M.K.Y. Fung et al Journal of Development Economics 61(2000)111-135 decline in government fiscal revenue and the lack of a mechanism that imposes effective financial control over the state sector. In the process of reforms, as marketization deepened, many state-owned enterprises began to suffer heavy losses and could no longer generate as much revenue for the state as they did in the years before 1978. Moreover, without an effective internal revenue system, the government had a great difficulty in collecting taxes from the newly developed non-state sector. Consequently, there was a sharp decline in the consolidated government budget revenue, falling from over 34% of GNP in 1978 to just above 10% in the early 1990 On the other hand, the overall investment level in the state sector remained hig and even exhibited an increasing trend in 1990s(see Naughton, 1995). With the onopolization of the financial sector, the state relied heavily on the state-con- trolled banking system directly and indirectly to raise funds so as to substitute for declining direct budgetary revenues. Both local governments and the central government compelled the banking system to provide credit for their priority investment projects. Further, the government allowed the loss-making state-owned enterprises to borrow from the state-controlled banking system. This perverse flow of bank credits constituted monetizing the government expenditure and thus, was the major cause for the loss of control over the money supply, which in turn led to the rapid increase in the general price level The presence of a large government deficit is a common problem in many economies burdened with either social welfare programs or producer subsidization schemes, or both. Usually, there are two ways to finance the government deficit printing money and/or issuing bonds. Financing deficit through money creation constitutes taxing the money holders through inflation; and bond financing is to shift the fiscal burden from the current generation to the future generations Conventional wisdom suggests that financing budget deficit by money creation will generate high inflation and thus social instability. It is for this reason that In China, the process of decentralization and marketization in the financial sector has been rather limited. Although the banking system has been restructured, and now consists of a central bank and a group of specialized banks, it remains state-controlled. The central bank can tightly control the llocation of bank loans whenever it is necessary. In addition, only government agencies and tate-owned enterprises are permitted to raise funds by issuing bonds. The estimated total budget deficit was 6% of GDP in 1988 and 1989, and 8% of GDP in 1990 and 1991(See Wong et al., 1996) tandard textbooks suggest that, by using the traditional IS-LM model, monetization alw to more inflation. This conclusion is first questioned by Sargent and Wallace (1981). They conditions under which the conclusion is exactly reversed, and term it "unpleasant me arithmetic". Subsequent authors have debated on the theoretical and empirical validity of these conditions. See for example, Darby(1984), Scarth(1987), Papadia and Rossi (1990), Dotsey (1996) and Bhattacharya et al. (1998)M.K.Y. Fung et al.rJournal of DeÕelopment Economics 61 2000 111–135 ( ) 113 decline in government fiscal revenue and the lack of a mechanism that imposes effective financial control over the state sector. In the process of reforms, as marketization deepened, many state-owned enterprises began to suffer heavy losses and could no longer generate as much revenue for the state as they did in the years before 1978. Moreover, without an effective internal revenue system, the government had a great difficulty in collecting taxes from the newly developed non-state sector. Consequently, there was a sharp decline in the consolidated government budget revenue, falling from over 34% of GNP in 1978 to just above 10% in the early 1990s. On the other hand, the overall investment level in the state sector remained high and even exhibited an increasing trend in 1990s see Naughton, 1995 . With the Ž . monopolization of the financial sector, 2 the state relied heavily on the state-con￾trolled banking system directly and indirectly to raise funds so as to substitute for its declining direct budgetary revenues. 3 Both local governments and the central government compelled the banking system to provide credit for their priority investment projects. Further, the government allowed the loss-making state-owned enterprises to borrow from the state-controlled banking system. This perverse flow of bank credits constituted monetizing the government expenditure and thus, was the major cause for the loss of control over the money supply, which in turn led to the rapid increase in the general price level. The presence of a large government deficit is a common problem in many economies burdened with either social welfare programs or producer subsidization schemes, or both. Usually, there are two ways to finance the government deficit: printing money andror issuing bonds. Financing deficit through money creation constitutes taxing the money holders through inflation; and bond financing is to shift the fiscal burden from the current generation to the future generations. Conventional wisdom suggests that financing budget deficit by money creation will generate high inflation and thus social instability. 4 It is for this reason that 2 In China, the process of decentralization and marketization in the financial sector has been rather limited. Although the banking system has been restructured, and now consists of a central bank and a group of specialized banks, it remains state-controlled. The central bank can tightly control the allocation of bank loans whenever it is necessary. In addition, only government agencies and state-owned enterprises are permitted to raise funds by issuing bonds. 3 The estimated total budget deficit was 6% of GDP in 1988 and 1989, and 8% of GDP in 1990 and 1991 See Wong et al., 1996 . Ž . 4 Standard textbooks suggest that, by using the traditional IS-LM model, monetization always leads to more inflation. This conclusion is first questioned by Sargent and Wallace 1981 . They provide Ž . conditions under which the conclusion is exactly reversed, and term it ‘‘unpleasant monetarist arithmetic’’. Subsequent authors have debated on the theoretical and empirical validity of these conditions. See for example, Darby 1984 , Scarth 1987 , Papadia and Rossi 1990 , Dotsey 1996 , Ž. Ž. Ž. Ž. and Bhattacharya et al. 1998 . Ž