Governments in the developed world have spent record amounts of money, leading to unprecedented levels of deficits and debt. In the United States, for instance, $3.5 trillion dollars of pandemic-related spending helped create record deficits, and debt has climbed to more than $30 trillion – equal to more than 100 percent of America’s annual economic output.
Price levels also are climbing in many industrialized nations. Once again, the United States is an unfortunate example. As of December 2021, seasonally adjusted consumer prices as measured by CPI-U were up 7.1 percent year-over-year. That’s the highest level in about 40 years.
Are these two facts related? Are we seeing higher levels of price inflation because of fiscal profligacy? Some Republican U.S. Senators and Representatives have blamed this acceleration of price inflation on Biden’s blowout of federal spending.
There are many good reasons to criticize Biden’s spending spree. It is not good for the economy to increase the burden of government spending and push for higher tax rates on work, saving, investment, and entrepreneurship.
But that does not necessarily mean deficit spending is inflationary. Nobel laureate Milton Friedman observed, “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
This does not mean there is some sort of formulaic relationship among the monetary base, which central banks determine; the supply of money, which central banks influence; and price inflation. Indeed, Friedman noted that there is a “long and variable lag” between a change in monetary policy and its effect on prices.
That being said, the relationship definitely exists. Price inflation occurs when the supply of money exceeds the demand for money, which reflect the cumulative decision of households and businesses. To resolve this imbalance, households and businesses bid up the prices of goods and services until the supply of money and the demand for money are back in balance. In other words, price inflation.
Notably, none of the mechanisms that central banks use for monetary policy (buying and selling government securities, setting interest rates paid on reserves, loans to financial institutions, etc) have anything to do with federal spending or budget deficits. The Fed and other central banks can maintain price stability regardless of whether governments are enacting reckless fiscal policies. All of which helps to explain why scholars (see here and here) do not find a meaningful statistical relationship between deficits and inflation.
So why, then, do some people claim more government spending and higher government budget deficits cause rising prices? To be fair, this is not an unreasonable concern. Some governments, particularly in less-developed countries, cannot easily borrow money and they rely on their central banks to finance their budget deficits. And that is clearly inflationary.
But developed countries generally are not subject to the same constraint. International investors seem willing to lend endless amounts of money to the United States Treasury, notwithstanding record levels of debt. And Japan’s government also has no problem borrowing money, even though it has an even greater level of debt.
Having pointed out that deficits and debt do not necessarily lead to rising prices, now let’s now explain why it might happen in the future.
Excessive government spending, large and sustained budget deficits, and a rising level of government debt eventually may cause investors to get nervous about whether governments will honor their financial commitments. To the extent that investors think a government may be heading toward a Greek-style fiscal collapse, those investors may demand higher yields on government bonds to compensate them for the higher risk of default. Higher yields increase the cost of servicing government debt, potentially creating pressure to restrain spending on entitlements and other programs.
Needless to say, politicians will not want to do that. As such, they in response may press central banks to pursue a more accommodative monetary policy to reduce interest rates and lower government debt servicing costs. This has happened before in the United States. Between 1945 and 1951, the Truman administration cajoled the Fed to hold down the yields on long-term Treasury bonds to contain debt servicing costs after the large accumulation of federal debt during the New Deal and World War II. The Fed acceded to Truman’s demands. The result was high price inflation. Between the end of World War II in September 1945 and the Treasury-Fed Accord in March 1951, which ended this practice, CPI-U rose by 43 percent.
The purpose of this column has been to explain that bad fiscal policy is not necessarily inflationary. A government can have big deficits and lots of debt and still have stable prices. Japan is a good example. But some readers may be wondering why prices are rising in other nations. What’s causing inflation, if not budget deficits and government debt?
The most plausible answer is that central banks have been pursuing an inflationary policy. But they’ve been pursuing that approach not to finance budget deficits, but instead are motivated by a Keynesian/interventionist viewpoint that it is the role of central banks to “stimulate” the economy and/or prop up the financial market with easy-money policies.
Now the chickens have come home to roost.
Dan Mitchell will be traveling this year with the Free Market Road Show, presenting keynotes in Castellon (Apr 4), Barcelona (Apr 5), Madrid (Apr 6), and Porto (Apr 8). We will also welcome him for the events in London (Apr 25), Paris (Apr 26), and Zurich (Apr 28). You can find out all the cities the FMRS will visit this year here.