No, you won’t tame inflation with more government spending

A recent research report from the Bank of Canada makes the improbable claim (based on U.S. data) that more government spending could lower inflation, if the spending boosts aggregate supply in the economy. Certainly, the relationship between government spending and inflation can be complex, but the idea that more government spending could actually lower inflation seems far-fetched.

To start, in today’s economy where the Bank of Canada has identified aggregate demand exceeding aggregate supply as the main source of inflation, any additional government spending will fuel inflationary pressures—unless the stimulus to supply exceeds the boost to demand.

Proponents must explain exactly how such a card trick can be executed. That will be difficult since the inflation that erupted during the pandemic surprised central banks whose models of the economy’s supply side do not extend much beyond using the unemployment rate as a proxy. The supply potential of the economy changed during the pandemic more than policymakers imagined. However, according to the IMF, this was not due to global supply chain disruptions but because governments in North America paid millions of workers to stay home while Russia’s invasion of Ukraine raised energy prices.

For years, we’ve heard repeated claims that more government spending would pay for itself. Outlays for infrastructure projects were supposed to improve our capital stock, while expanding child care would boost the labour supply. More capital and labour inputs should have increased the supply side of the economy. But instead of government spending paying for itself, we’ve seen a steady erosion of per-capita GDP growth and persistent government deficits. The OECD secretariat is pessimistic about Canada’s long-term growth potential, projecting we will trail all OECD countries through 2050.

Moreover, the claim that more government spending can lower inflation is based on current government spending on goods and services rather than transfers. Current government spending is the least likely way to boost supply. Why? Because while most transfers do reach their intended target (usually households), current government spending on goods and services is administered by the civil service whose sticky fingers latch on to sizeable amounts of money for programs intended to serve the public. For example, the huge increase in health-care spending that followed the recommendations of the 2002 Romanow Report did not improve the supply of health care in Canada—instead, most of the money was diverted to higher pay for government workers.

Finally, if more government spending truly helps lower inflation, then we should be mired in a 1930s-type of deflation after the orgy of government spending during the pandemic. Instead, inflation soared to its highest rate since 1988 and the Bank of Canada had to implement a surprising hike to interest rates this month as inflation remains stubbornly entrenched.

And interest rates rose sharply over the past year partly because governments have relied on monetary policy alone to fight inflation. Even Paul Volcker, legendary head of the Federal Reserve Board who’s credited with single-handedly slaying the inflation dragon in the 1980s, acknowledged that monetary policy by itself was not enough. Back then, lowering inflation required a coordinated effort to reduce regulations, which curtailed potential growth, and a commitment from President Reagan to shrink government’s footprint in the economy—two examples of how less government helped lower inflation. Today’s high inflation (and subsequent higher interest rates) will persist until monetary and fiscal policy act together to rein it in.