Sunday, September 18, 2005

Why Government Spending Is Inherently Inflationary

Note that the title of this post doesn't say "only deficit spending is inherently inflationary," which is the prevalent conception among laypersons, commentators, and even many economists. In the interest of keeping the preceding post from being any longer that it is, I glossed over the relationship between government spending, deficits, and inflation. This post fills the gap.

That government spending is inherently inflationary can be shown by the following first-order approximation of its effects, in the case where government spending is "financed" by taxes:
  • Suppose the GDP of the United States would be, as it is today, about $12 trillion in the absence of all government. (Actually, as I show here, GDP would be a lot more than today's $12 trillion in the absence of government -- defense and justice, excepted -- but I'm giving government some benefit of the doubt in this example.)
  • Suppose government arrives on the scene one fine day and says: "You Americans need our services, so we're going to tax you $2 trillion in order to provide things that we want you to have." A few of those things -- such as defense and justice -- will be worth something to almost everyone. Some of those things will be valued only by persons who want someone else to pay for them. Most of those things will be heavily regulatory and thus will detract from GDP. To assume, as I do in this example, that the $2 trillion is effectively thrown away is to be generous to government.
  • Government's edict has the same effect as if the producers of $2 trillion worth of valuable goods and services walk off the job. (More accurately, it's as if they walk off the job and begin to vandalize homes and businesses.) Only, in this case, government entices them off the job with $2 trillion in "tax dollars." But the the taxes are an illusion.
  • When the producers of $2 trillion worth of real output walk off the job, at the behest of government, it is as if government were destroying real output. But government pretends that it's producing $2 trillion worth of real output, so (1) it levies taxes for government services, most of which taxes fall on the productive sector, and (2) it pays producers of government services from those taxes.
  • But the producers of real output know what's happening, so they raise prices by enough to compensate for the taxes they're paying. And government collects those "empty dollars" in the form of taxes. Why are those tax dollars "empty"? Because they don't represent real output, government having destroyed the same by enticing producers out of the real economy.
  • In sum, government pays the producers of government services in "empty dollars," which those producers then try to spend on real output.And so we have $12 trillion chasing $10 trillion worth of real goods and services.
That's real inflation. No deficit spending necessary. And it happens every time government finds a way to widen the gap between what the productive sector could produce and what it actually produces, after government has worked its will.

What if government were to borrow the $2 trillion instead of raising taxes by $2 trillion? Borrowing doesn't change the outcome, just the way we get there. It's still as if the producers of $2 trillion worth of valuable goods and services walk off the job. Only, in this case, government entices them off the job with $2 trillion that it calls "borrowing" instead of "taxes." Again, if the producers of $2 trillion simply walk off the job, that leaves a real GDP worth $10 trillion. This time, however, the producers of that output don't raise prices to compensate for taxes; they raise prices to capture the $2 trillion that government puts in the hands of producers of government services. The result is as before.

Here's another way to look at it: Taxation results in supply-side inflation, as producers of real output raise prices to compensate for taxes; borrowing results in demand-side inflation, as producers of real output raise prices as government injects new money into the system.

What about the "crowding out" effect of government borrowing on private, growth-inducing investment? Here's the real story:
  • When government enters financial markets for additional funds, that raises the demand for money. The usual result would be higher interest rates, which would tend to dampen private investment and consumption to some degree.
  • However, when government borrows instead of raising taxes it leaves nominal dollars in the hands of the private sector. Some of those dollars flow into financial markets, thus increasing the supply of money.
The precise net effect depends on the marginal propensity to save, and on the elasticity of investment and consumption with respect to interest rates. But it seems likely that the net effect of government borrowing is close to zero. As I wrote here:

The actual effect of government borrowing on interest rates -- and thus on the cost of private capital formation -- is minuscule, and perhaps nonexistent, as Brian S. Westbury explains:

The theory [that deficits drive up interest rates] suggests that deficits "crowd out" private investment, putting upward pressure on interest rates. In other words, government borrowing eats up the available pool of capital. But today's forecasted deficits of $300 to $500 billion are just a small drop in the pool of global capital markets. In the U.S. alone, capital markets are $30 trillion dollars deep, for the world as a whole they approach $100 trillion. Deficits of the size projected in the years ahead cannot possibly have the impact on interest rates that many fear....

The next time someone tells your that taxes should be raised in order to be "fiscally responsible" and to stem the tide of inflation, tell him this: Government spending is inherently irresponsible because it reduces real output. And government spending is inherently inflationary, not matter how it's financed.