government spending on economy

What is the Effect of Government Spending on the Economy? Is Runaway Inflation Inevitable?

Like many people in the age of pandemic, I’m grateful for the Stimulus packages that governments all around the world have announced. Many have asked how exactly does government spending suppose to help the economy?

Every single one of us has been affected by the illness, either by health or by economics. So I’ve been hearing a lot of sighs of relief for the stimulus aid that is coming.  That will alleviate a lot of immediate pressures of rent and mortgage payments, utility bills and just getting food on the table.

But there’s also been an undercurrent of concern: With the new stimulus plan by the government, especially in the US & Canada, won’t that lead to a lot of inflation that will hurt us in the long run?

Not necessarily.

Modern economic theory is that the more money governments spend or print, the higher the inflation will be. There is more money in circulation, so each piece of loses a bit of value because there is more of it out there. The idea is that if each dollar is a slice of a pie, as more slices are cut, each piece gets smaller and smaller. We’ve heard of tales of a certain country’s money being “worth less than the paper it was printed on.”

However, that actual result depends on what was happening in the economy at the time. If the economy is in good shape and the government spends more money, it will result in inflation. Because everyone has access to a lot of dollars and there is not an unlimited amount of goods like cars, or food or even haircuts (yes, it’s included in CPI!) So each person tries to outbid each other to get the item they want.

What Exactly is Inflation?

It works like this, say there is 1 hair cutter in town. They can serve 7 people a day. And say at 4pm, during their last appointment, you arrive for a haircut at the same time as someone else. In order for you to get your haircut, you must be willing to pay more than the next person. You offer them $5 more and you get your haircut. The next morning, the haircutter thinks, well, I can charge $5 more today for every hair cut because it’s apparent that people are willing to pay that. And at 4pm, the same situation plays out with 2 new people and one of them is willing to pay an additional $5. So with more money chasing finite resources, prices increase.  This is why inflation happens.

The concept is that government spending crowds out regular folk, driving prices up.

What is the Opposite of Inflation?

But if the economy is in real trouble like it was in 2008 and now, then government spending money in the form of a stimulus plan is a necessity.

The opposite of inflation is deflation.  Deflation is when prices spiral down and down. Deflation is a situation where households don’t spend money today and it gets into a cycle this day after day. In times like now, when our jobs are so tenuous and we’ve seen a reduction in our paychecks, our natural tendency is to hoard it like we’ve been hoarding toilet paper.

The more we are uncertain about tomorrow, the more we hoard cash and are unwilling to spend it. But it creates a vicious cycle because if we don’t spend any money, then businesses can’t make money and might go bankrupt. However, this potential bankruptcy makes us even more uncertain about tomorrow so we hoard even more.

In the case of government spending, they are substituting our spending with theirs.  Because at this point, regular folks aren’t spending, the government isn’t crowding anyone out.

How Deflation Works in the Economy

Going back to the same haircutter example, times are uncertain and people are thinking; I can have a bit of a shaggy hairdo so I’ll wait an extra 2-3 weeks before getting my regular haircut. The hair cutter needs to pay for rent and electricity wants to entice people to come into the shop so they offer a $5 discount.

But times are tough and while I might be tempted, I’m going to wait until tomorrow to see if there’s better news on the horizon. On the next day, because the haircutter didn’t get any customers yesterday, they offer another $5 off haircuts. I walk by again, I haven’t heard good news, but now I think to myself, I can save more money if I wait another day and get another $5 off. And of course, the haircutter is not spending any money because their future is so uncertain.

In this way, the economy slows down even more. This is the vicious cycle of deflation.

Economic Impacts of Inflation vs Deflation

We have generational experience of both; our parents tell us how bad it was in the ’70s and ’80s when inflation was high and the interest rates they were paying on their mortgages were 15-18%. But our grandparents experience deflation during the Great Depression. We all know how traumatized they were through that experience. We all have that grandmother who still scraped every last bit of butter off the wrapper before throwing it away.

They lived through a time when, because of the lack of spending led to otherwise profitable businesses going under which lead to a lack of supplies in basic goods.

Anecdotally and from historical data, we know that deflation has a more negative impact on the economy.

We Are Teetering on the Edge

Right now, we are in a highly deflationary situation. A lot of us are hoarding money because we are uncertain of our future.  Some of us have no money at all because we aren’t working. There is another group of us that can’t even spend money if we wanted to with so many shops and restaurants being closed. For the first time in a long time, we don’t only have a demand issue, we also have a supply issue.

Government Spending Effects on the Economy

The government stimulus plans are acting as the grease that keeps our economy functioning like grease for your bicycle chain. Without it, riding the bike is super effortful and it grinds down the mechanisms and damages the bike and it breaks down very soon. Without the stimulus checks, that’s what the economy would do.

Some businesses might be able to grind it out, but like the strain that grocery stores and Amazon warehouses face, they will start to see damage. People continually getting sick, having to go to work, getting others sick. And then the system breaks down that even in the businesses that could have survived don’t because they can’t remain open.

The stimulus is an effort to keep a minimum amount of supply and demand in the system. Keeping those businesses that can remain open open. Those who’ve had their businesses shut down can still go out and buy the necessities they need.  That’s the bare minimum of supply and demand that will keep our economy at least functioning.


What’s Next for Our Economy?

Unlike what happened in 2008, which we are all still scarred by, this time, we are facing an economic emergency along with a health emergency.  That is not to say that everything we throw all we have learned from the past out the window.

First is that we have to receive the checks from the Stimulus/Relief package.  This is the first step in creating more demand.  Once people have money in their hands, they can go to grocery stores to buy food and household necessities.

Corporations will get help in the form of wage subsidies or loans so they can continue to employ their workers.

But most importantly and this is tied closely with economic recovery, we have to have a COVID-19 recovery.  We have to see the number of cases of new infections plateau and decrease.  With having a better handle on containing the health threat, we can better plan our economic response, either nationwide or at our household level.

That is what we are on the lookout for.

Once the Pandemic is over, is Inflation Inevitable?

No, it’s not.

But it will have to be carefully managed.  If we continue to have all the money loaned out by the government and all the relief dollars floating around in the economy, then inflation is likely.

Another scenario is that this is temporary and the government has ways, through the Federal Reserve and the Banking system, to slowly withdraw the supply of dollars changing hands.

If policymakers can coordinate the slow withdrawal of these funds, then we have a good chance of meeting the 2% target inflation of the Central Bank.

We can only control this indirectly through our participation in elected officials.  For now, we have to come together and weather the storm.

Happy Endings are Still Possible

One day, when this is an acute crisis is behind us, this stimulus will have to be withdrawn. It might take a long time to slowly withdraw these aid packages, just as it took 6+ years for the Fed to slowly withdraw the QE packages after 2008.

But if governments and central bank policymakers learn from the past experiences of all the upheavals we’ve experienced; previous pandemics like the Spanish Flu, World Wars, Great Depression and Great Recession, Japans’ lost decade. We can shape policy that helps us recover from this particular upheaval and position us better to grow forward.

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1 thought on “What is the Effect of Government Spending on the Economy? Is Runaway Inflation Inevitable?”

  1. Pingback: What Might the Economic Recovery Look Like? - Sunday Brunch Cafe

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