FTPL is not dead

Noah Smith (@noahpinion) recently wrote a blog on bloomberg about how our most cherished economic theories have been burried by the economic reality of Japan. One of the economic theories that have failed, according to Noah, is the Fiscal Theory of the Price Level (FTPL), because inflation rates have been low despite the high levels of government debt. But does FTPL really imply that higher government debt should lead to higher price levels?

In this series of blogs about FTPL, I will try to explain the ideas behind FTPL (as far as I understand them myself). In this first blog, I will react on the blog post of Noah Smith by asking the question whether FTPL dictates that higher government debt should lead to a higher price level.

To find out whether this is the case, I will first show the basic equation that is central to FTPL:

On the left hand side, Bt is the nominal value of government debt. The government is assumed to finance itself via short term liabilities as T-bills, and in this case Bt represents the nominal value of a maturing T-bill. The value of a such a bill can be considered equivalent to money, so in this case we might just as well say that we are dealing here with money. The right hand side shows us all the future real primary surpluses, Dt+j, discounted by the discount rate. This means that the value of the maturing T-bill is equal to the present discounted real primary surpluses that the government will run.

So how can the price level (Pt) go up, according to FTPL, if the government increases it’s nominal debt? First, one has to assume that the discounted future surpluses of, for instance, the Japanese government are relatively constant. If under this assumption Bt is increased, then Pt would have to go up in order for the equation to hold. In this case one could say that a higher amount of government debt, must lead to a higher price level according to FTPL.

The problem is that these expected surpluses will probably not stay unchanged. Investors will probably assume that an increase in the amount of Japanese government debt will lead to an increase in the real surpluses. I expect this, as it is unlikely that the Japanese government will default on her debt. In this case, the price level will stay unchanged.

Offcourse, the Japanese government does not have to default on her debt (or a part of it) to lower the discounted real surpluses. If inflation would pick up somewhere in the future, the BoJ could keep interest rates low, in order for the Japanese government to finance herself cheaply, which would lead to more inflation. If investors would expect this to happen, future inflation rates will go up, which will depress the real surpluses. For now, interest rates are already very low, because the discount rate is very low. The question is what happens if the discount rate would start to rise suddenly. Perhaps than expected future price levels will be a lot higher as investors might fear that the Japanese government would have to inflate away an uncontrollable amount of government debt. According to the equation, this would lead to a higher price level now. This is a kind of scary, as inflation could suddenly come out of nowhere.

According to me the price level can stay low in FTPL in the current situation, even when the government debt increases, but inflation might suddenly emerge when the discount rate would start to go up n the future.

In the next blog I will go some deeper into the relationships between the central bank’s policy rate, the surpluses and inflation.

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