How one could blame government for inflation

To put my personal value judgments out initially, I generally DO NOT think that government (through fiscal policy) can be blamed for inflation. However, among many people, and even many economists there is a feeling that government is to blame in some way. Personally, I completely blame monetary policy for the failure to control inflation – and although I think they are behaving in an appropriate way in the current crisis – I think that policy was too weak in the past, which has made things more difficult now.

However, the view that it is “the government fault” is not completely without merit. Iprent at the Standard asked me to link to a discussion of how this COULD happen, and as a result I will write a post and link to it here 🙂

The interaction of fiscal and monetary policy

Although it is the role of monetary policy to restrain inflation, the choices of the Reserve Bank are not the only policy elements that can lead to an increase in inflationary pressure.

Take interest rates as fixed (so monetary policy is not changing) and assume that the economic environment is chugging along – then a change in fiscal conditions can influence inflationary pressures.

It the simplest model of this, an increase in government spending increases “aggregate demand” (note, requires assumptions, such as a failure of strict Ricardian Equivalence and a belief that something like AD actually exists 😉 ) – thereby igniting capacity constraints and increasing the price level (by bidding up the price of limited resources).  People then take this increase in the price level partially as an indication of future growth in prices – thereby increasing inflation expectations and leading to inflation.

Now this doesn’t matter as long as monetary policy reacts to looser fiscal policy – as long as monetary policy and fiscal policy share information, it is the fault of monetary policy if inflationary outcomes are not met.

Sure fiscal policy can change the shape of the inflation-output trade-off, by changing the demand and capacity in different industries (eg making sections of the labour market tighter) and influencing long-term output levels, but as long as monetary policy knows that higher spending is going to happen they should react with even HIGHER interest rates.

So the problem is?

Many people believe that monetary policy was not informed about the growth in the scope and scale of government spending.  If Treasury tells the Bank that government spending will be lower than it is, then the Bank will set interest rates too low as a result – causing a greater degree of inflation.

If this is a descriptively accurate assumption, then some of the blame for the current crisis can be put on the shoulders of government.

What about productivity, and capacity constraints, and the tighter labour market!!

These issues are important in a macro sense – however, does the government really have that much ability to influence domestic productivity etc.  If we think it does then this is an important issue insofar as it influences the countries long-term growth rate – but when discussing the failure of inflation targeting it is a mute point.

If fiscal policy pushes funds down the throat of industries that are heavily capacity constrained we will see prices fly upwards – but that is a relative price effect, which stems from distributional issues, it is not inflation.  Truly, poor inflation outcomes, in of themselves, are the result of poor monetary policy.

Now I am not blaming the Bank for food and petrol price increases – these are relative price effects.  I am stating that the Bank has allowed inflation expectations out of the bag in a fundamental, wage-price setting sense.  In order to pin the blame on government we have to say that the government tricked the RBNZ – it is not sufficient to say that government spending made the Banks job harder, if this is the case it should have tried harder by lifting interest rates more.

Furthermore, the Bank should have said – higher government spending forces us to lift interest rates by more to meet our inflation target.  That way society would be able to see the trade-off associated with fiscal policy.

So the question is “why did the Bank do react sufficiently”. we can say:

1. Because the government tricked them,
2. Because they misinterpreted the situation,
3. Because they just weren’t doing there job.

I’m in the second camp, and I don’t think it was just them mis-reading what was going on (I didn’t see much pressure on them by economists over 2003-2006 when the problem was festering).  To blame government you have to sit in the first camp – and I find that position untenable.

Conclusion

People can still blame the government for retarding long-term growth, if we believed that was what there policies were doing (note that there is an equity-efficiency trade-off we have to discuss here) – but I don’t think that we can successfully blame them for inflation.