There has never occurred a hyperinflation in history which was not caused by a huge budget deficit of the state. Deficits amounting to 40 per cent or more of expenditures cannot be maintained. The examples of both Germany and Bolivia suggest that at least deficits of about 30 per cent or more of gross domestic product are not maintainable since they imply hyperinflation. In all cases of hyperinflation deficits amounting to more than 20 per cent of public expenditures are present—Peter Bernholz, Monetary Regimes and Inflation
In this issue
Supply Side Inflation? A Philippine Congressional Think Tank Warns of "Runaway Inflation" from Excessive Public Spending!
I. Wow! Congressional Think Tank Warned of Runaway Inflation from Excessive Public Spending!
II. How Public Spending Causes Inflation
III. The Collateral Function of Public Debt
IV. From Automatic Stabilizers to Fiscal Dominance
V. Risks of Excessive Deficit Spending: Debt Crisis and Hyperinflation
VI. Rising USD Share of Philippine Public Debt: "Rising USD Shorts"
Supply Side Inflation? A Philippine Congressional Think Tank Warns of "Runaway Inflation" from Excessive Public Spending!
A Congressional think tank has recently warned about "runaway inflation" from excessive public spending. Fiscal policy management from countercyclical to procyclical. The rising USD "shorts."
I. Wow! Congressional Think Tank Warned of "Runaway Inflation" from Excessive Public Spending!
Businessworld, September 28: A HOUSE of Representatives think tank has warned of runaway inflation if the government of President Ferdinand R. Marcos, Jr. fails to rein in spending. “Given the present level of inflation and the inflationary pressure accumulated in the past three years, the risks associated with maintaining a high public spending strategy are not insignificant and, perhaps more importantly, growing over time,” the Congressional Policy and Budget Research Department (CPBRD) said in a report this month. (bold added)
Has the mainstream begun to admit to the inflationary repercussions of credit-financed deficit spending?
Is the mainstream's narrative of supply-side "transitory" inflation falling apart?
Are authorities also acknowledging the effects of diminishing returns on their fiscal tools? Or are they running out of fiscal space?
More…
“The government constantly runs the risk of exacerbating inflationary pressures and, by extension, heightening the severity of economic contractions,” the CPBRD said. (bold added)
Are they also admitting to the boom-bust cycles it creates?
Only a few people openly acknowledge the inflationary impact of public/deficit spending, even when most economists know this.
Since the mainstream embraces public/deficit spending as sacrosanct, political correctness demands conformity to this belief, hence its suppression.
II. How Public Spending Causes Inflation
Figure 1
Due to higher prices (from liquidity expansion), the rising trend of public revenues has mainly contributed to the present decline of the fiscal deficit (as of August). (Figure 1, topmost graph)
This slowdown is about change once the economy fumbles.
Even with revenues up, eight-month Treasury liquidity has been dropping. As such, Treasury borrowings have picked up. (Figure 1, middle chart)
Deficit spending is not inflationary when funded solely by taxes. However, since the capacity to tax is constrained, this implies innate spending limits. But that won't fit well with a populist government.
Budget gaps are inflationary when funded by credit and money creation from the central bank (BSP) and the banks.
Credit expansion unbacked by savings increases demand relative to supply.
The long-term trend of public spending has resonated with the CPI. (Figure 1, lowest diagram)
Let us use the rice industry as an example.
The BSP can print money, while banks can issue credit, but both can't print rice. Many other factors determine rice production than cheap money, such as protectionism, controlled markets, weather, productivity, farming lands, irrigation, fertilizers, returns, farmer’s income, etc.
Meanwhile, increases in public spending benefit public agencies and private sector entities directly and indirectly involved with the bureaucracy and their political projects (e.g., PPPs) by expanding their demand.
Or demand (for rice) from the public sector increases faster than the supply of rice.
The consequential imbalances lead to tight supply and higher prices, which the government responds with price controls and even more deficit spending via subsidies.
Because bailouts are integral to public spending, the recent path-dependent policy response is a byproduct or a legacy of the BSP's easy money policies.
Or authorities throw money at social problems because they think financial repression (inflation tax) would accommodate it.
Recently, the government has splurged on bailouts. It has authorized billions in subsidies for farmers and sari-sari store owners affected by the rice price caps. It also has provided grants to the transport sector affected by higher energy prices (Php 4 billion fuel subsidies).
Therefore, the government's mechanical demand-based solution exacerbates supply imbalances.
Besides, public spending, representing transfers, consumes people's savings.
So, this vicious cycle progresses.
III. The Collateral Function of Public Debt
Public spending is not the only reason for the issuance of public debt.
Figure 2
Public debt has a collateral function, which banks use to obtain financing from the BSP.
In essence, the BSP uses government securities (including its own BSP Securities Bill) as part of its monetary operations to provide liquidity to or withdraw liquidity from the financial system.
Since its introduction, BSP Bills Payable in the BSP’s balance sheet have exploded and grabbed a substantial share of the volume of the fixed-income security markets traded at the PDS. (Figure 2)
Figure 3
Applied to the present, banks have recently taken over in providing liquidity to the government and financial system.
The banking system's Net claims on Central Government (NCoCG) are close to their historic high even while the BSP's NCoCG has slowed (as of August). (Figure 3, topmost window)
And so, while the BSP is supposedly "tightening" by raising rates, banks continue to amass public debt, providing liquidity to the government and financial system. The chart reveals the incredible record monetization of government debt by banks. (Figure 3, middle graph)
In the meantime, Treasury securities are used as collateral by banks when borrowing or obtaining finance from the BSP.
Further, as the government issues even more debt, this requires more currency issuance to accommodate it. M3 has supported public spending growth through the years. (Figure 3, lowest chart)
The government benefits from "seignorage," paying bondholders with depreciated currency (Financial repression/inflation tax).
Hence, because the easy money regime functions as a free lunch, government indulges in a spending orgy, which benefits banks too.
IV. From Automatic Stabilizers to Fiscal Dominance
Figure 4
In the past, contemporary governments used the Keynesian framework of countercyclical policy of deficit spending as an "automatic stabilizer" tool. Authorities embark on public works when aggregate demand slows, evidenced by high unemployment or slowing or contracting growth. But when growth resumes and accelerates, they raise taxes to control inflation and moderate growth.
But things change.
In the recent past, with the idea that rising inflation is a "transitory" phenomenon, governments have become addicted to it. Governments have leaned on pro-cyclical policies.
Deficit spending became a primary policy of GDP management irrespective of conditions.
This dynamic applies here too.
As it is, the government previously depended on the BSP's monetary policies of low rates to provide nominal spending growth and, therefore, tax revenue growth. At the same time, the BSP uses the same money tools to manage inflation.
The embedded assumption is that the economy is like a car, which can be accelerated or decelerated by its driver (the government & the BSP).
This dynamic is especially relevant today as the stabilizing function of the government budget has transformed into "fiscal dominance." The US deficit is an example. (Figure 4)
The "ratchet phenomenon" syndrome has also afflicted governments. Authorities have used recent crises to justify further expansion of control and power through the fiscal channel.
The popularity of the expanded powers of government has increased during the crisis. It seems to have been supported by a psychological and ideological shift. Increased feelings of vulnerability made people seek comfort in expanded political control.
More importantly, the underlying behavioral structure could not revert to the status quo ante because the events of the crisis created new understandings of and convictions about the potentialities, workings, dangers, and desirabilities of governmental action; that is, each crisis altered the prevailing ideological climate. Though the postcrisis economy and society might, at least for a while, appear to have returned to precrisis conditions, this appearance disguised the underlying reality. In the minds and hearts of the people who had passed through the crisis and experienced the expanded governmental powers—that is, at the ultimate source of behavioral response to future exigencies—the underlying structure had indeed changed. (Robert Higgs, 1985) [bold added]
Stockholm’s Syndrome?
In this context, governments increasingly have used deficit spending to centralize the economy, which means that the executive branch has taken control of policies from the central banks—as the latter has been tightening.
And with the likelihood of a deepening economic downturn, which magnifies the risks of a crisis, the deficits should reaccelerate from their recent deceleration. Deficits would soar from a revenue slump and a further spike in government spending (bailouts, fiscal transfers, "stimulus" via public works, etc.).
This dynamic should apply to the Philippine political-economic setting as well.
V. Risks of Excessive Deficit Spending: Debt Crisis and Hyperinflation
One risk of excessive government spending is that creditors lose faith in the ability of governments to redeem their liabilities. A "sudden stop," where creditors pull back, usually results in a debt crisis.
Another risk is that when access to credit has vanished, governments increasingly depend on their central bank's printing press, leading to hyperinflation.
Some governments might be crazy enough to use this to extinguish their debt.
When assessing the debt burden, the rate of price inflation constitutes an important factor. Price inflation devalues outstanding debt. This happens in a creeping way when inflation rates are low and in a dramatic way when inflation rates are high. In the case of hyperinflation when ordinary goods of daily consumption fetch prices in the billions or trillions even a gargantuan public debt would evaporate. However, a deliberate fabrication of hyperinflation in order to get rid of the debt burden can hardly count as a rational strategy. Such a policy would come at the price of wreaking havoc with the economy as a whole. (Mueller, 2012)
"Runaway inflation" is a path to or another word for hyperinflation.
Except for the think tank above, the mainstream crowd usually ignores such risks.
They have come to believe that public spending can only result in positive outcomes while the impact of debt is neutral.
Again, such mindsets signify inflationary psychology borne of the programming from decades of the easy money regime.
But that’s about to change too.
VI. Rising USD Share of Philippine Public Debt: "Rising USD Shorts"
Figure 5
For instance, the outgrowth of foreign debt has increased its share of the total Philippine debt stock since Q1 2021 (as of August 2023). (Figure 5, upper chart)
While the frail peso may partially be responsible for its increase, a build-up of foreign-denominated debt has resulted in most increases. Media reported that the Philippine government "secured $32.40 billion worth of loans and grants in 2022."
The increase in foreign debt to fulfill near-term economic or financial requirements (say, support the peso or finance trade deficit or for BSP’s GIR management) translates to a "short USD position."
"Short" implies funding mismatches.
Such imbalance occurs when organic financing is inadequate to meet the maturing liabilities. In this case, increased borrowing is used to refinance existing liabilities. In short, shades of Ponzi finance, debt piles up on the mountain of existing debt, along with the mismatches.
Once you create those “dollar” assets, you are on the hook for funding them, in “dollars”, until they are disposed of – voluntarily or not. (Jeffrey Snider, 2018)
Should the peso continue to weaken, the economy would have to export more to meet its FX obligations. Otherwise, this puts further pressure on the currency—a feedback loop.
This widening mismatch increases the nation's vulnerability to a currency or external debt crisis.
Yet, a global USD shortage would make borrowing and refinancing costlier, exert further strains on the peso (as the BSP drains its reserves), and aggravate such risk conditions.
As a side note, since 2018, "other reserve assets" (ORA) (Financial derivatives, repos, etc.) have comprised a substantial segment of the BSP's Gross International Reserve (GIR) according to the IMF's International Reserves and Foreign Currency Liquidity (IRFCL). ORA accounted for 8.11% of the GIR as of August 2023. (Figure 5, lower window)
Rising FX rates mean the costlier use of ORA to manage the GIRs, which is one possible reason its use has declined.
In the end, the law of scarcity means that the Philippines is not immune to the risks emanating from excessive deficit spending.
Along with the think tank's caution, with the temptation to exercise "fiscal dominance," risks should only accelerate.
___
References
Robert Higgs, Crisis, Bigger Government, and Ideological Change Independent Institute January 1, 1985
Antony P. Mueller, The Economics of the Fiscal Cliff Financial Sense.com November 8, 2012
Jeffrey P Snider, Some First Principles Of A ‘Dollar Short’ Alhambra Investments, April 16, 2018
