Gov spending causes demand-pull inflation to escalate

If legislators continue pushing government spending to new heights, they should be aware of the costs. These costs go beyond the simple sticker price of new spending. For instance, government investment has well-demonstrated opportunity costs and in many cases replaces relatively more productive private investment to the point that the private sector shrinks. Furthermore, large government spending packages are usually accompanied by tax increases which reduce economic growth by depressing employment and investment. One study finds that, if the $3.5 trillion budget resolution boosts productivity in line with historical norms, the effect of the corresponding proposed tax increases eliminate any benefits of the government investment, decreasing economic growth only five years after its enactment. Lawmakers should also be aware of the additional risks that swelling government spending poses to American families. The most pressing risk today is rising inflation. While monetary tightening serves as the traditional tool to prevent inflation, future monetary tightening may not be effective if extraordinary spending patterns continue. Inflation is Rising By two common price metrics, inflation is rising at the fastest paces since the early 1990s. In August, the Core Consumer Price Index—which tracks the prices of commonly-purchased goods excluding volatile items in the food and energy sectors—increased 4 percent year-over-year. Likewise, the most recent Core Personal Consumption Expenditures Price Index—which tracks actual spending by households on items excluding food and energy—rose 3.6 percent. Although inflation has stopped accelerating in recent months, it remains significantly above the Federal Reserve’s 2 percent target. Furthermore, the recent cooling is largely driven by consumer anxiety about the Delta variant which has reduced consumer demand for transportation and travel. Increasing anxiety is neither a laudable nor sustainable approach to reducing inflation. If high inflation persists, it will harm American families by decreasing their purchasing powe. In the first quarter of 2021, the rise in consumer prices effectively erased all nominal wage gains causing real earnings to fall. Recent measures of consumer sentiment have also dropped significantly, with surveys showing that Americans are increasingly concerned about inflation. What Causes Inflation? To better understand whether this rising inflation is simply a temporary phenomenon or the direct result of government intervention, it is important to first understand two different types of inflation. The first is cost-push inflation, which happens when the cost of production rises. Cost-push inflation can occur if businesses are faced with sudden rising prices for raw materials, intermediate goods, or labor, and pass those higher costs on to consumers. This type of inflation may be sustained if it is the result of a lasting policy change, such as new taxes on foreign-made inputs, but it can also be a temporary response to an exogenous shock, such as supply chains adjusting to the re-opening of the global economy. The second is demand-pull inflation, caused by increases in consumer demand. Demand-pull inflation can be a sign of growth if it is the result of a strong economy in which more individuals are employed, income rises, and demand rises with it. But it can also be harmful if it is triggered by new government policies that provide consumers with so much money (subsidies and transfer payments, or easy access to credit via a low cost of borrowing) that demand grows too fast for production to keep up. The price increases facing American families today are likely the result of both types of inflationary pressures, and these pressures are interacting with each other to exacerbate prices even further. Rising consumer demand for goods is increasing consumer prices, and it is also putting pressure on businesses to increase production while they are constrained by supply chain disruptions and labor shortages. When this occurs, American families are simultaneously faced with higher prices and shortages, lowering their quality of life.