Deficits and money growth in the United States 1872–1983

Journal of Monetary Economics 16 (1985) 329-351. North-Holland

DEFICITS

AND MONEY GROWTH IN THE UNITED STATES 1872-1983 Douglas H. JOINES*

Unicwsity

o/Southern

Coli/ornia.

Los Angeles,

CA 90089-1421,

USA

This paper reports empirical evidence on the relation between government budget deficits and the growth of high-powered money in the United States. High-powered money growth appears to be positively related to war spending during periods when such spending is a substantial fraction of GNP. There is little evidence that the growth of high-powered money is related to the non-war government deficit, measured either in cash or in real terms, after controlling for the level of overall economic activity.

1. Introduction The large federal government budget deficits experienced in the past several years and the even larger deficits projected for the near future have sparked a heated debate as to their consequences. Many people believe that these deficits pose a policy problem which should be corrected by reducing government outlays, increasing revenue, or both. The policy problem is said to arise in part because the government will compete with private borrowers for scarce loanable funds. This will drive up interest rates and crowd out private spending on both consumer and capital goods. Reduced capital formation will result in lower output, labor productivity, and real wages in the long run. A related aspect of the policy problem concerns the consequences of government deficits for money growth and inflation. The pressure on financial markets and interest rates implied by large government borrowing is said to constitute an irresistible force leading the Federal Reserve to purchase at least part of the newly issued government debt. While these open-market purchases may ease the upward pressure on interest rates, they will also lead to more rapid growth of the money supply and higher inflation.’ *I am grateful to Robert Barre. Fischer Black, Truman Clark, Gerald Dwyer. Paul Evans, Gerald Nickelsburg, and John Seater for comments on earlier drafts of this paper. This research was supported by a grant from the Graduate School of Business Administration, University of Southern California. ‘There might be channels other than the money supply through which government deficits are inflationary. See Niskanen (1978) and Dryer (1982b) for a discussion of some of other possible inflationary effects of government spending and deficits. 0304-3923/85/$3.3001985.

Elsevier Science Publishers B.V. (North-Holland)

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This paper examines the historical record in the United States to determine the extent to which federal government deficits have been associated with growth in the stock of high-powered money. The data used extend back considerably further than those used in previous studies. The findings reported here disagree with those of previous studies which have reported a significant effect of deficits on money growth since the early 1950’s. The data examined in this paper reveal no relation between non-war federal deficits and the growth of high-powered money. High-powered money growth does appear to be positively associated with war spending and possibly with the unemployment rate. The apparent positive association between nominal deficits and money growth since the early 1950’s appears to be due in part to a common upward drift since that time in the money growth rate, the inflation rate, and the inflation-induced depreciation in the real value of the government debt. The data are consistent with the view that the government has set its non-war real deficit and the growth of high-powered money independently of each other and has let its nominal deficit drift upward over time in part to offset the inflation-induced depreciation in the real value of its debt and in part because its real deficit2 has grown. Section 2 of ‘the paper reviews some existing theory and evidence on the links between government deficits and money growth. Sections 3 and 4 discuss the data and the sample periods used in this study. Sections 5 and 6 contain the principal empirical results, and section 7 briefly summarizes the findings of the paper. 2. Deficits and money: Theory and evidence

The views summarized above on the effects of government deficits have many adherents among academic economists and are prominent in the popular press and within the financial community. They are not unanimously held, however. Barro (1974) and Miller and Upton (1974) lay out conditions under which government borrowing does not crowd out private spending, but instead elicits an equal increase in private saving. Barro examines a situation in which a larger deficit today is accompanied by lower current tax revenues. Both current and future money growth and current and future government spending (other than debt service payments) are held fixed. The higher future debt service payments mean that tax revenues will have to be greater in the future than they otherwise would have been. Sargent and Wallace (1981) present a model in which a larger government debt does not lead to higher future taxes. In their model, the time paths of both government spending (apart from interest payments on its debt) and tax ‘As a fraction of GNP.

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revenues are taken as fixed. A current increase in the stock of government debt must lead to more rapid money growth either now or in the future.3 Barro (1979) presents a model in which one might observe a positive relation between government deficits and money growth even if the government does not monetize its debt. In this model, the government is concerned with the real rather than the nominal value of its debt. Consequently, it allows its nominal debt to grow by one percent (as compared with where it otherwise would have been) for each anticipated one percent increase in the price level. This leads to a positive association between the inflation rate and the nominal government deficit. If inflation and money growth are in turn positively related, then one would expect to observe a positive association between money growth and nominal government deficits. Theory thus provides no clear answer to the question of whether the government must monetize a portion of its debt. A similar lack of unanimity characterizes previous empirical studies of U.S. time-series data. Hamburger and Zwick (1981), Levy (1981), and Allen and Smith (1983) all report a positive relation between federal deficits and the growth of either MI ‘or the monetary base during various portions of the period since World War II. Barro (1977), Niskanen (1978), and Dwyer (1982b) use similar data and sample periods, yet they find no significant relation.4

3. Choice of variables and sample period

None of these studies uses data from before World War II. Several employ annual data with the money supply defined as Ml, while others use the monetary base. The latter is preferable for testing whether the Federal Reserve reacts to government deficits by purchasing part of the newly issued debt, since the monetary base is more directly affected by Federal Reserve open-market operations than are the broader monetary aggregates. Some studies define the deficit on a national income accounts basis, while others use variables more’ closely related to government borrowing. Due to the vagaries of national income accounting, the national income accounts measure has less to do with government borrowing than does the excess of the government’s cash outlays over its cash receipts. The difference is due to the timing of government receipts and outlays in the national income accounts. This study uses time series of the cash budget of the federal government and the stock of high-powered money dating back to 1866 to examine the relation ‘See King and Plosser (1984) for a more detailed comparison of the implications of monetary dominance and fiscal dominance. 4Dwyer (1982a) analyzes several factors which could account for the differences between his results and Levy’s. The most important appears to be severe serial correlation of the residuals from Levy’s equation.

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between deficits and money growth. This period includes not only the years since World War II, which have been the focus of most previous empirical work, but the early years of the Federal Reserve System as well. It also includes a substantial period of time before the creation of the Federal Reserve. This earlier period is worth ex amining for several reasons. The Federal Reserve plays an important institutional role in the usual stories about monetization of deficits. It is not clear that the existence of a separate monetary authority is a crucial part of these stories, however. As Friedman and Schwartz (1963, p. 9) have noted: The Federal Reserve System began operations in 1914. This far-reaching internal change in the monetary structure of the United States happened to coincide with an equally significant external change - the loosening of links between external conditions and the internal supply of money which followed the outbreak of World War I - destined to become permanent. Taken together, the two changes make 1914 a major watershed in American monetary history. Important as they were, both changes were changes of degree. The Treasury had long exercised central. banking powers that were no less potent because they were not so labeled, and.. . it had been doing so to an increasing extent. If the Federal Reserve does provide a crucial institutional link in the monetization process, then one would not expect to find any relation between deficits and money growth in the years before World War I.’ As Friedman and Schwartz note, there are other reasons why one might not find such a relation in this early period. During much of that time the United States conformed well to the model of a small open economy on a gold standard.6 As such, its money supply would have been determined endogenously and would not have been under the control of the government. Also, the federal government ran persistent surpluses during that time so that, far from being a large net borrower, it was in fact a net lender. If the United States did conform fairly closely to the small open-economy model and if international capital markets ‘Although the Federal Reserve System began operations in 1914, it did not purchase any government debt until fiscal year 1916. It did not acquire a substantial amount of such debt until after the United States had entered World War I. 6When the United States formally resumed the convertibility of the dollar into specie in 1879, it probably conformed fairly closely to such a model. As Friedman and Schwartz note, this conformity had begun to erode even before the creation of the Federal Reserve. They continue the passage quoted above: The growing size of the U.S. economy relative to the world economy and the declining importance of U.S. foreign trade relative to domestic trade had long been increasing the importance of internal changes in the United States for world monetary conditions and introducing ever greater play in the links between the two.

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were well integrated, then the government’s borrowing or lending would have had a negligible effect on market interest rates. Government deficits or surpluses would therefore have done nothing to create or alleviate pressures for monetization. 4. The data

The appendix describes annual series on the federal government’s cash deficit and the stock of high-powered money from 1866 through 1983. Data are for twelve-month periods ending on June 30 of the year indicated. Prior to 1976, this corresponded to the government’s fiscal year. Both the deficit and year-to-year changes in the stock of high-powered money displayed increasing variability over time, and it is likely that residuals from a regression relating the two would also exhibit non-constant variance. Heteroscedasticity in a regression of nominal values is plausible since both the price level and the size of the economy have grown over time. Homoscedasticity of residuals from a nominal regression would imply a secular decline in the residual variance either in real terms or relative to the size of the economy. In order to determine whether heteroscedasticity is likely to be a severe problem in a regression using nominal variables, the change in the stock of high-powered money was regressed on a constant, the cash deficit, war spending, and autonomous gold inflows for the period 1872-1983.‘A GoldfeldQuandt (1965) test of the hypothesis that the residual variance was no greater after 1947 than before 1916 yielded an F-statistic of 2164.5 with 34 and 41 degrees of freedom. The hypothesis of constant variance is thus decisively rejected. Furthermore, the residual standard error appears to be positively related to the trend value of nominal GNP.8 A regression of the absolute values of the above residuals on a constant and trend GNP [Glejser (1969)] results in an R* of 0.525 and a slope coefficient of 0.00206 with a r-statistic of 11.02. In addition, the test suggested by Breusch and Pagan (1979) yields a x2 statistic of 229.6 with one degree of freedom, thus decisively rejecting the hypothesis that the standard error of the residuals from the nominal model is unrelated to trend GNP. Since the residual standard error in the regression using nominal variables is positively related to trend GNP, both the deficit and year-to-year changes in high-powered money were deflated by that series. The resulting variables, ‘These variables are described in more detail below. ‘This trend value was calculated by regressing the logarithm of nominal GNP on a quadratic time trend and exponentiating the fitted values. It was necessary to use an estimate of trend GNP since actual GNP data are readily available on an annual basis only back to 1889. Furthermore, deflating all nominal series by another stochastic series like GNP might induce spurious correlation among the deflated variables. See Madansky (1964). Use of a deterministic deflator would not induce such correlation.

IWO

(“0

1eso

l9oI

,910

,919 “EAn

I ,39

I.40

IOSO

IWO

Fig. 1. Change in the monetary base, 1869-1983 (percent of trend GNP).

denoted DEF and DM and expressed as a percent of trend GNP, exhibited no marked change in variance except for wartime periods (figs. 1 and 2).9 Examination of the deflated deficit variable shows that it attained extremely large values during the two World Wars. It is quite possible that the monetary authority reacts differently to such extreme deficits than to more normal ones. This conjecture was examined by including in the empirical analysis a variable which measures war spending. This variable was non-zero only for fiscal years during which the United States was at war and during post-war transition periods. The values of the war spending variable are shown in table 1, and the method of measuring the variable is described in the appendix. This variable was deflated by the trend value of GNP, and the deflated values were denoted WAR (fig. 3). WAR is quite similar in spirit to variables measuring military ‘Repetition of the Goldfeld-Quandt test using DM, DEF, and the similarly deflated variables and GOLD yields no strong evidence of heteroscedasticity. The residual variance actually appears larger for the earlier subperiod, but a test of the hypothesis that it is constant over time yields an F-statistic of only 1.08 with 41 and 34 degrees of freedom. WAR

D. H. Jokes.

Fig. 2. Federal

cash deficit,

DeJicirs

und motley

1869-1983

Table War spending Fiscal year

“This

(percent

(millions

on values

GNP).

of zero in all remaining

Fiscal year

War spending

1951 1952 1953 1954 ... 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975

6,735 26,902 32,431 5.990 ... 4.808 17.136 24,915 22,103 18,014 12,085 11,124 5,254 1,499 1,135

.. .

1,070 11,382 16,504 3,534 1,911 .. . 5,ooo 24,455 65,078 79,026 83,369 45,763 502 took

of trend

of dollars)?

69.4 209.5

variable

335

1

War spending

1898 1899 . 1917 1918 1919 1920 1921 .. . 1941 1942 1943 1944 1945 1946 1947

grow/t

years

between

1869 and 1983.

336

l.SP

,110

I to.

1.1,

,010 VEAR

1.30

I MD

lDSD

IS19

IWO

Fig. 3. War expenditures, 1869-1983 (percent of trend GNP).

strength and battle deaths which Barro (1977,198l) has found to have significant explanatory power in some of his empirical work. It was used instead of these variables, however, because the most relevant measure of the intensity of a war for present purposes is the level of spending on the war and because Barro’s casualty rate variable was not readily available on a fiscal-year basis. Since the correlation between WAR and DEF over the period 1866-1983 is 0.88, it would be quite difficult to identify separate effects of these two variables on money growth. In order to reduce this collinearity, DEF was regressed on WAR and a constant. This had the effect of decomposing the deficit into one component perfectly correlated with war spending and another uncorrelated with WAR. The latter, denoted DEFN, can be regarded as a measure of the ‘normal’ federal deficit and was used in subsequent statistical analysis.‘o “The pair of variables (DEF,. WAR,) contains the same information as the pair ( DEFN,, WAR,). If the former pair is used, the coefficient on WAR, measures the increase in DM associated with a one-unit increase in war spending, holding constant the deficit. While this may be an interesting hypothetical experiment, it has little to do with historical experience. Extremely high levels of war spending tend to result in extremely large deficits. If DEFN, is used, then the coefficient on WAR, measures the increase in the monetary base associated with a one-unit increase in war spending with the deficit left free to react in its usual manner.

Another exogeneous factor which from time to time exerted a noticeable influence on the stock of high-powered money was large autonomous inflows of gold into the United States. Such large inflows occurred on three occasions, two of them related to wars. During each of the two World Wars, the United States transferred large quantities of war materiel to its allies. After the United States formally became a combatant, these transfers were classified as loans or grants to the allied countries and show up in the government budget. They are included in the items used to calculate the war spending variable described above. Before the U.S. entered World War I, American war supplies were purchased by countries already at war, and these purchases resulted in net gold inflows into the U.S. during fiscal years 1916 and 1917 of over $1 billion. [See Clark (1931, pp. 22-26) and Friedman and Schwartz (1963, pp. 198199).] The recently created Federal Reserve System was powerless to sterilize the effect of these gold inflows on the stock of high-powered money since its total security holdings at the beginning of fiscal 1916 were only about $200 million. A similar sequence of events occurred prior to U.S. entry into World War II. Net gold inflows into the United States during fiscal years 1939-1941 totaled more than $10 billion, compared with the Federal Reserve’s security holdings of $2.5 billion at the beginning of that period. Beginning with the enactment of the Lend-Lease program in March, 1941, most transfers of war supplies to the allies were incorporated into the government budget. Gold inflows had largely ceased by the middle of calendar year 1941. The remaining instance of large gold inflows occurred in fiscal years 1880 and 1881, immediately following U.S. resumption of the gold standard. These inflows seem to have been attributable in part to a shift in money demand due to the change in the monetary standard. According to Friedman and Schwartz (pp. 97-98) these shifts ‘were powerfully reinforced by accidents of weather that produced two successive years of bumper crops in the United States and unusually short crops elsewhere. The result was an unprecedentedly high level of exports.’ A variable denoted GOLD was included in the estimated equations to control for these autonomous gold inflows. This variable was non-zero only during each of the seven years when large inflows occurred. It was calculated as the ratio of net gold inflows in each of these years to the trend value of GNP. Data on net gold inflows are listed and their sources are described in the appendix. Finally, the unemployment rate, denoted UN, was included as another potential determinant of high-powered money growth in some models.” Previ“The unemployment rate series is for calendar years and is available only from 1890 onward. This series is displaced six months in time compared with the other variables. For this reason, only lagged values of the unemployment rate were included in the models. An unemployment rate of one percent is recorded as 1.0 rather than 0.01. The sources for this series are described in the appendix.

D. H. Joines,

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ous studies of the money supply process have found some evidence that money growth can in part be explained by the overall level of economic activity as represented by either the unemployment rate or the growth rate of real income. If, for example, the monetary authority expands the money supply in response to high unemployment rates, then omitting this variable might seriously bias the coefficients on the remaining variables. This is true because both the unemployment rate and the government deficit are likely to be highly correlated with the level of aggregate economic activity. 5. Empirical results - the cash deficit

Table 2 shows estimates of equations with DM as the dependent variable: l2 M

N

P

DM,=(Y+CPiDEFN,_i+CyiWAR,-i+~GOLD,+C6iVN,-i+E,. i-0

i=O

i-l

The unemployment rate is absent from some equations since data on that variable are available only since 1890. It was necessary to include a lagged dependent variable to correct for autocorrelation of residuals in some models. The trend values of GNP used in deflating nominal variables in models beginning in 1915 or later were calculated from annual GNP data for the period 1912-1982. The units of measurement of these deflated variables are thus not exactly the same as for models beginning in 1872. In the model in column 1, estimated over the sample period 1872-1983, both DEFN and WAR appear to be associated with increases in the stock of high-powered money. The point estimate is that a one-dollar increase in war “The lag length for each of the independent variables DEFN, WAR, and UN was determined empirically. It was initially set to 3 years. The coefficients on the longest lags of each of the three variables were examined. The coefficient with the smallest absolute r-statistic was set to zero. This process was continued until no lagged values remained or until the longest lag of each variable had a r-statistic of 1.5 or greater. This procedure was used for the model estimated over the full sample period (1915-1983 for equations including the unemployment rate and 1872-1983 otherwise). The functional form thus identified was then estimated over various subperiods. Before any coefficients were set to zero, the residuals were examined for autocorrelation and heteroscedasticity. The residual variance appeared larger for war years during the 1915-1953 subperiod than for other years. A dummy variable was set equal to unity for years between 1915 and 1953 when war spending was positive. Regression of the absolute values of the residuals from the 1872-1983 model on this dummy yielded a slope coefficient 0.0794 with a r-statistic of 3.64. A similar regression for the residuals from the 1915-1983 models (which included UN) yielded a slope coefficient of 0.0804 with a r-statistic of 3.32. To correct for war-related heteroscedasticity. observations during 1915-1953. for which war spending was positive were weighted by the square root of the ratio of the mean squared residual for all other years to the mean squared residual for the 1915-1983 war years. This weight was 0.4564 for the 1872-1983 models and 0.4084 for the 1915-1983 models.

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spending is associated with a contemporaneous increase in the monetary base of 4.1 cents. The standard error of this coefficient is only 1.1 cents. The relation between non-war deficits and base money growth appears statistically significant at commonly used significance levels. The point estimate is that a one-dollar increase in the non-war deficit is eventually associated with an increase of 8.9 cents in the stock of high-powered money. Large autonomous gold inflows appear to lead to an almost equal increase in the stock of high-powered money eventually and to a substantial increase within the same year. The model in column 1 was also estimated for selected subperiods. The earliest subperiod, 1872-1914, covers years before the creation of the Federal Reserve System. During much of this time the United States was on the gold standard. The second subperiod, 1915-1953, includes both world wars and ends when the Federal Reserve ceased supporting the price of Treasury securities. The third, 1954-1983, corresponds approximately to the period used in most previous empirical studies of deficits and money growth. These equations show a positive relation between deficits and high-powered money growth during the second and third of these subperiods, after creation of the Federal Reserve System. The models for these two subperiods are similar to each other and are not reported separately. In fact, a test of the hypothesis that the coefficients are equal across all three subperiods yields an F-statistic of only 1.11 with 11 and 95 degrees of freedom. A similar test of the hypothesis that the models are the same before and after 1915 results in an F-statistic of only 1.31 with 6 and 100 degrees of freedom.r3 There appears to be no relation between deficits and money growth in the period before 1915, yet this period is not significantly different from the post-1915 period in which such a relation can apparently be identified. This is because the standard deviation of the deficit is close to zero before 1915. Therefore, the sum of squared residuals for that period is not terribly sensitive to the coefficient assigned to the deficit, and it is impossible to estimate the deficit’s coefficient very precisely. This apparent lack of relation before 1915 might suggest that the Federal Reserve plays an important institutional role in the monetization of deficits. In light of the Treasury’s central bank functions “The equations in table 2 were re-estimatedwith the deficit variable measured for the years 1880-1928 using data reported in Firestone (1960). The resulting equations were almost identical to those reported in the table. The equations were also re-estimated for 1916-1983 and two subperiods with the dependent variable measured as the change in that portion of the monetary base under the direct control of the fiscal and monetary authorities. This portion of the base was taken to be the sum of Treasury currency outstanding and Federal Reserve holdings of government debt less the sum of Treasury cash holdings and Treasury deposifs at the Federal Reserve. The functional forms identified using this redefined money growth variable were the same as those in table 2. The coefficients were also very similar except for that on GOLD, which was almost zero. This indicates that neither the Treasury nor the Federal Reserve sterilized any appreciable amount of the gold inflows that preceded the two World Wars.

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before the creation of the Federal Reserve, however, this conjecture is far from certain. It becomes even less convincing when one realizes that the Treasury continued to perform some of these same functions even after the Federal Reserve was created. The strongest relation between deficits and money growth appears during the 1915-1953 period. This period includes a span of nine years during which ‘the Treasury had become the active monetary authority’. Through its printing of gold certificates, the Treasury ‘accounted for the major movements in high-powered money from 1933 to 1941’ [Friedman and Schwartz (1963, p. 506)]. It therefore seems more likely that any increased tendency to monetize deficits after World War I can be attributed to the increasing monetary independence of the United States. Even the apparent relation between the deficit and base money growth during 1915-1983 disappears when lagged unemployment rates are added to the model (column 4). By contrast, the hypothesis that the coefficients on all the lagged unemployment rates are zero can be rejected at the one percent level, and the sum of the coefficients is significantly positive.14 This is consistent with the view that the monetary authority pursues countercyclical policies to stabilize output and employment. If so, its reaction appears to be a lagged one, since the coefficient on the first lag of the unemployment rate is negative, albeit insignificantly so. Since the periods used in measuring Dh4, and UN,-i actually have six months in common, this lag is not as extreme as it at first appears. Furthermore, the unemployment rate is very heavily autocorrelated. A negative partial regression coefficient on UN,-, is therefore not too surprising, since there is limited variation in UN(-, independent of that in UN,-,. When UN,-, is drropped form the equation, the coefficient on UN,-, becomes positive and significant (t-statistic = 2.54). Omitting UN,- Z causes the residual standard error to increase by about 17 percent, however. Despite its statistical significance, the estimated effect of unemployment on high-powered money growth is modest. The point estimate is that a one-percentage-point increase in the unemployment rate is eventually associated with base money growth of about 0.055 percent of trend GNP. Given that the sample average velocity of high-powered money was a little less than 11 during the sample period, this corresponds to an increase in base money of about 0.6 percent. Columns 5 and 6 of table 2 report estimates of the same model for the subperiods 1915-1953 and 1954-1983. These models appear to be very different. Base money growth seems to be positively related to unemployment and unrelated to nonwar deficits in the earlier period. By contrast, unemployment appears to have little power to explain money growth during the later period, 14Equations reported in earlier versions of this paper were also initially estimated with lagged short-term interest rates included since the interest rate is sometimes said to be a target of Federal Reserve Policy. The interest rates made no significant contribution to the explanatory power of these equations and were therefore omitted from the models.

343

while the deficit seems to be quite important. A test of the null hypothesis that the model is actually the same across the two subperiods yields an F-statistic of only 0.955 with 6 and 56 degrees of freedom. This test is not likely to be very powerful in detecting any actual differences across subperiods, however, since (the weighted values of) DEFN, and UN,-, have a correlation of 0.90 during the later period as compared with only 0.60 during the earlier one. Consequently, shifting the explanatory burden from the deficit (column 6) to the unemployment rate (as implied by the restricted model in column 4) is not likely to cause a very severe decline in goodness of fit during 1954-1983. When the 1954-1983 period is considered separately, however, the deficit seems to dominate the unemployment rate in explaining high-powered money growth. Dropping the unemployment rate from the 1954-1983 regression (column 7) does not substantially affect the standard error of the residuals but does reduce the size of the coefficients on the deficit. The data seem to suggest that for the 1915-1953 period, the apparent positive relation between government deficits and money growth is due to their common correlation with the level of aggregate economic activity. When unemployment was high, so was the government deficit. In addition, the government seems to have expanded the stock of base money somewhat more rapidly the higher the unemployment rate, possibly in an attempt to stabilize the level of economic activity. The resulting positive association between the deficit and money growth may be purely fortuitous rather than the result of a conscious attempt to monetize the debt. The data lend support to the notion that the deficit-money relation is due to stabilization policies rather than to monetization of the debt, since there is little remaining association between deficits and base money growth once lagged unemployment rates are added to the model.” The results in columns 6 and 7 seem to support previous studies which have reported a positive relation between government deficits and money growth. The results do not in fact support those previous findings, however. Both the dependent variable DM and the independent variable DEFN are, to one degree or another, positively trended over the 1950-1983 period.16 This raises the possibility that the apparent relation between them is spurious in the sense of Granger and Newbold (1974) and is due merely to the common trend. A time trend was included in the post-war models so that this possibility could be ‘SSome previous studies have also included the ratio of federal spending to either GNP or the money supply as an explanatory variable. Barre (1977) gives theoretical reasons why the levelof normal or permanent federal spending might not affect money growth. He defines a variable FED V to measure temporary federal spending on a national income accounts basis. An analogous variable defined on a cash basis was included in equations estimated for earlier drafts of this paper. It did not prove significant. It is possible that the variable WAR captures most of transitory federal spending. 16DM and DEFN were regressed on a constant and a linear time trend. The r-statistics on the time trend were 3.71 and 4.80, respectively.

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examined. The results, shown in columns 8 and 9 of table 2, indicate that the estimated effect of DEFN on money growth drops substantially and is insignificantly different from zero. The only previous author to find similar evidence was Niskanen, who discovered that when he allowed the mean rate of money growth to shift upward halfway through his sample, an apparent positive relation between deficits and money growth disappeared. These results indicate that DM and DEFN appear to be positively related during the post-war period because both are trended, but that deviations of DM from trend are unrelated to deviations of DEFN from trend.” The results do not rule out a scenario in which the size of the government’s cash deficit was an important determinant of the growth of high-powered money. The cash deficit may have drifted upward over time for reasons unrelated to money growth, and, in an attempt to monetize part of the deficit, the government may have allowed the growth of the high-powered money stock to follow the deficit upward.” It may also be that the growth of high-powered money drifted upward for reasons unrelated to the deficit and that the government allowed the deficit to follow money growth upward.

6. Empirical results - the real deficit

It is conceivable that higher base money growth could lead to a larger cash deficit if it led to higher expected inflation and thus to a higher nominal interest rate on government debt. If the higher expected inflation is realized, then this increase in the government’s nominal interest payments does not constitute an expense; it amounts to a partial repayment of the real value of the government debt. If one subtracts the inflation-induced depreciation in the real value of the debt from the government’s nominal interest expense, one is left with a measure of its real interest expense. Similarly, one can define the government’s real deficit to be its cash deficit less the depreciation in the real value of its debt. According to this definition, the government would run a zero real deficit over any given period if the real par value of its debt remained constant over that period. If the real rather than the cash deficit were the true target of government policy, and if the target real deficit displayed no trend over time, then the government would let the cash deficit drift upward with the inflation rate. [See, for example, Barro (1979).] If the government made no attempt to monetize “The coefficient on the time trend was insignificantly different from zero at usual significance levels in the 1915-1953 subperiod and its inclusion did not materially affect the models for that subperiod. ‘*The data contain evidence inconsistent with this hypothesis. When DM is replaced by the change in that portion of the monetary base under the direct control of the government, the coe4icients on the deficit are insignificant even without a time trend in the model.

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and mo~q~ growth

345

real deficits, then there would be no relation between real deficits and money growth. As long as money growth and inflation displayed a common upward trend, however, there would be a positive relation between money growth and the cash deficit.” The real government deficit (DEFR) was calculated by taking the difference between the cash deficit and the inflation-induced depreciation in the real value of the government debt held by the private sector and then deflating this difference by the trend value of GNP. The price level used in calculating the depreciation in the real value of the government debt was the Consumer Price Index. The data were, with a few exceptions, June observations. They were not seasonally adjusted. As with the cash deficit, DEFR was regressed on WAR to obtain a series, denoted DEFRN, uncorrelated with WAR. DEFRN was taken as a measure of the non-war real federal deficit. Equations analogous to those in table 2 were estimated using DEFRN rather than DEFN, with the results shown in table 3. The functional form for these models was arrived at by the procedure described in footnote 12. The weight for 1915-1953 war years was 0.4528. One can reject the hypothesis that all the coefficients on DEFRN are zero at the 4 percent level in the full 1915-1983 period (column 1). However, any effect of the real non-war deficit on base money growth appears to be transitory, since the sum of the coefficients is insignificantly different from zero at commonly used significance levels for the full sample and for both subperiods (columns 2 and 3). The sum of the coefficients on the unemployment rate is positive and significant at commonly used significance levels during the full sample and the earlier subperiod, suggesting that the monetary authority has pursued countercyclical polices. Most of the effect is concentrated at lag 2. The coefficient on WAR is uniformly positive and is significantly so in the full sample and the first subperiod. The evidence in table 3 is not consistent with the notion that the upward trend in the cash deficit since 1954 is due entirely to a similar upward trend in 19A necessary but not sufficient condition for this conjecture to be correct is that base money growth help explain the future values of the government’s nominal interest expense or the depreciation in the real value of its debt. The direrence between these two is that the depreciation in the real value of government debt in a given period depends on the actual inflation rate realized in that period, whereas the government’s nominal interest expense depends on inflationary expectations prevailing at the time the debt was issued. The implication that base money growth contains incremental predictive power with respect to the government’s nominal interest expense was checked by regressing nominal interest expense (deflated by the trend value of GNP) on eight lags of itself and four lags of DM over the period 1915-1983. A test of the hypothesis that the coefficients on lagged DM were all zero yielded an F-statistic of 2.56 with 4 and 56 degrees of freedom. This corresponds to a marginal significance level of 0.049. thus supporting the view that the growth of base money helps to predict future government interest expense. A similar test using the depreciation in the real value of the government debt rather than its nominal interest expense yields an F-statistic of 9.68, corresponding to a marginal significance level of less than 0.001.

346

D. H. Jobres,

Deficits

aud momy

growrh

Table 3 Estimated money growth equations: 2

3

DM,=~+I+C~,DEFRN,_,+~~WAR,+~GOLD,+CS,~N,-;+~,.” i-0

i-l

(2)

19151983

19151953

(3) 19541983

(4) 19541983

(5) 19541983

- 0.029 (0.020) 0.034 (0.021) 0.036 (0.017) 0.041 (0.038) 0.041

- 0.045 (0.028) 0.028 (0.029) 0.031 (0.023) 0.014 (0.059) 0.117

- 0.033 (0.071) 0.076 (0.066) 0.057 (0.052) 0.099 (0.127) 0.250

0.017 (0.029) 0.031 (0.035) 0.063 (0.029) 0.111 (0.043) 0.054

- 0.021 (0.031) 0.019 (0.032) 0.025 (0.031) 0.022 (0.054) 0.472

WAR,

0.061 (0.008)

0.063 (0.010)

0.109 (0.087)

0.100 (0.062)

0.056 (0.060)

GOLD,

0.701 (0.073)

0.722 (0.086)

-

-

-

- 0.007 (0.022) 0.038 (0.029) 0.028 (0.018) 0.059 (0.016) 0.001

- 0.009 (0.027) 0.055 (0.035) 0.024 (0.022) 0.070 (0.023) 0.006

0.081 (0.108) - 0.121 (0.092) 0.058 (0.070) 0.018 (0.129) 0.538

-

-

- 0.079 (0.114) -

- 0.217 (0.198) -

0.148 (0.726) -

0.243 (0.053) -

0.211 (0.050) 0.016 (0.006)

0.792 0.297 -0.12 0:OO 0.11 0.12

0.844 0.339 -0.22 - 0.10 0.02 0.16

0.332 0.244 0.16 0.09 0.07 0.18

0.264 0.240 0.10 0.16 0.05 0.18

0.411 0.219 - 0.03 0.09 - 0.05 0.18

(1)

DEFRN, DEFRN,-, DEFRN,-,

SlUll P-value

UN,-, UN,-2

UN,-3

Sum P-value Constant Trend R2

s(e) r1 ‘2 ‘3

s(r)

“Standard errors appear in parentheses below parameter estimates; s(e) is the standard error of residuals; r, is the sample autocorrelation of residuals at lag k; and s(r) is the approximate standard error of the autocorrelations. The P-value is the marginal significance level for testing the hypothesis that the coefficients on the current and lagged values of a variable are all zero. Estimation is by weighted least squares in columns 1 and 2. Observations for war years during the 1915-1953 subperiod are assigned a weight of 0.4528. Other observations receive a weight of 1.0.

base money growth. While the model in column 3 shows a lack of relation between base money growth and the real deficit (in contrast to the positive relation in the analogous cash deficit model in column 6 of table 2), deletion of the insignificant unemployment rates results in an apparent positive relation between real deficits and money growth. In fact, the sum of the coefficients is larger than for the analogous cash deficit model in column 7 of table 2. As with the real deficit, however, that relation appears to be due to a common upward trend in the r’eal deficit and base money growth. (A regression of DEFRN on a constant and a linear time trend yielded a r-statistic of 2.54 for the trend.) The upward trend in the real deficit suggests that not all of the secular increase in the cash deficit can be attributed to an attempt to offset a growing, inflation-induced depreciation in the real value of the government debt. It does not imply that no such offset was made, however.20 Nor does it imply that the secular increase in the real deficit is responsible for the upward trend in base money growth. The real deficit is inferior to a simple linear time trend as a predictor of base money growth. With a trend in the equation (table 3, column S), the coeffihents on the deficit become insignificantly different from zero, both individually and collectively. If the government did let the money supply accommodate the budget deficit, one would expect to see a positive deviation of the real deficit from trend eventually associated with a positive deviation of money growth from trend. The model in column 5 reveals no such predictive power of deficits. An increase today in the real deficit above trend appears not to be reliably associated with an increase in base money growth above trend either now or in the future.

7. Conclusions

The data examined in this paper provide no evidence that the growth of high-powered money is related to the nonwar government deficit, measured either in cash or in real terms, after controlling for the level of overall economic actiiity. High-powered money growth does appear to be positively related to war spending during periods when war spending is a substantial fraction of GNP. The data are consistent with the view that the government has set its target real deficit and the growth of high-powered money independently of each other and, since the early 1950s has let its nominal deficit drift upward in part, but not entirely, to offset a growing inflation-induced depreciation in the real value of its debt. 2oThe inflation-induced depreciation (as a fraction of trend GNP) in the real value of the government debt e ‘bited a secular increase after 1954. A regression of this variable on a constant and a linear time P end resulted in a r-statistic of 3.94 for the trend: A regression of DEFN on one lag of itself, a constant, a linear time trend and the current value and one lag of DEFRN resulted in a r-statistic of 2.41 for the trend. This indicates that the secular increase in the real deficit does not account for all of the upward trend in the cash deficit.

348

D. H. Joines,

Deficits

and monqv

growth

Appendix

Data on government deficits and high-powered money Annual data are for twelve-month periods ending on June 30 of the year indicated. The federal government’s cash deficit for the period 1940-83 is taken to be the sum of the unified budget deficit and outlays of federal off-budget entities. These outlays began in 1973. Data for 1940-76 are from the Budget of the United States Government, Fiscal Year 1983, table 23. Figures for 1977-83 were constructed from monthly data taken from various issues of the Treasury Bulletin. For 1929-39, the deficit is measured on the consolidated cash statement basis and is taken from Historical Statistics of the United States, Colonial Times to 1970, series Y 341. For 1869-1928, the deficit is measured on the administrative budget basis as reported in Historical Statistics, series Y 337. For 1917-33, the monetary base is calculated as the sum of currency in circulation and member bank reserves at the Federal Reserve on June 30 of the year indicated. Data on member bank reserves are from Banking and Monetary Statistics, 1914-1941 (henceforth called BMS, 1914-1941) table 102, and data on currency in circulation are from table 109 of the same volume. Prior to 1917 there were no member bank reserve deposits at the Federal Reserve, and the monetary base consisted entirely of currency in circulation. Data are from BMS, 1914-1941, table 109, for the years 1914-16 and from Historical Statistics, series X 423, for 1868-1913. All observations are as of June 30. Figures for state banknotes (Historical Statistics, series X 437) were subtracted from total currency in circulation for the years 1868-78. No state banknotes circulated after 1878. Data for 1914-33 incorporate an adjustment made by the Federal Reserve for gold coin presumed to have been lost or melted down. No such adjustment was made for prior years. Since both the adjusted and unadjusted series were available for 1914, changes in currency were computed from the adjusted data for 1915 and later years and entirely from the unadjusted data for 1914 and prior years. June observations on member bank reserves deposited with the Federal Reserve were taken from various issues of the Federal Reserve Bulletin for the period 1960-83, from BMS, 1941-1970, table 10.1, for 1942-59, and from BMS, 1914-1941, table 102, for 1934-41. The observations for 1942-59 were as of the last Wednesday of the month; all others were end-of-June figures. End-of-June data on currency in circulation were obtained from various issues of the Treasury Bulletin for 1971-83, from BMS, 1941-1970, table 11.1, for 1941-70, and from BMS, 1914-1941, table 110, for 1934-40. The monetary base was taken to be the sum of these two series and was calculated for the period 1934 to 1983.

D. H. Joines,

Deficits

atId monqv

growth

349

End-of-June data on Treasury currency outstanding, Treasury cash holdings, and Treasury deposits at the Federal Reserve were taken from various issues of the Federal Reserve Bulletin for the years 1971-83 and from BMS, 1914-1941, table 102, for 1916-41. Data on these series for the last Wednesday in June were taken from BMS, 1941-1970, table 10.1, for the years 1942-70. Several difficulties arise in constructing an annual series on war expenditures. Data on war spending are available in Historical Statistics, series Y 850, but this series is broken down only by war and not by year. Annual data on military spending are available from various sources, but these data include both war-related costs and some normal level of peacetime military spending. It also seems that the military incurs some war-related costs during a transition period after hostilities cease [see Kendrick (1955)]. The original war costs reported in Historical Statistics extend one year beyond the end of the conflict. Finally, some war expenditures appear in accounts other than those of the War, Navy, and Defense Departments. This is particularly true of both World Wars, during which the United States transferred large amounts of war materiel to its allies [see Clark (1941) and Wright (1949)]. Kendrick classifies the fiscal years surrounding and including each war up through World War fi into peacetime, wartime, and transition periods. Fiscal years during which the United States was actually engaged in hostilities are classified as war years. The transition period generally consists of the first fiscal year after hostilities ceased. Expenditure levels during these years were compared with those during peacetime periods generally consisting of five fiscal years before the first war year and five fiscal years after the last transition year. Kendrick made a few exceptions to this rule. Since the Spanish-American War lasted less than four months and was spread over two fiscal years, he did not designate a post-war transition year. He did, however, include both fiscal years 1920 and 1921 in the transition period after World War I. He also classified fiscal year 1941 as a year of transition prior to World War II. The United States had by that time begun to increase its military expenditures in anticipation of possible entry into the war and to make substantial transfers to Great Britain under the Lend-Lease program [see Wright (1949, pp. 794-797)]. The peacetime period following World War II consisted only of fiscal years 1948-1950, since the Korean War began on June 25, 1950. Kendrick’s classifications were used to compute war spending for the Spanish-American War and the two World Wars. During each of the war years (and the pre-war transition year of 1941), war spending was taken to be the excess of real federal expenditures for the national security and intemational affairs functions over the average of such expenditures during the five pre-war peacetime fiscal years. For the Spanish-American War, there were no international transfers to allies, and the relevant measure of national defense expenditures was taken to be the sum of Army and Navy Department spending (Historical Statistics, series Y 458 and Y 459). Transfers to allies were

an important component of war spending during the two World Wars, and the relevant measure of national defense expenditures was taken to be the sum national security expenditures and international affairs expenditures (Historical Statistics, series Y 467 and Y 468, followed by series Y 473 and Y 474). The same procedures and data sources were used to calculate Korean War spending. The pre-war peacetime period consisted only of fiscal years 1948-1950. and the single post-war transition year was 1954. United States troops were engaged in combat in Vietnam during fiscal years 1966-1973. War expenditures for these years were calculated in the manner described above. The data were obtained from the Budget of the United States Government for fiscal years 1970 and 1975. The expenditure items used were Department of Defense, Military, and foreign economic and financial assistance. The post-war transition period was taken to be fiscal years 1974 and 1975. War expenditures for 1975 were taken to be actual outlays for military and reconstruction assistance to Vietnam. War expenditures for 1974 were taken to be actual reconstruction assistance of $499 million plus assumed military assistance of $1 billion. Actual military assistance was included in Department of Defense accounts and was not broken out. The $1 billion figure was the amount budgeted for 1975, when such assistance was moved to the international affairs category of the budget. Net gold inflows amounted to $77 million in 1880 and $97 million in 1881. These figures are taken from Historical Statistics, series U 197 and U 198. Data on net gold inflows for remaining years are from BMS, 1914-1941, table 156. These data, in millions of dollars, are $403.6 (1916), $685.3 (1917), $3572.0 (1939), $4299.1 (1940), and $2697.9 (1941). Years denote twelve-month periods ending June 30. Data on the unemployment rate are from Historical Statistics, series D 86, for the years 1910-30 and 1944-70, from Darby (1976) for the years 1931-43, and from various issues of the Suruey of Current Business for 1971-83. The Consumer Price Index for the years 1908-18 is from Historical Statistics, series E 135. The data are for calendar years. Data for 1919-40 are from the Monthly Labor Review, October 1940. They are June observations except for 1921 (May), 1935 (July), and 1936 (July). Data for 1941-42 are also from various issues of the Monthly Labor Review and are June observations. Data for 1948-78 are June observations of the CPI-W series from the 1979 edition of Business Statistics. June observations of the same series for 1979-83 are from various issues of the Suruey of Current Business. Data have been converted to a 1967 base and are not seasonally adjusted. Reported price data for 1943-47 are distorted by World War II price controls. Barro (1984) reports estimates of inflation rates for calendar years 1943-47. These estimates are used to construct a mid-year price index series for 1943-48 by assuming that the inflation rate was the same in all months of a given calendar year.

D.H.

Joiues,

Deficits

md

nror~qv growth

351

Data on interest on the public debt for 1907-70 were taken from Historical are from various issues of the

Staristics, series Y 461. Data for 1971-83 Treasury Bulletin, table FFO-3. References

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