Deficits and Spending Are a Tax, But They Do NOT Cause Inflation

There’s been a lot of sloppy thinking about inflation in the run-up to this week’s elections. Campaigning lends itself to broad, rather than nuanced, pronouncements. Successful governance requires the reverse. And so as the new Congress wends its way to Washington, it must think carefully about inflation and price levels.

Scott Shepard

Scott Shepard

A bit of clarity to begin with: Government spending, and even government deficit spending, do not by themselves cause inflation. They only cause inflation if they also cause the value of the currency to fall against other currencies and fixed assets for which there isn’t much powerful use demand, such as gold. (That, after all, is the definition of inflation.)

The unique power that government has, alone amongst other market actors, is that it can cause inflation or deflation – it can change the value of the currency itself. No other actors can, except in the far margins, do that. (One marginal example: War, especially to unconditional surrender. The Yankees did a number on the Confederate currency, eventually driving it to valuelessness because it had much bigger armies than the foe. But unless Xi is even more sinister than many of us have come to realize, we can set that aside for now.)

If government removes a formal peg between a currency and fixed assets, like Richard Nixon did when he closed the gold window in the early ‘70s, currency depreciation will follow. Likewise, if a government abandons an informal, policy-driven peg, as Jim Baker did as Treasury Secretary during Ronald Reagan’s second term, or as the W. administration did in the early aughts, depreciation will follow.

But without that sort of action, currency depreciation will not follow merely from large bouts of government spending, even if it’s deficit spending. In the absence of depreciation, the government is merely a market actor. Yes, it’s a market actor that doesn’t by itself produce anything, and so takes all it gets and spends because of its monopoly on force: Ultimately, if you don’t give the government what it demands from you, it will shoot you and take your stuff anyway. And because of that anomaly, governments should spend sparingly so that they can minimize their threat and use of brute force.

It remains, though, a market actor. And so when it is not manipulating the currency, all of its actions have normal intra-market effects.

In other words, when the government spends money, it is by definition spending money that would either be spent or saved (meaning, ultimately, invested, except in the de minimis stuffed-into-the-mattress style of exception) by private actors. This is generally a bad thing because private actors almost always spend more efficiently and with less corruption than governments, which means that their spending results in greater cumulative benefits to productivity, economic growth and society generally. But it doesn’t cause inflation any more than anyone else’s spending or investing does.

Likewise, when government borrows to spend, it is again not, without more, causing inflation. Money borrowed by the government is money that could otherwise have been borrowed by private parties. Government borrowing thus “crowds out” private borrowing, a result that can be achieved, if government borrowing is big enough, by raising interest rates generally. But a rise in interest rates by itself is also not inflation; it’s just a rise in a single price – the price of borrowing money.

This is all going to become terribly important to lawmakers beginning this winter as they try to put together new budgets. Sensible legislators will want to reduce government spending, of course, but not because it will lower inflation or even lower price levels – which it in any case could only do for things that the government had been buying, but with spending reductions, won’t be buying any more.

They will want to lower government spending because government is the one spender that is guaranteed not to have earned – to have created – any of the wealth that it spends, so that every dollar it spends is a form of legalized theft from genuine creators, which should be kept to a minimum. They will also want to lower it because government is, on average, just about the least productive spender there is; most non-governmental uses of a dollar are higher and better uses than governmental uses, and lawmakers should prefer higher and better uses.

The same analysis holds for government borrowing: Government should crowd out higher-and-better private borrowing as little as possible. Additionally, at some point, the government’s borrowing will cause it to be an unworthy borrower that will have to, in effect, pay junk-bond rates on its borrowing once lenders begin to doubt its ability to pay all the debt back (or to pay it back without deflating the currency, which, finally, is where (the specter of) inflation makes its first legitimate appearance in this drama).

But thinking that imbalanced budgets themselves cause inflation leads back to an Eisenhower Era (and earlier) way of misinterpreting the economic world, and thus to terrible consequences: Like balancing budgets by keeping taxes monstrously high at the expense of economic growth.

The way to know if government actions are causing inflation is to watch the value of world currencies and gold (or other relatively fixed commodities without high use value) against the dollar. In the genuine inflation of the ‘70s, the dollar price of gold rose from about $40/ounce in 1970 to $800/ounce in 1980: a multiple of 20. During the Reagan Administration, a time of huge tax cuts, huge productivity increases and what the even-then-liberal press called monstrous deficits, the price fell by 60 percent before settling at about half by the end of the administration.

It is vital to the American economy to cut government spending. It would be a very good idea to cut deficits and grow down all of the debts that were accumulated during the intensely stupid lockdowns – lockdowns the effects of which are still being felt in the form of higher price levels. But those price level increases are not themselves inflation – or at least, they’re far from all inflation, as witnessed by the fact that the price of gold spiked up to about $2000/ounce twice in the last three years, but is now back down to about $1700/ounce.

Cutting government spending will reduce some price levels. Cutting deficits by cutting government spending will reduce interest rates and leave more money for more productive borrowers, which will also reduce price levels. But cutting deficits by jacking up taxes or leaving them high – the Eisenhower Era method – will not lower price levels because it will deaden productivity, which is the primary engine of price-level declines.

Inflation has nothing to do with it.


Scott Shepard is a fellow at the National Center for Public Policy Research and Director of its Free Enterprise Project. This first appeared at RealClearMarkets.

The National Center for Public Policy Research is a communications and research foundation supportive of a strong national defense and dedicated to providing free market solutions to today’s public policy problems. We believe that the principles of a free market, individual liberty and personal responsibility provide the greatest hope for meeting the challenges facing America in the 21st century.