Do Deficits cause Inflation?

Deficit spending. The political norm in both the UK and US since the turn of the decade. At a time of spiralling inflation, the question of a link between deficits and inflation is once again coming into the fray. A huge increase in government spending and subsequent budget deficits arose prior to the inflation crisis of the 1970s; yet, increased deficits during the Reagan revolution coincided with disinflation. The answer is complicated. Inflation is ultimately driven by money supply growth; hence, the funding for government deficits is the determining factor.

Expenditure

Governments can fund increased expenditure in three ways – the most logical of which is through higher taxes. Increasing marginal tax brackets should theoretically raise more revenue; whilst this doesn’t hold in some cases, the result wouldn’t be inflationary. Higher taxes take money out of the private sector to fund public expenditure. This isn’t inflationary, as the increase in demand for services through government spending is offset by a decrease in demand for other products through higher taxes.

Secondly, governments can issue gilts to private sector investors to fund spending sprees that prove politically popular. Producing a deficit, a government offers bondholders an interest rate (bond yield) to purchase debt. Similar to the case of tax increases, the money supply remains in this case. Increases in public spending are offset by decreasing private sector investment. However, as governments pay interest on this debt, government expenditure cannot afford to be wasteful as this wouldn’t produce the necessary economic growth that would minimise the exponential growth of debt. Inefficient spending fails to produce the tax revenues to service the growing debt, thereby inevitably creating a debt crisis – witnessed in the likes of Greece and Venezuela.

Finally, expenditure can be funded by Central Banks purchasing government bonds. Inflating the money supply, this creates inflation. As more money chases the same amount of goods, the price of every good must rise to accommodate the rise in demand. Unlike with increasing taxes and private sector bond issuance, there is no decrease in demand that offsets the increase in demand that comes with deficit spending. Under the Coalition government in the UK between 2010 and 2015, the budget deficit fell by two-thirds. This coincided with the CPI falling to 0% by 2015. During the financial crisis, the Bank of England purchased large quantities of gilts, producing a large increase in prices. However, as the deficit decreased, as did the inflation rate as the Central Bank was no longer to purchase government bonds in such a large quantity. The latter of which increases the broad money supply, producing consumer price inflation.

Broad money supply growth in the US: 1990-2020

Pandemic

The coronavirus pandemic saw a wave of deficit spending globally. Whilst in 2019, the UK had a balanced budget, this swiftly evaporated to produce a deficit of £400bn in 2020. Similarly, the US congress pursued a wave of stimulus packages that ballooned the 2020 deficit to $3 trillion. As these both resulted in increases in the broad money supply, the result has been consumer price inflation. As of July 2022, the annual inflation rate in both the UK and US ranges between 9-10%. Had these deficits been funded through higher taxes or private sector bond purchasing, the budget deficits wouldn’t have resulted in broad money growth, provoking the inflationary spiral we see today.

Ultimately, budget deficits result in higher inflation when funded by Central Bank bond purchases. Higher taxes, crowded out private sector investment, or inflation – the three ways to fund a deficit. The latter of which gave birth to the inflationary spiral of 2022.