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  • Writer's pictureMathieu Provencher

Is government spending to blame for today’s inflation problem?

(taken from Wix's library)

Hello again everyone!

This is a follow-up article to the previous one (link here), discussing the conditions that are likely to have led to today’s (the past year or so in fact) high spikes in inflation.

As mentioned in the previous article, an increase in government spending can indeed lead to higher prices. This is especially true when that money is spent on what Economists call ‘consumption products’ (short-lived goods and services).

So, was the spending of our governments during the pandemic lockdown(s) to blame for the high inflation we have seen since the reopening of the economy?

As I have shown in the previous article, there was indeed a significant increase in government spending in several countries during the lockdown(s). However, we did not see a corresponding increase in consumption. In Canada, consumption spending between 2019 and 2021 (inclusively) increased by a mere 0.22% while in the USA, it decreased by almost 3% (from 2019 to 2020, 2021 numbers were not provided) and decreased by 2.2% both in the UK and in Germany (data from the World Bank).

This increase in government spending did not lead to higher short-lived consumption spending because, in most countries, shops, restaurants, cinemas, and other businesses were closed by the lockdown. Income support programmes from some governments, including Canada, kept demand somewhat stable for groceries and has helped increased it for online streaming and shopping, but not enough to compensate for the high decrease in demand in other consumption industries.

If these income support programmes had not been there, we would most probably have seen a significant decrease in prices, perhaps accompanied with social unrest. At least from a consumption perspective, inflation doesn’t seem to have come from those government programmes. Most of that increase in government spending seem to have been directed at improving and supporting the healthcare system (investment spending), which can yield benefits for years to come. The same goes for governments that spent money in updating their practices and moving government services to more efficient platforms (online services for example)

Looking at the other two factors I mentioned in the previous article, that money spent by governments came from borrowing (and not literally printing) and although it was indeed spent fairly fast and focused in few industries (except income support programmes, those were spread out), the size of that spending was not enough to generate inflation at that time.

So… if not because of government spending, why do we have so much inflation these days? There are in fact two different periods of inflation to consider here: (1) Q4 (October to December) of 2021 up to the heating up of the invasion of Ukraine (February/March of 2022), (2) 2022 following the invasion of Ukraine.

Before we do, please keep in mind that there is an overarching reason for prices to have increased so much lately: The Central Banks’ expansionary policies since 2008. As you may all remember, 2008-2009 saw an important economic crisis around the world, mostly in advanced economies. Central Banks (part of the government) of those countries stimulated the economy by lowering their interest rates and releasing huge amounts of money in the economy (generally referred to as Quantitative Easing). I’ve been advocating for a stop to these expansionary policies since around 2014 but they have kept going, in one shape or another, all the way to Q1 2022! The impact on inflation of what I will be presenting below have been multiplied by these stimulating policies of our Central Banks.

Let’s start with the first period, Q4 2021. I have identified four reasons for prices to have increased during that period: (1) pent-up demand, (2) production shocks, (3) transportation shocks, (4) labour shocks.

(1) The closure of many leisure industries meant that Canadians, and others around the world, saved more money than they were used to. This led to what we call 'pent-up demand', which is when people want to consume but are saving instead, leading to a build up of demand that is likely to spring into action as soon as it can… which happened when the pandemic lockdowns were removed.

For example, Canada saw an increase in savings of around 37.17% from 2020 to 2021 (savings decreased initially from 2019 to 2020 before the pent-up demand phenomenon started) while Germany’s savings increased by 12.05% and the UK saw an increase of 13.64% (data from the World Bank). A good part of those savings were converted into consumption when the economy reopened late in 2021, leading to a surge of consumption and an increase in prices. The increase in consumption does appear when comparing 2020 to 2021 but note that most economies reopened late in 2021, which means that most of that year saw low consumption and a substantial spike later in the year.

(2) As lockdowns were implemented around the world, many firms lost the ability to produce for a good time. Factories being closed, supply lines being disrupted, input and output contracts being paused… all of that meant that when the economies were reopening, firms were not able to quickly start producing again to meet the new (and higher) demand. It takes time for firms to resupply their factories, get workers back to work efficiently and set up supply lines. This led to a shortage of production, less production than there is demand, and this naturally leads to higher prices, and thus inflation for the economy.

(3) Transportation was also greatly disrupted during lockdowns. Local transportation was somewhat affected by a lack of truckers (discussed in the next point) and a lack of maintenance and availability of trucks and other vehicles. International transportation, however, was very strongly affected by the lack of boats and crews that make globalisation possible. Cargo ships were slow to be put back to work and international ports were very slow at reorganising themselves to run their operations efficiently. Stories about containers being left, empty, in ports instead of being reloaded for the next trip as well as waiting times for cargo ships of days on end were rampant in Economic news. All this led, again, to less products on the shelves while demand was high and growing, again bringing more inflation.

(4) lastly, but perhaps more importantly for today and tomorrow’s problems, was a significant shift in the labour market. Not many Economists seem to be discussing this but I have a feeling this will become a hot point of conversation in my field, and everywhere else most probably, in the next few decades. The pandemic brought with it a re-evaluation of many people’s priorities regarding their work-life balance. Many older workers decided, because of health concerns or just because the benefits were just not high enough anymore, to leave work and retire early (or earlier than they thought). At the same time, many young-ish and middle-aged people found that work had taken too much space in their lives and decided to, if given the opportunity, reduce their working hours or dedication to work (some of that is now called “quiet quitting” or, in China, “lying flat”). As less workers are available, or less productive at work, the supply for goods and services decrease even further, leading to more of those shortage problems I mentioned before.

I am quite excited about that because we may be witnessing a structural change in the labour markets of our advanced economies, perhaps more acutely in western economies. These shifts don’t happen very often guys so pay attention to the next 10 years or so, they may be very interesting… and very disruptive.

OK! Now that I’ve presented several reasons for inflation to have already increased in 2021, let’s see what new economic events have pushed prices in overdrive in 2022: (1) government spending, (2) energy prices.

(1) Government spending during the pandemic lockdown is, in my opinion, unlikely to have caused inflation in the economy. However, the latest spending plan of the government of the USA (a highly revised and watered-down “build back better plan” that adds up to around 1.6 trillion USD) is very likely to have brought more inflation than we would have had otherwise. Although this spending is mostly for infrastructure, which could lead to less inflation later down the line, the timing of that spending is very bad. Spending more in the economy when there is a supply shock never works out well, especially when talking about inflation. If that spending had been done during the previous president’s term or after the current inflation issues have been resolved, it would have been much better for the economy.

This is indeed something that is happening in the USA but since that country is so important in the world, it is unfortunately likely that at least some of that inflation is passed down to its trading partners, Canada being one of them.

(2) Disruptions in the oil and natural gas markets brought important increases in the price of energy worldwide. When energy prices increase, we normally see prices of everything else in the economy also increase. The war in Ukraine and the consequences of sanctions on Russia, and its retaliation following them, have put very high pressures on prices because of lower availability of those resources. When the price of commodities increases in important markets, such as Europe for example, they tend to increase everywhere (including in countries that have nothing to do with the shock). Note that the energy market is also facing an important speculative force that tends to multiply any potential problems and their impact on prices.

Well! This article is quite long but I hope it helped you guys understand much better how today’s high prices have come about.

Now, if several important economies in the world fall into recession in the next few months, as many economists are predicting (not me though, I am looking at something else at the moment), then inflation should go down. Lower levels of inflation over time are called 'de-inflation', which normally shows a movement of the economy back towards normality.

Also, price expectations are a very important factor that should never be forgotten. Once people start expecting prices to increase on a regular basis, inflation becomes endemic and it becomes very difficult to remove. We probably have not reached that point yet in the countries I have mentioned thus far but this is always a risk when inflation stays high for a long time. No amount of interest rate hikes will do if price expectations start going up and become self-sustained.

That’s everything for now! Take care everyone and don’t forget to have fun!!!

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