Does government spending bring inflation?
(Picture from Wix's library)
Let’s tackle a big political question that has been at the center of many debates lately: the link between government spending and inflation.
Many governments around the world spent substantial amount of money supporting their people during the government lockdowns of the economy.
During that time, not only did governments give income support to their people but they also spent large amounts of resources (money, public servants, equipment) reacting, preparing, and adapting to the pandemic. A few examples include Canada’s increase in total government spending by 22.39 billion Canadian Dollars (5% increase) between 2019 (right before the pandemic) and 2021 (somewhat end of the lockdowns). The UK had an increase of 30.08 billion pounds (7.6%) while Germany had an increase of 44.34 billion Euros (6.8% increase), both during that same period (data from the World Bank).
SO, what’s wrong with the government spending money in your economy, especially since those economic troubles were caused by the government lockdown to start with (although it could indeed have been justified to do so, depending on your views… I have an article on that topic if you want to read more, link here)?
Well… higher government spending is often blamed for higher inflation in the economy. Higher inflation is a problem for most people since it makes everything more expensive while their incomes might not increase (enough) with it, we call that a decrease in purchasing power (or real income in Economics).
In fact, an increase in spending by the government might indeed lead to higher prices but it may also lead to lower prices… over time. There are many factors that influence how much inflation (or even perhaps deflation) will come out of government spending programmes. I will present three major factors affecting the direction of prices as well as the size of that change. One extremely obvious factor is not mentioned here because it is indeed self-explanatory: how much is spent… more spending is more likely to lead to more inflation.
The first, and perhaps most important factor, is the provenance of that money. There are two main ways governments can use to get money and spend it in the economy: borrow it or just make it.
If that money is borrowed, perhaps by selling government bonds (also called securities), the risk of inflation is much lower. Money that is borrowed usually needs to be repaid, which means that the entry of money in the economy right now will be an exit of money later (perhaps by lowering government spending later or increasing taxes, which reduces private spending). Monetarists (a sub-group of Neo-Classical economists) have rightfully pointed out the link between the size of the money supply in the economy, or rather the change in that size, and the level of prices. A lot more money in the economy leads to, eventually, higher prices (if real GDP is not increasing very fast at that same time).
If that money is created (freshly printed) instead, then the risk of inflation is much higher. Actually, printing money (literally printing more, not what we call quantitative easing, or QE) is the best way to create hyperinflation in a country, one of the most destructive economic event that can plague an economy (and also my favourite topic of Economics). I have an article describing how printing more money leads to higher prices in your economy, you can find the link here.
The second factor is the spending period. What I mean by that is how spread out that government spending is, both in terms of timeline and in terms of industries or regions. When government spending is very abrupt, or very concentrated in a specific industry or region (province or state), it can lead to a bigger increase in inflation in the short run.
Government spending might not lead to much inflation when it is well expected by markets and when it is distributed relatively slowly. The more time markets have to adjust to new spending and new economic conditions, the less they have to rely on substantial changes in prices instead of slow and calculated changes in production.
The last factor I want to mention today are the recipients of that spending. When governments spend on what Economists call consumption products, which are short-lasting goods and services (restaurant food, gasoline, cinema tickets), there might be a short-run benefit to doing so (more things are bought, more things are made, more people are employed) but there is generally no, or very low, long-run benefits. As such, that money spent on consumption products today will just lead to more money in the economy later without any corresponding increase in production later. Those products that were purchased were consumed and are now gone. This comes back to the first factor, which measures if that extra money stays in the economy or gets removed, or used, in the future.
If, instead, governments spend on what Economists call investment products, which are long-lasting goods and services (affordable housing, infrastructure like bridges and factories), then inflation might not be generated at all from that spending. In fact, spending in investment projects might lead to more productivity, lower costs, and perhaps even lower inflation in the somewhat near future. Please note that not all infrastructure projects are beneficial to the economy or to society in general, only the ones that bring clear production or lifestyle improvements to their populations will limit the amount of inflation generated by such spending.
This little article of mine is getting a bit too long for that format and I have so many other things to tell you guys!
I will end that one here and write another one soon to discuss the current levels of inflation around the world and see how much of that new-ish inflation is due to our governments spending money during the pandemic and afterwards.
I will also get back into making podcasts from my new articles for those that prefer that format. I need to re-learn how to make it work but don’t despair my avid listeners, I am going to succeed… eventually.
Stay tuned for more and have lots of fun everyone!!!