Government spending and inflation

John Hussman has written an excellent piece, which I’ve linked below, that addresses the subject of government spending and inflation.  The entire piece is worth reading, but here if you can’t find time to read it all, I commend the following:

A comment on inflation

It bears repeating that ultimately, inflation is not driven by monetary expansion per se, but by growth of government spending, regardless of how it is financed. Inflation basically measures the percentage change in the ratio of two “marginal utilities”: the marginal utility of real goods and services divided by the marginal utility (mostly for portfolio and transactions purposes) of government liabilities. Think ice cream cones – the first one has a very high marginal utility, but the second one you eat has a little less, and so on. So increased supply tends to depress marginal utility, while scarcity raises it.

Rapid expansion in government liabilities, whether in the form of money or Treasury debt, depresses their marginal utility in relation to that of goods and services, driving inflation higher. Frantic safe-haven demand for currency and Treasury debt, as we’ve seen lately, increases the marginal utility of government liabilities and clearly depresses inflation. Scarcity of goods and services in relation to their demand raises the marginal utility of goods and services relative to that of government liabilities and is therefore inflationary. A glut of goods and services in relation to their demand lowers the marginal utility of goods and services and is therefore deflationary.

The reason we’re not seeing inflation here and now is that despite a near doubling in the monetary base, we’ve seen a buildup in goods inventories combined with a surge in safe-haven demand for government liabilities. So investors have absorbed the increased supply of government liabilities without a collapse in their marginal utility. This will not persist indefinitely, so unfortunately, any nascent economic recovery in the next couple of years will be against the headwinds of both Alt-A mortgage defaults (coming to your neighborhood in 2010), and inflationary pressures as soon as safe haven demand for Treasuries eases back even moderately.

Milton Friedman was mostly right about inflation – inflation may be a monetary phenomenon, but only because governments ultimately can’t help but monetize huge amounts of spending (as the Fed is doing now). He was entirely right about fiscal discipline – “the burden of government is not measured by how much it taxes, but by how much it spends.”

Unfortunately I couldn’t get the charts to reproduce in this post.  Here is the entire piece:

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