Do Enlarged Fiscal Deficits Cause Inflation: The Historical Record

This National Bureau of Economic Research (NBER) Working Paper, “Do Enlarged Fiscal Deficits Cause Inflation: The Historical Record,” is co-authored by Mickey D. Levy and Michael D. Bordo, Professor of Economics at Rutgers University and Senior Visiting Scholar at the Hoover Institution, Stanford University. An earlier version was presented at the IIMR Annual Monetary Conference “The Return of Inflation? Lessons from History and Analysis of Covid-19 Crisis Policy Response” in October 2020.

One theme that has tended to repeat itself in the historical relationship between deficits and inflation is the dominance of fiscal policy over monetary policy. During periods of deficit spending, fiscal policymakers exert pressure on central banks to maintain accommodative monetary policies. This leads to excess demand and higher inflation. The most extreme episodes linking deficits and inflation have occurred during wartime, both in the U.S. and globally, but there have also been notable peacetime experiences.

The current situation provides a timely and interesting context for this paper. In the U.S., unprecedented deficits have been accompanied by the most expansive monetary policy in history. However, to date, financial markets, the Federal Reserve, and fiscal policymakers have remained quite sanguine about inflation risks. Presumably that reflects the last decade, during which inflation remained subdued despite high deficits and the Fed’s easy monetary policy following the financial crisis of 2008-2009, rather than lessons from history. While the pandemic has temporarily depressed inflation, very recently market-based inflationary expectations have edged above the Fed’s 2% longer-run inflation target.

Among other topics, this paper describes in detail how the current situation and thrusts of fiscal and monetary policies are far different than the period following the financial crisis, suggesting that the risks of inflation are likely understated.

Do Enlarged Fiscal Deficits Cause Inflation: The Historical Record

NBER Working Paper No. 28195

December 2020

ABSTRACT

In this paper we survey the historical record for over two centuries on the connection between expansionary fiscal policy and inflation. As a backdrop, we briefly lay out several theoretical approaches to the effects of fiscal deficits on inflation: the earlier Keynesian and monetarist approaches; and modern approaches incorporating expectations and forward looking behavior: unpleasant monetarist arithmetic and the fiscal theory of the price level.

We find that the relationship between fiscal deficits and inflation generally holds in wartime when fiscally stressed governments resorted to the inflation tax. There were two peacetime episodes in the early twentieth century when bond financed fiscal deficits that were unbacked by future taxes seem to have greatly contributed to inflation: France in the 1920s and the recovery from the Great Recession in the 1930s in the U.S. In the post-World War II era a detailed examination of the Great Inflation in the 1960s and 1970s in the U.S. and the U.K. suggests that fiscal influences on monetary policy was a key factor. Finally we contrast the experience of the Great Financial Crisis of 2007-2008, when both expansionary fiscal and monetary policy did not lead to rising inflation, with the recent pandemic, which may involve the risks of fiscal dominance and future inflation.

Do Enlarged Fiscal Deficits Cause Inflation: The Historical Record

Mickey Levy, mickey.levy@berenberg-us.com

Member FINRA & SIPC
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