Inflation is not caused by the actions of private citizens, but by the government: by an artificial expansion of the money supply required to support deficit spending. No private embezzlers or bank robbers in history have ever plundered people’s savings on a scale comparable to the plunder perpetrated by the fiscal policies of statist governments—Ayn Rand
In this issue
BSP’s Primer: How Fiscal Deficits Influence Interest Rates! Global Tightening Exposes the Risks of the Twin Deficits
I. BSP’s Next Admission: How Fiscal Deficits Influence Interest Rates!
II. The Fiscal Dimension of Monetary Inflation
III. The Crowding Out Syndrome
IV. Global Financial Tightening Exposes the Risks of the Twin Deficits
BSP’s Primer: How Fiscal Deficits Influence Interest Rates! Global Tightening Exposes the Risks of the Twin Deficits
I. BSP’s Next Admission: How Fiscal Deficits Influence Interest Rates!
Last week, we tackled the striking Bangko Sentral ng Pilipinas (BSP) admission that a prolonged era of low-interest rates "can cause inflation." (Prudent Investor, 2022)
Although the BSP makes this conclusion in their literature on interest rates under the "Financial Education, Inclusion, and Consumer Protection" category, they tell a contrasting narrative about the current inflation cycle in media.
Figure 1
Here, we shall deal with another critical acknowledgment by the Bangko Sentral ng Pilipinas (BSP): "Fiscal deficits...exerts upward pressure on domestic interest rates, particularly, if the government borrows from a relatively less liquid domestic market." (BSP, 2022) (bold mine] (Figure1, topmost pane)
Amazing.
August's fiscal deficit has been 40% lower than last year but in the eight months of 2022 remains just 14% off last year's record. (Figure 1, middle window)
The "lower deficit" attributed by media to the slower growth rate in public spending has mainly been due to the higher base effect. (Figure 1, lowest window)
So the BSP also confesses to the influence of deficit spending on inflation, consequently, interest rates.
II. The Fiscal Dimension of Monetary Inflation
Figure 2
When funded by savings through sales of Treasury securities, deficits are not inflationary.
However, it becomes inflationary when "financed by selling bonds to the banking system. If that occurs, the banks create new money by creating new bank deposits and using them to buy the bonds. The new money, in the form of bank deposits, is then spent by the Treasury." (Rothbard, 1984)
Direct funding of National Government spending by the BSP through debt monetization is likewise inflationary.
Domestic authorities have been shifting the onus of financing deficits from the BSP to the banking system ever since the pandemic culminated.
While the BSP has diminished the use of debt monetization, which plunged 38.9% YoY in August, the banking system's net claims of the central government surged by 21.2% YoY to a new milestone. (Figure 2, topmost pane)
And from this perspective, it is clear why most of the emergency relief measures by the BSP to the industry remain in place and why current deficits are inflationary.
That is, the relief measures by the BSP allowed banks to finance fiscal deficits and reassume their role as the primary credit providers.
Meanwhile, the accelerated uptrend in public spending corresponds with the CPI trend, depicting the increasing role of authorities in allocating economic resources and finances. (Figure 2, middle window)
How is the present setup not a first-order function of inflation?
III. The Crowding Out Syndrome
Aside from funding, the other factor influencing is the crowding out syndrome.
When governments borrow, they compete with everybody else in the economy who wants to borrow the limited amount of savings available. As a result of this competition, the real interest rate increases and private investment decreases. This is phenomenon is called crowding out. (Kahn Academy)
In a simplified context, competition for access to savings and resources results in the crowding-out effect with its consequences: higher inflation and interest rates.
In August, public debt jumped by 11.84% YoY to a record Php 13.02 trillion, while universal and commercial bank loans swelled by 12.11% YoY. (Figure 2, lowest pane)
Figure 3
With the twin debt engines in full throttle, systemwide credit expanded by 11.96% YoY to a historic Php 23.05 trillion or has reached 110% of the estimated 8% NGDP! (Figure 3, topmost window)
In this respect, an era propped up by a regime of artificially repressed rates through the operations of the BSP facilitated such unparalleled accretion of debt or leverage.
But the story we hear from officials, experts, and media about the relationship between the fiscal deficit and inflation careen away when presented in contemporary politics.
Businessworld, September 15: THE CONTINUED WEAKNESS of the Philippine peso against the US dollar works for the benefit of the proposed 2023 national budget, Finance Secretary Benjamin E. Diokno said, as it would translate to higher revenues and a narrower fiscal gap.
The increase in revenues is seen as "beneficial" to facilitate and finance more public spending.
In short order, political institutions benefit directly from inflation.
Since transaction prices are the basis for sales and excise taxes, the BIR's nominal collection has risen in tandem with the CPI since 2015. (Figure 3, middle window)
Political institutions and the other biggest borrowers also benefit from the inflation tax through negative 'real' rates, where the latter acts as a subsidy at the expense of the general public.
Again, how is this not a representation of first-order inflation?
In this case, why should we expect a determined approach to contain inflation from financial authorities when they are its primary beneficiaries?
IV. Global Financial Tightening Exposes the Risks of the Twin Deficits
Figure 4
As part of its primary mission, monetary authorities claim to prioritize price stability.
But how does the surge in street prices, the plummeting peso, bond prices, and the stock market represent price or financial 'stability'?
Instead of practicing what it preached, the priorities of the BSP’s monetary policies have accommodated the political agendas of the past and present leadership.
This deviation of the BSP from its priorities demonstrates its interdependency on the affairs of the political leadership. Or, the central banks are hardly independent as commonly proclaimed.
And through economic maladjustments, what the BSP cites as the source/s of inflation have become entrenched policies that transformed into economic and financial instability.
And are we supposed to be surprised that most nations with "twin deficits" (except for the US as the de facto FX reserve standard), or countries that spent more than they earned, have been enduring a drastic decline in their respective currencies vis-a-vis the USD? (Figure 4 topmost table)
As an aside, the USD comprises most of the world's FX debt. According to the Bank for International Settlements, as of Q1 2022, the outstanding US Dollar denominated debt amounted to USD 13.37 trillion, with emerging Asia comprising 12%.
Hence, when the Fed raises rates that reduce the amount of liquidity to contain inflation, these outstanding external debts or "USD shorts" become the focus. Nations with extensive USD shorts require increased USD revenues or compete intensively with others for access to the mounting scarcity of the USD in circulation.
The problem isn't the US Fed alone. The elementary problem is the monetary-fiscal policies of its counterparties. As they say, the USD is the cleanest shirt in the dirty laundry of fiat money.
From the perspective of the twin deficits, among the worst currencies are the British pound, the Indian rupee, and the Thai baht. (Figure 4)
While deficits signify a substantial factor, there are areas of concern inducing economic and financial stress, such as Japan's monetary policies, China's imploding property sector, the Ukraine war, and more.
Circling back home, as a biblical quote goes, you reap what you sow. (Galatians 6:7)
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References:
Prudent Investor BSP’s Interest Rate Primer: Low Rates Are the Cause of Inflation! BSP Rate Hikes: Peso, Treasuries, and Stocks Plunge (September 25 2022)
BSP Media and Research, "Why Should Interest Interest You," (2022) bsp.gov.ph
Murray N. Rothbard, Ten Great Economic Myths, April, 1, 1984, Mises.org
Kahn Academy, Lesson summary: crowding out
