Economic Inquiry
      vol. 22, no. 4 (October), 1984, pp. 593-96.

    Deficits and Inflation: A Comment on Dwyer

    Roger W. Garrison
     

    I. Introduction
    In a recent article appearing in this journal (July 1982) Gerald P. Dwyer, Jr. offered some empirical tests of several hypotheses concerning the relationship between federal government deficits and the rate of inflation. Dwyer's summary contains the "tentative inference" that "deficits play no role in determining inflation..."—an inference that runs directly counter to the views of Buchanan and Wagner (1977). The purpose of this comment is to suggest that Dwyer's inference cannot be justified by his analysis.
            The problems with Dwyer's analysis are conceptual, theoretical, and methodological. Each of these aspects will be taken up in sequence. Section II shows that Dwyer's measure of the deficit conflates the cause and the consequence of the debt-monetization process. Section III argues that his counter-intuitive views of the relationship between deficits and inflation are a result of undue reliance on the comparative-statics mode of analysis and neglect of the market-dynamics mode. Section IV stresses that the meaningfulness of Dwyer's conclusions depends on the unusual (Granger-Sims) usage of the word "cause." 

    II. The Real Deficit: A Cause or a Consequence?
    In Section I of his article, Dwyer obscures the relationship between deficits and inflation by suggesting an alternative—and unconventional—measure of the deficit. "If the real rate of interest is unaffected by inflation, the change in the real value of the government debt is a more pertinent measure of the deficit than the real deficit" (p. 318). This terminological twist results in a conflation of the process that constitutes the causal link between deficits and inflation and the ultimate consequences of that same process. High deficits may result in debt monetization, which increases the rate of inflation, which in turn erodes the real value of the debt. The question of the pertinent measure of the deficit depends upon whether one is interested in the causal relationship (in which case the conventional measure is the more pertinent) or the ultimate consequence (in which case the alternative measure can be defended).
            But Dwyer is clearly interested in the issue of causality. He does not hesitate to suggest that the fact that the real value of the total federal debt has fallen as often as it has risen since the early 1950s "...raises serious questions about the empirical basis of the arguments by Buchanan and Wagner (1977), for example, that inflation in this period is largely a result of deficits" (p. 316). These "serious questions" can be answered by carefully distinguishing between cause and consequence. Buchanan and Wagner argue in terms of the conventionally defined deficits which lead the central bank to engage in debt monetization; Dwyer points to statistics that reflect the ultimate consequence of that debt-monetization process.
            It is interesting to note that the same "serious questions" might be raised in connection with the Great German Inflation of the early 1920s. Shortly after the "London Ultimatum" in May of 1921, which set the reparations payment in the neighborhood of 132 billion Gold Marks, the German money supply began its dramatic ascent along a geometric growth path. Historical accounts leave no doubt that Germany's obligation to procure fixed sums of foreign exchange at regular intervals to pay her war debt was the proximate cause of the dramatic inflation that followed (Graham, p. 8). But an analysis based on the Dwyer-pertinent measure of the deficit would focus on the time profile of the real debt. The observation that the real debt rose more slowly during the twelve months following the London ultimatum than during the twelve months preceding it may be seen as a basis for serious questions about the relationship between debt and inflation.(1) The fact that the cause of the inflation is seen as the war debt while the consequences are seen largely in terms of domestic debt reduces the likelihood of a misinterpretation. Nonetheless, an understanding of the distinction between cause and consequence warns against adopting the Dwyer-pertinent measure when causality is at issue.

    III. Comparative Statics and Market Dynamics
    That Dwyer chose to redefine the deficit as the change in the real value of the debt is symptomatic of a common analytical error: the failure to distinguish between comparative statics and market dynamics. This critical distinction closely parallels the distinction between cause (market dynamics) and consequence (comparative statics). Attention to these two separate modes of analysis can put Dwyer's contribution in a new light.
            To focus on the real value of outstanding bonds for each of a sequence of years, as Dwyer does, limits the analysis to the comparative-statics mode. It overlooks the debt-monetization process, and the subsequent market process by which the economy becomes adjusted to each increment of monetized debt. These processes constitute the market dynamics that cause the real value of outstanding bonds to fall largely offsetting the newest increment of debt. That is, the monetizing of debt is an important part of the market dynamics that cause the amount of debt in real terms to be no higher than before.
            The distinction between comparative statics and market dynamics offers a reconciliation of the belief that the central bank tends to accommodate the Treasury with statements that, on a superficial level, seem to imply such a belief has no historical foundation. Consider Dwyer's statement, for instance, that "Even though there were substantial deficits [during the years 1952 through 1981], federal government indebtedness does not increase substantially because the nominal growth rates of bonds associated with the deficits are frequently less than the inflation rate" (Dwyer, 1982, p. 317). The statement is true, but an accommodation central bank may be responsible for both inflation and a constant level of real indebtedness. If so, the observation of (roughly) constant indebtedness cannot be used as evidence that the central bank was not accommodating. That is, the comparative-statics results cannot be used as evidence that a dynamic process capable of yielding those results did not take place. Dwyer's empirical observation does not, by itself, confirm the Buchanan-Wagner view (that deficits lead to monetary growth), but if their view is correct, the monetization process they describe would give rise to the very pattern of inflation and real indebtedness that Dwyer has observed.
            It might be noted that the failure to distinguish adequately between comparative statics and market dynamics is not at all unique to Dwyer's article. The blurring of these two modes of analysis was largely responsible for the extended controversy about the importance of the real-cash-balance effect in monetary theory (Archibald and Lipsey, 1958). By clearly distinguishing between a "market experiment" (comparative statics) and an "individual experiment" (market dynamics), Don Patinkin demonstrated that the absence of the real-cash-balance effect in the former mode of analysis does not imply its unimportance in the latter (Patinkin, 1965, p. 11f and passim). The arguments in the present comment can be seen as paralleling Patinkin's.

    IV. The Issue of Causality
    Dwyer offers an empirical test which appears to cast doubts on the Buchanan-Wagner view and to support the view that money creation cannot be "explained" by deficits. He skirts the issues of market dynamics by making use of the technique suggested by Granger and Sims. This technique imposes no restrictions from any specific theory about the market process which generates the text data. Each of six different variables (the level of prices, the level of income, the nominal quantity of money, the interest rate, the nominal quantity of government debt held by the Federal Reserve, and the nominal quantity of debt held by the public) is written with the use of matrix notation as a function of lagged values of these same six variables. Of all the different tests that this technique makes possible, the one of greatest relevance here involves the equation in which the quantity of money is the dependent variable. The question of whether or not the central bank tends to monetize deficits is answered by looking at the coefficients of the lagged and contemporaneous values of the debt variables. But if Dwyer's own caveats are taken seriously, his negative empirical results do not have the significance that he ascribes to them. The key issue is the concept of "causality" in economic relationships.
            While the Granger-Sims technique does not impose any particular theoretical restrictions on the relationship among the six variables singled out by Dwyer, it does impose and important general restriction. Each variable is related only to contemporaneous or past values of the other variables. No allowance is made for the effect of anticipated future values of those variables.(2) The Granger-Sims technique is confined to the identification of post hoc relationships because of this general restriction. Unfortunately, this inherent shortcoming of the technique has been disguised as a virtue (both in Dwyer's article and in the literature in general) by imputing causality to the relationships identified. But to take the earlier event as the cause of the later event is precisely to commit the logical fallacy of post hoc, ergo propter hoc.
            A dim recognition of the post hoc fallacy has led users of the Granger-Sims technique to retain the word "cause" while disclaiming its conventional meaning. Dwyer clearly recognizes this practice when he writes that "Interest rates lead inflation, i.e., last period's interest rate ... 'Granger-causes' this period's inflation rate, but this does not mean that interest rates 'cause' inflation in the usual sense" (p. 323). Lamentably, the unusual sense of the word is not specified-unless "lead" and "Granger-causes" are taken to be perfectly synonymous, in which case the latter term is redundant at best and misleading at worst. The truth is that "Granger-causes" does not me "causes" at all. What does it mean to say that, for example, toting an umbrella to work on a cloudy morning "Granger-causes" rain to fall sometime during the day? If debt is monetized in a given period because of the anticipation of even greater government borrowing in subsequent periods, then the monetary creation and the subsequent inflation should be attributed to the deficits. The anticipation of large deficits, in this hypothetical case, causes money creation.(3) The Granger-Sims technique, however, would identify the toting of the umbrella and the creation of money as the causes and the mid-day rain and the large deficits as the effects.
            In the final paragraph of the summary section, Dwyer uses the word "causal" but without the quotation marks he had been careful to use earlier. The reader is likely to believe that he means "causal" in the usual sense. Once it is recognized he does not, it is easy to reconcile Dwyer's conclusions with those of Buchanan and Wagner. He states "there is no reason to predict that a reduction of deficits has a causal role in any policy to reduce inflation" (p. 327). It need only be said here that there is no contradiction between the econometrician's findings that deficits do not Granger-cause inflation and the political economist's understanding that deficits do Webster-cause inflation.
            In order to produce empirical results, Dwyer deliberately ignored the issue of market dynamics and hence the underlying economic processes. But only insofar as it is understood how the different variables are related one to the other is some theoretical and historical context can it be discovered what causes what. Identifying the relevant incentives and constraints out of which such theory and history are made is precisely what Buchanan and Wagner did, and what Dwyer did not do. 

    References

    Archibald, G. C., and Lipsey, R. G., "Monetary and Value Theory: A Critique of Lange and Patinkin," The Review of Economic Studies, October 1958, 1-22. 

    Bresciani-Turroni, Constantino, The Economics of Inflation, Augustus M. Kelley, Publishers, Northhampton, Great Britain, 1937. 

    Buchanan, James M., and Wagner, Richard E., Democracy in Deficit: The Political Legacy of Lord Keynes, Academic Press, New York, 1977.
    Dwyer, Gerald P., Jr., "Inflation and Government Deficits," Economic Inquiry, July 1982, 20, 315-29. 

    Graham, Frank D., Exchange , Prices, and Production in Hyper-Inflation: Germany, 1920-1923, Princeton University Press, Princeton, New Jersey, 1930. 

    Patinkin, Don, Money, Interest, and Prices: An Integration of Monetary and Value Theory, 1st ed., Row, Patterson, and Co., Illinois, 1956. 

    Notes:

    1. This characteristic of the real debt's time profile is recorded in Bresciani-Turroni, pp. 30-33. And empirical study that adopted a longer time horizon and considered the debt profile beyond 1922 would yield different results. In this later period the debt itself rose dramatically. The exponential rise can be attributed largely to the asymmetrical effect of inflation on the Reich's receipts and on its expenditures (Bresciani-Turroni, pp. 64-70). But the increased deficits during the extended period does not support the view that deficits cause inflation any more than the initial decrease in deficits calls the causal relationship into question. 

    2. Dwyer recognizes the existence (p. 323) but not the significance of this problem. 

    3. Similarly, if the central bank maintains a tight-money policy in the face of high deficits and then, succumbing to political pressures, begins to monetize the cumulative deficits, the money creation can be attributed to the deficits. But because of the political element, this relationship between the deficits and the money creation may not be systematic enough to be captured by the Granger-Sims technique.