It is amazing the way the defunct economist John Maynard Keynes wields complete power over modern economic minds. Consider analyses of the budget. The Treasurer thinks that the additional spending is targeted to reduce inflation. It will lower electricity prices and medical costs, for example. News for the Treasurer, government spending no matter on what, unless it miraculously boosts productivity, is always inflationary. That’s not to say it will cause inflation. That depends upon whether the spending is matched by taxes or bond sales. If it is, then there is zero inflationary effect.
By the way, this is easier to grasp for those not suffering the cerebral dissonance which comes from studying and embracing Keynesian economics. Government spending, taken in isolation, is always inflationary. Not because it increases demand. But because it increases the money supply. When government spends it creates an increase in the money supply dollar-for-dollar; abstracting from the possibility of government spending on foreign goods.
Inflation is a monetary phenomenon. An appreciable and persistent rise in the general level of prices has its counterpart in an appreciable and persistent fall in the value of a dollar bill. Other things equal, the more dollar bills the government spends, the lower will be the value of each dollar bill in terms of the goods and services it can buy. Not hard to understand — unless you’re a Keynesian.
If government matches its spending with taxation or borrowing then there is no change in the money supply; and, thus, no inflationary effect. Why do most economists get it wrong? Aggregate demand, that is the reason.
Aggregate demand is the sum total of all spending by government and the private sector. It is a Keynesian concept which, having been introduced into the economic lexicon in 1936, has since plagued all attempts by economists, outside of a rare few of mainly Austrians and Monetarists, to understand how economies work. In other words, to be more useful that a nine-bob note.
I won’t name names. But I read from more than one bright spark that the increases in JobSeeker payments, rent assistance, energy bill subsidies and cheaper medicines, plus increased wages for aged-care workers, are likely to go to people who will spend every cent. And, on that account, engender an inflationary stimulus in demand. Another economist who will also remain nameless (I think she’s pretty good most of the time) wrote that it doesn’t matter whether, say, electric-bill subsidies lower the cost of electricity in the CPI because the money will be spent on other things. All this is symptomatic of Keynesian capture. And a completely wrong way of looking at things.
Whether recipients of taxpayer largesse spend the money, or save it, is irrelevant to inflation; and to the demand for goods and services taken as a whole, i.e., aggregate demand. Though it will affect the incidence of demand among different goods and services. Think of aggregate demand as a derivative. It has no independent life of its own. It falls out of production. It’s the tail of the production dog. Keynes had the tail wagging the dog. And this, for some mystical reason, has proved to be enduringly alluring to the economics profession.
Let me put it in extreme terms. The government has increased spending by over $20 billion since its October budget. Suppose it was $200 billion. Would that be inflationary? Not at all, provided the $200 billion were mopped up by taxes or bond sales. True, it would likely have deleterious consequences for economic growth. The reason is clear enough. Taxes would lessen business investment. Bond sales would drive up interest rates and also lessen business investment. Spending by business, disciplined and shaped by market forces, is inevitably more productive than spending by government.
Incidentally, this doesn’t mean that increases in government spending are necessarily bad. Economics is not the be and end all. Strong defence forces, public amenities, a fair and just society, taking care of the disadvantaged are part of having a civilised society. It’s a question of finding the right balance, which is why we have adversarial politics.
It would be good to have robust adversarial economics. But our side is thin on the ground. Steven Kates has fought the good fight but I can’t think of many more in Australia. I assume they still exist in the University Chicago, Milton Friedman’s old stamping ground. Apparently, none have made it into central banks or treasury departments or the IMF. Unless of course some have and they keep shtum for fear of being shunned.