•  Fifth, there may be a lurking fear that the government will be tempted to acquiesce to inflation and currency depreciation as the means both to repair its current finances (if it believes that revenue may be affected more quickly and positively than expenditure) and to reduce the real value of its outstanding indebtedness. •  Sixth, there may be a consequential fear that, as a means to that end, the government will seek to monetise its debt – "printing money" to fund the deficit. This would, however, require the cooperation of the central bank, and in most jurisdictions nowadays there is some form of prohibition on the central bank abetting such a strategy. More specifically, governments tend to be prevented – by force of law or moral pressure – from obtaining finance direct from the central bank (eg as might occur if the bank was forced to take up issues of government securities in the primary market), although the central bank is invariably permitted to buy (or sell) government paper in the secondary market as part of its discretionary monetary policy operations. Practical experience What of experience in the real world? Reference has already been made to the case of the United States. The US government is regarded as just about the best credit risk in the world and there is a huge global appetite for US treasury securities. The Federal Reserve has an equally strong track record in avoiding inflation.
Between these two extremes – the US and the no-hoper – there are of course many cases where the situation is less clear-cut or less predictable. Euroland provides an interesting example. Given the careful steps which were taken before the advent of the euro to ensure the insulation of monetary from fiscal policy and to outlaw monetary financing of budget deficits, we might wonder why the news of impending budget overruns should cause the euro to weaken. It seems that not only do credit spreads faced by individual deficit countries widen (presumably for fear, however slim, of sovereign default), but also the currency weakens for fear of governments conspiring with the central bank to abandon its mandate against inflation or to break the rules against monetary financing. A rather different interpretation could be that foreign exchange markets are merely exhibiting a pavlovian reaction: having been brainwashed to the effect that a deficit is inherently bad if it surpasses certain preannounced limits, the reaction when such a breach does occur is bound to be negative, even if analysis of the substance underlying the breach provides little or no justification for such a reaction. In the context of trying to identify a relationship between the fiscal position and the exchange rate, these examples demonstrate that there is no simple, pre-ordained relationship. The outcome depends on a wealth of factors, including the nature of the disturbances affecting public finances, the policy regime and policy responses, and the state of sentiment in financial markets.