Working Paper: CEPR ID: DP2205
Authors: Willem H. Buiter
Abstract: It is not common for an entire scholarly literature to be based on a fallacy, that is, "onfaulty reasoning; misleading or unsound argument". The 'fiscal theory of the pricelevel', recently re-developed by Woodford, Cochrane, Sims and others, is an exampleof a fatally flawed research programme.The source of the fallacy is an economic misspecification. The proponents of thefiscal theory of the price level do not accept the fundamental proposition that thegovernment's intertemporal budget constraint is a constraint on the government'sinstruments that must be satisfied for all admissible values of the economy-wideendogenous variables. Instead they require it to be satisfied only in equilibrium.This economic misspecification has implications for the mathematical or logicalproperties of the equilibria supported by models purporting to demonstrate theproperties of the fiscal approach. These include: overdetermined (internallyinconsistent) equilibria; anomalies like the apparent ability to price things that do notexist; the need for arbitrary restrictions on the exogenous and predetermined variablesin the government's budget constraint; and anomalous behaviour of the 'equilibrium'price sequences, including behaviour that will ultimately violate physical resourceconstraints.The issue is of more than academic interest. Policy conclusions could be drawn fromthe fiscal theory of the price level that would be harmful if they influenced the actualbehaviour of the fiscal and monetary authorities. The fiscal theory of the price levelimplies that a government could exogenously fix its real spending, revenue andseigniorage plans, and that the general price level would adjust the real value of itscontractual nominal debt obligations so as to ensure government solvency. Whenreality dawns, the result could be painful fiscal tightening, government default orunplanned recourse to the inflation tax.
Keywords: Fiscal theory of the price level; Ricardian fiscal rules; Government budget constraint; Price level indeterminacy
JEL Codes: E31; E41; E51; E52; E62; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| non-Ricardian fiscal rules (E62) | overdetermined fiscal programs (E62) |
| overdetermined fiscal programs (E62) | internally inconsistent equilibria (D59) |
| non-Ricardian fiscal rules (E62) | anomalous price level behaviors (E30) |
| anomalous price level behaviors (E30) | economic instability (E32) |
| general price level cannot serve as a default discount factor on government debt (E43) | arbitrary restrictions on budget constraints (D10) |
| adherence to Ricardian principles (D72) | intertemporal budget constraint satisfied (D10) |