Thursday, May 19, 2011

Is Fiscal Crisis Possible With Floating Exchange Rates?

When the comparison is made between the fiscal problems of for example Greece and the fiscal problems of the Unites States, many people argue that the United States could never get into similar problems because it has its own currency and could thus essentially print its way out of any fiscal crisis (unless it is self-imposed because of the debt limit, but that is a somewhat different matter).

It is certainly true that having a printing press makes deficit spending easier, but it is not the case that it makes a fiscal crisis impossible.

If it really had been the case that an own currency makes a fiscal crisis possible, why can we now read that Egypt turns to the IMF for loans? And why has four European countries with independent floating currencies, Iceland, Ukraine, Hungary and Romania also felt compelled to turn to the IMF. Are these governments just uninformed?

More likely is that they are afraid of the downside of financing through the printing press: it could lead to escalating inflation. Unless you're willing to let inflation spiral out of control you must limit your money printing. And that in turn means that you can in fact become unable to finance the deficit.

And even if the government don't care about the inflationary consequences, it might still not be able to finance the deficit through the printing press if inflation increases so much that it becomes hyperinflation, something that might cause a total collapse of the currency, like in Germany in 1923 or Zimbawe in 2009.

These scenarios are highly unlikely in the near future for the United States-or Britain or Japan. But they are not impossible in a more distant future.