Front Page Titles (by Subject) 6.4.: Inflationary Expectations under Leviathan - The Collected Works of James M. Buchanan, Vol. 9 (The Power to Tax: Analytical Foundations of a Fiscal Constitution)
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6.4.: Inflationary Expectations under Leviathan - James M. Buchanan, The Collected Works of James M. Buchanan, Vol. 9 (The Power to Tax: Analytical Foundations of a Fiscal Constitution) 
The Collected Works of James M. Buchanan, Vol. 9 The Power to Tax: Analytical Foundations of a Fiscal Constitution, Foreword by Geoffrey Brennan (Indianapolis: Liberty Fund, 2000).
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Inflationary Expectations under Leviathan
In order to explore more fully the question of what expectations concerning inflation individuals might rationally adopt under Leviathan government,8 we shall examine three simple cases:
In each case, the assumption is made that fiat money is acceptable by the government in payment of taxes so that the implicit resource base of the money stock is validated. We also assume that other taxes exist of such magnitude as to ensure that liabilities more than absorb the payback requirements of fiat money issue.
Permanent Leviathan: the three-period case. Suppose in period 1 that the government releases an initial money stock of 100 units and that taxpayers believe that no increase in the supply of money will occur in the second period. They will then exchange for that money stock a certain quantity of real goods and services—$100’s worth at period 1 prices. When period 2 comes, the revenue-maximizing government has a clear incentive to inflate to the maximal extent possible. If, for example, it increases the money stock to 1000 units, and individuals believe that no further inflation will occur, there will simply be a denumeration of the currency so that new prices are 10 times the old ones. By this period 2 inflation, the government obtains a further quantity of real goods and services equal to nine-tenths of the quantity that it obtained initially. In the third period (and final period in this model), the government simply allows individuals to use cash to pay off their tax liabilities at second-period prices—a real payment of $100’s worth at period 1 prices, or $1000’s worth in period 2 prices. The government has gained additional revenue here equal to nine-tenths of the value of the money stock (when inflation is expected to be zero). What has happened is that the initial “loan” of real resources made by individuals to government when they accepted money (interest-free debt) is effectively denumerated in money terms. Those individuals can in period 3 only “buy back” tax relief at period 3 prices. Inflation enables government to organize for itself a capital gain worth virtually the full amount of the real value of initial money stock. We should note that this incentive toward maximum inflation is independent of individuals’ inflationary expectations. If citizens believe that a tenfold increase in the money stock will occur, they will be prepared to hold money only up to the point where the capital losses due to the inflation are compensated by the transactions virtues of money. Period 1 prices (i.e., the relative values of goods and money) will be such as to be equal to period 2 prices minus the marginal
benefits of holding money per se. Whatever initial price level obtains, however, it is always in Leviathan’s interests to inflate to the maximum possible extent.
Recognizing that maximum inflation—independent of inflationary expectations and hence of initial prices—is the dominant strategy for Leviathan, the rational citizen will not hold any cash balances at all. The taxpayer-government interrelation is precisely identical to that which occurs with a tax on wealth,9 and can be depicted in the game matrix as shown in Table 6.1. The taxpayer will recognize that if he holds cash, the government will maximize the rate of inflation, hence imposing a cost larger than that consequent upon holding no cash balances at all. The predicted outcome is the lower row, with zero payoffs to both parties, whereas both could secure positive payoffs in the upper right-hand cell.
Permanent Leviathan: unbounded time horizons. Games of the sort depicted above are, as is well known, more likely to have socially superior solutions when played over long periods, particularly if there is no end point. Even in the absence of an explicit monetary constitution, government may rationally refrain from inflicting maximum inflation in every period in the expectation that individuals may be induced to hold positive cash balances. Since a necessary condition for holding positive cash balances is that citizens believe that government will not maximally inflate, it is in government’s interest to establish an environment in which citizens hold those beliefs. To do this, Leviathan needs to play a strategy of restraint.
It is, however, clear that any outcome of this type, in which individuals hold positive cash balances and Leviathan exercises voluntary restraint in new money creation, is inherently precarious. If such an “equilibrium” can be achieved, it seems reasonable to suggest that it may also be achievable after implicit agreement has broken down. In that case, the cost to Leviathan of departing from the “equilibrium” is determined by the number of periods (noninfinite) in which individuals will aim to hold zero money balances, until confidence in government restraint is reestablished. Periodic departure from the policy of restraint may therefore be in Leviathan’s interests.10
A very simple form of the playing of such a game is described in a short note by Harry Johnson.11 In Johnson’s discussion, he assumes (Cournot-like) that citizens believe that government will in each period inflate at the rate applying in the previous period. In this rather simplistic case, he shows that it is rational for Leviathan to depart from a stable inflationary equilibrium and “play” alternately high and low rates of inflation. In other words, the constant rate of inflation strategy is dominated by the policy of alternate high inflation and low inflation.
As Johnson himself observes, the expectations imputed to citizens in this model seem highly questionable. But it is of the essence that, in situations of this type, expectations are difficult to model. A small increase in inflation rates may lead individual money holders to unload cash very quickly, if it leads citizens to believe that larger inflation rates are imminent. Alternatively, quite substantial variations in the money stock may lead to little change in real money balances or inflation rates. The adjustment of desired real money balances (and therefore prices) to changes in the money stock seem impossible to predict here, but seem likely to be extremely volatile. Needless to say, in this setting, the “revenue-maximizing inflation rate” as derived in a world of perfect foresight is totally inapplicable—and indeed must be under anything other than a fixed predetermined monetary rule, because it is only with such a rule that perfect foresight is possible. In much the same way, the extent of revenue that may be obtained from the money-creation power must remain somewhat doubtful. The level of money balances individuals would be prepared to hold in the absence of a given money rule is presumably quite different from that which they would hold in the world of perfect foresight. Whatever the influence on revenue potential, it seems clear that the welfare costs in terms of surplus forgone will be much higher in the absence of a fixed money rule. As we have shown in Chapter 5 in relation to wealth taxes more generally, if governments have discretion over effective rates welfare losses seem certain to be higher than in the case where tax rates are known with certainty ex ante.
Probabilistic Leviathan. In what ways would the foregoing model be altered if governments only assume Leviathan attributes occasionally? One of the interesting features of the perpetual Leviathan model is that it seems likely that government would not be motivated to act so as to maximize aggregate revenue in each period. Leviathan-like attributes will not always be in evidence. This is because the cost in revenue forgone in future periods exceeds the benefit in current revenue obtained—at least over some range.
With a Leviathan government operative in fact only occasionally, these prospects of lost revenue in future periods are hardly relevant. These costs will not be borne by the revenue-maximizing government itself. Hence, when and if such a revenue-maximizing government does come into power, it could be expected to inflate to the maximum extent possible. As long as notes have value, it will continue to print them.
In one sense, this model introduces an additional element of volatility into taxpayer-citizen expectations. If a government is recognized to have Leviathan-like properties, a very rapid inflation may ensue as individuals try to dump cash on the market—and this sort of inflation could be substantially independent of any increase in the money stock as such. The modest built-in constraints in the perpetual Leviathan model are not operative in this situation, and taxpayers-citizens will recognize this fact. Even the risk of massive exploitation through inflation will not necessarily be sufficient to prevent individuals from holding any cash at all. But such risk will rationally be taken into account in determining the desired quantities of real money balances. It is interesting to note here that the taxpayer-citizen may gain virtually nothing from the relative frequency of “good” government. If government has the power to create money, the citizen who holds cash remains open to exploitation by the occasional revenue-maximizing Leviathan who may obtain office, and the costs of potential exploitation may not be much different from those that would be incurred under a continuous revenue-maximizing Leviathan.
[8. ] Our analysis in this chapter has both points of similarity and points of difference with the “rational-expectations” models that have been developed in modern macroeconomic theory. (See Thomas Sargent and Neil Wallace, “Rational Expectations and the Theory of Economic Policy,” Journal of Monetary Economics, 2 (April 1976), 169-83; and R. E. Lucas, “Econometric Testing of the Natural Rate Hypothesis,” in O. Eckstein, ed., The Econometrics of Price Determination Conference (Washington, D.C.: Board of Governors of the Federal Reserve System, 1972). Like economic orthodoxy generally, these models do not contain a specific objective function for government, although implicitly, government is considered to be interested in promoting the standard macroeconomic policy goals. The models concentrate attention on the prospect that the individual will be able to act on the same information that is available to government; hence, government cannot independently influence behavior in a way that is not subsequently validated. Government cannot “fool the people.” Our revenue-maximizing Leviathan does have a specific maximand, and the fully “rational” citizen-taxpayer may know what this is, but such knowledge cannot eliminate the strategic aspects of the interaction between the individual and government, as our analysis indicates. For example, if the individual predicts that Leviathan will adopt the revenue-maximizing permanent rate of inflation and acts on this prediction, Leviathan will find it to its own interest to inflate beyond such limits. To our knowledge, the only specific critique of the rational-expectations literature that concentrates on these strategic aspects is that by Gerald P. O’Driscoll and Andrew Schotter, who do not, however, model government in Leviathan terms. See Andrew Schotter and Gerald O’Driscoll, “Why Rational Expectations May Be Impossible: An Application of Newcomb’s Paradox,” Discussion Paper, Center for Applied Economics, New York University, November 1978.
[9. ] See Chapter 5, note 3.
[10. ] For a discussion of this point that has some similarity to our treatment, see Larry A. Sjaastad, “Why Stable Inflations Fail: An Essay in Political Economy,” in Inflation in the World Economy, ed. Michael Parkin and George Zis (Manchester, England: Manchester University Press, 1976), pp. 73-86.
We should note that a shift from a high rate to a low rate of inflation may, for a short period, increase rather than decrease government’s revenue-raising potential in money creation. If the shift causes persons to expect higher values of the money unit, they will seek to increase money balances. Government may, temporarily, gain more from the increased money creation dictated by a response to this demand than it loses by the initial shutdown or slowdown of the presses. On this point, see Gordon Tullock, “Can You Fool All of the People All of the Time?” Journal of Money, Credit and Banking, 4 (May 1972), 426-30.
[11. ] Harry G. Johnson, “A Note on the Dishonest Government and the Inflation Tax,” Journal of Monetary Economics, 3 (July 1977), 375-77.