The flip side of more effective government spending

The other day I wrote about new research from the IMF that showed that in the Eurozone at least, government spending was far more effective in an environment when real interest rates were lower than real potential GDP growth (i.e. r-g<0). The chart below summarises the results of that research. In an environment where interest rates are low compared to growth, businesses and households have little incentive to save and at the same time grasp that the government may not have to enact austerity measures to pay for higher deficits. And the longer such a low-interest rate environment persists, the more effective government spending becomes, because fewer and fewer people hold on to their money to save for potentially higher taxes in the future.

Fiscal multiplier depending on the level of interest rates vs. growth

Source: IMF

This is great news because it shows that the recent government spending measures to get us out of the recession of 2020 were highly effective and have definitely helped to speed up the recovery.

But there is a flip side to this story. We know that once an economy is back to full capacity any additional growth will trigger labour shortages and thus higher wages. And it may also trigger excess demand for raw materials that cannot be matched by the existing supply. The result is, of course, higher inflation. And this is where the chat above becomes a bit disconcerting. Because the fiscal multiplier of government spending doesn’t decrease over time, but instead slightly increases, any government spending in years 3, 4, 5, etc. will become even more effective. But typically, in years 3, 4, or 5 after a recession, the economy is already back to full capacity. Currently, economists expect the US and UK economies to fully recover from the pandemic lows by late 2021 and in the Eurozone in 2022. Any additional government spending beyond that point will push inflation higher. And that includes the fiscal spending that was part of the pandemic rescue packages enacted in 2020 and 2021 but scheduled to be spent only in later years.

Is that going to be enough to create high inflation for years to come or even a runaway inflation scenario like the 1970s? No. According to my calculations, the government spending enacted so far should lead to somewhat higher but not worrisome inflation. In the United States and the UK inflation may in the long run level off at 2.5% instead of 2%, while in the Eurozone, inflation may level off around 2% instead of 1.5%. And that assumes that central banks just sit on the sideline and do nothing. But they are of course already toying with the idea of tapering asset purchases and guiding the market to interest rate hikes in 2023 or potentially sooner. And I am pretty sure, that if they see inflation remain high for too long, they will accelerate their rate hikes and help push inflation lower. But they will also be happy to let inflation run slightly above 2% for a while, so realistically, we should probably expect inflation to run above 2% in the next five years or so, but not by much.