Wednesday, June 10, 2009

Inflation and the Size of Government

Copyright, The New York Times Company

The federal government is spending a lot these days, and going deeply in debt. Although it is easy to imagine high inflation as a consequence of excessive government spending, inflation rates and government spending are weakly correlated, if correlated at all.

John Maynard Keynes wrote the most important and insightful economics book ever — “The Economic Consequences of the Peace” — successfully predicting an instance in which excessive government spending would create inflation, and worse. Published shortly after World War I, the book analyzed the economic capacity of Germany, and explained how it was not nearly enough for the German government to pay the debts (“reparations”) imposed on her by the Allied powers’ Treaty of Versailles.

Dire political and economic consequences would result from the excessive debt burden created for Germany by the Treaty of Versailles, Keynes wrote. The Allied powers did not reduce the reparations nearly as much as Keynes recommended; the German economy and polity subsequently produced hyperinflation, the Holocaust and violent contributions to World War II.

The Bush and Obama administrations have added, and continue to add, much to the United States’ national debt. Both Republicans and Democrats spend too much of taxpayers’ money, but excessive government spending does not mean that inflation will necessarily — or even probably — follow.

The Treaty of Versailles gave Germany debts that amounted to years of the nation’s gross domestic product, whereas 2008-9 bailout mania has so far given us debt that amounts to “only” several months’ G.D.P. Moreover, thanks to the emergence of payroll taxation and income tax withholding, the capacity of governments to tax its citizens without resorting to inflation is much greater than it was before World War II. Neither inflation nor war will be needed to settle the debts that Presidents Bush and Obama are giving us.

Last year the Federal Reserve Board’s Song Han and I published a study of 80 countries where we looked at the correlation between inflation and government spending. We found inflation to be similar (or even somewhat less) in countries whose governments spend more for nonmilitary purposes as compared to countries whose governments spent less.

Our study found significant positive correlations between inflation and government spending only in cases when military spending grew — as it does during wartime. But the government spending growth we have seen in 2008 and 2009 comes from the nonmilitary part of the budget.

Taxpayers will suffer as a result of the federal government’s recent and excessive spending, but a great many taxpayers around the world have faced similar liabilities, while nonetheless experiencing modest or low inflation.

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