Solving Inflation: Funding the Fiscal Deficit

Many commentators have recently suggested that monetarism is dead in Pakistan. That the monetary base or money supply going up is not one-to-one linked with inflation in Pakistan.

The thing is money supply doesn’t have to perfectly correlate with inflation all the time. In the basic equation of monetarism MV=PY, there are three variables which affect the price level P. Money supply (M), velocity of money (V) and output (Y). A basic understanding of math would reveal that inflation is linked positively with money supply and velocity of money, but negatively with output.

So, if money supply is going up by 10% and inflation by 20%, it might very well be the case that the other 10% of inflation is being caused by an increase in velocity of money and/or a decrease in output (negative supply shock). Pakistan’s recurring balance-of-payment crises have created negative supply shocks (aka import restrictions) time after time, hence a key reason why money supply has not one-to-one correlated with inflation in Pakistan.

Beyond this, many commentators have also suggested that expansionary fiscal policy or large fiscal deficit is the major cause of inflation. The government’s spending binge might very well be a crucial cause of inflation, but the way it funds its deficit is even more important.

Let’s look at two ways the government funds its debt: printing money or raising it from the public via bond financing/sale. In the former case, the government introduces newly minted money in the system which raises aggregate demand – more money chasing same number of goods.

Usually, we say that when the public sector (government) runs a deficit, the private sector must run a surplus. In this scenario, the private sector does run a surplus, but that surplus is dissipated without repayment as the value of money held by the private sector reduces due to money printing. So, the revenue earned from seignorage via money printing is, in fact, a transfer of resources from the private to the public sector. We can also analyze this via a basic IS-LM model.

When government spending expands, the IS curve shifts right. When the government funds that deficit by printing new money, the LM curve shifts right. Thus, the effect of fiscal expansion on inflation is amplified.

Now, let’s say the government decides to fund its deficit through sale of bonds to the public. In this case, the private sector directly funds the government’s deficit. Because, when the government sells bonds to fund its consumption, the public buys them. In the process, the private sector consumption translates to government consumption.

This is possible since the sale of bonds raises the interest rate (reward for saving), hence nudging people to save (reduce consumption). Consequently, increase in government spending through bond financing is somewhat cancelled out by decrease in private consumption. So, the amplified inflation seen in the previous scenario doesn’t occur.

In the IS-LM model, when the government finances its spending through bond sales, money demand increases (due to rise in wealth) so real money supply falls and the LM curve shifts left (the IS curve would shift rightwards again but we’ll ignore that since it gets too complicated). Hence, the economy doesn’t overheat, and inflation remains in range.

This model, of course, assumes government bonds are net wealth which isn’t always true. When government bonds are not net wealth, the LM curve remains static. In non-economics terminology, this means that the public buys bonds by selling other assets (stocks). So still, inflation doesn’t run as high as we saw in the first scenario.

Takeaway: government should always finance a deficit via bonds and not money printing.

How does this all relate to Pakistan? Well in Pakistan, the government does fund its deficit through bond sales – at least on paper. Before SBP Act 2021, the government could borrow money directly from the State Bank (SBP). Since the SBP is owned solely by the government, profits made by the State Bank from lending went back to the government. Hence, borrowing from SBP was essentially the government printing new money.

To put an end to this, IMF demanded that there be a complete restriction on government borrowing from SBP. The government adhered to this. But then the government found a loophole. It could make SBP lend cash to commercial banks, via open market operations, and the banks could lend cash back to the government. Hence, a new formula for money printing.

Once you realize this catch, the extraordinary inflation of the past two years becomes quite clear. What’s the way out of this then? Well, the government must fund its deficit truly through bond sales – in spirit, not just on paper.

Currently, the government sells bonds mostly to commercial banks – its main buyer. The liquidity from this avenue has been stretched to the max. However, there is potential to extract additional liquidity from the system by selling bonds directly to the public. Making it easier for the public to buy/sell bonds would do just that. The current procedure to do so is overly cumbersome in Pakistan.

Alternatively, SBP could promote and support the development of financial institutions such as microfinance banks, pension funds and insurance sector. All these savings institutions would extract existing liquidity from the system which can be utilized to fund the government deficit. For instance, microfinance banks attract deposits which the banks cannot or do not want to.

Making it more accessible for the public to buy/sell bonds and promoting new financial institutions would not only reduce inflation but also produce spillover benefits. It would reduce the government’s reliance on commercial banks for borrowing. Moreover, government’s borrowing costs would fall since the spread charged by banks would be squeezed with more competition from the public and other financial institutions.