Election Economic Misconceptions (11) Government Expenditure causes Inflation

Politicians (mostly on the right) frequently claim that increased government expenditure causes inflation. This is simply not true.

If the economy is overheated, then additional government expenditure can cause inflation if the government has to compete for scarce resources and staff by getting into a bidding war with businesses to obtain them. Unfortunately, New Zealand has seldom been overheated in the past few decades, so inflation caused by government spending has not been an issue. So it is mischievous to claim that government spending is the cause of the inflation experienced in the past few years.

The claim made by some politicians is that the government overspent during the Covid crisis, which caused inflation. They also claim that government spending had to be cut to bring inflation back in line. This narrative is not true.

During the Covid shutdowns of the economy, the government increased spending to pay subsidies to struggling businesses. At the time, they were screaming for help. Looking back, it can be argued that the government spending was too much, or too little, but most businesses were quite happy to take the money. Ironically, Air New Zealand was the single largest recipient of the Covid wage subsidy scheme, and Christopher Luxon has never suggested that Air NZ should pay the money back.

It can be argued about whether the Covid subsidies were good for the economy, but it is clear that the subsidies kept thousands of businesses open that otherwise might have closed down. More important, they did not cause inflation because the economy was struggling, so there was no bidding war for scarce resources.

What did happen was that the central bank kept interest rates low to stimulate the economy. In hindsight, they have admitted that they kept interest rates low for too long, which fed into a residential property boom when households realised that cheap mortgage finance was available. This property boom was not caused by government spending. Too late, the central bank increased interest rates sharply to calm the housing market, but they probably kept them too high for too long, which has resulted in a stagnant property market.

About the same time, the Ukraine war pushed up food prices. And more recently, the US war on Iran has pushed up fuel prices, which is causing the price of all goods that need fuel to rise. This is imported inflation that the government can do nothing about. It has nothing to do with government spending.

The narrative that the government had to cut spending to reduce inflation does not make sense.

The New Zealand economy is still sluggish, so it is unlikely that government spending could cause price inflation in the near future.