a virtual resource, ie it's a simulated thing, where something acts like a certain kind of object, based on how it's used, processed, or handled, and not intrinsic to the object itself.

    Strictly speaking, household spending is limited by the same thing that limits government spending-- this "simulated" object-like virtual behavior: But households are not authorized to print or counterfeit bills, without some type of legal inter-mediation, like a credit card company.

    The fed could just as easily buy all the consumer debts its wants, just as they can buy all the t-bonds they want. The only difference is, that fiat money and t-bonds are backed by the same entity, so there is no underlying difference, apart from what that entity dictates. Meanwhile, households can fail without the government failing, or vice versa. Most people don't realize that banks and others could keep operating with their own tokens, even if the government itself collapsed, provided they can emulate the necessary governmental functions such as resolving legal dispute, etc.

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