Governments and inflation

Inflation is a governmental choice

If you doubt the influence of governments in creating inflation, consider Switzerland. Price stability has been a government policy since 1973. Moreover, since 2000 it has required that its national bank (SNB) ensures that inflation stays within the range 0-2 per cent. It has averaged just 0.7 per cent since then.

Consider also the UK, which has tasked the Bank of England to create 2 per cent inflation (and has achieved 2.3 per cent measured by CPI). Indeed in every G20 country except Japan, inflation since the millennium has averaged around two per cent or above. Countries with higher inflation targets have had even higher levels. For example, both Russia and Turkey have 5 per cent targets and have averaged respectively around 10 per cent and 20 per cent inflation over 2000-2013.

Governmental influence

Source: IMF Database

Inflation usually results from governmental actions. It is not a random act of economics.

Governments and the money supply

The primary way in which governments have been influencing inflation is by sanctioning an ever-increasing money supply above the level required for the growing economy. Over the medium-term these excess increases in money supply feed through to price inflation.

The money supply growth that UK governments have allowed since World War II is a good example. It has grown by 8.7 per cent a year (see chart below) whereas during that time the economy has grown by just 2.3 per cent a year. Moreover since the mid-1960s, governments, starting with the Wilson administration, have allowed the money supply to grow above that long-term trend and significantly ahead of economic growth. This has created price inflation, particularly so during the 1970s and 1980s when money supply growth was at its peak.

Governments and money supply

Source: Bank of England. (M3 up to 1963, M4 1964 onwards.)

How governments create inflation via the money supply

Governments influence the money supply in two ways:

  1. Directly by bond creation or money printing
  2. Indirectly via permitting private banks to expand credit.

Governments can directly increase the money supply by the creation of new government bonds to finance their budget deficits. For example, no UK government for nearly 300 years has had a plan to pay back the capital of these debts. This is acting to increase the money supply.

In addition, more recently various governments around the world (e.g. the USA, UK and Japan) have been directly expanding the money supply by getting their central banks to print money in a process called Quantitative Easing (QE). The size of these operations in some countries has been huge. In 2013, the Japanese government embarked on a plan to double the money supply within two years.

Still, the primary way in which the money supply is expanded by governments nowadays is by permitting private banks to create more money, i.e. credit. Those banks have an incentive to expand the money supply to make more profits. And governments have little reason to curtail this expansion, as they gain not only from tax on the banks’ profits, but also from inflation tax through the reduced value of the money thus created and also electorally from the feel-good factor when the economy is seen to be expanding.

Inflation-friendly government policies

Inflation friendly policies

In addition to increasing the money supply by the methods outlined above, there are a number of other ‘inflation-friendly’ policies that governments can follow to help further enhance their inflation rates. These include:

1. Having an inflation target. This is the primary method used by many governments to ensure that they have inflation. They task their central banks to follow policies to ensure that inflation occurs in their economy.

2. Regulated prices. A large part of the inflation rate is under the direct control of governments through regulated prices. In the UK currently these include utilities, train fares, student loans and many other areas. Indeed, Mervyn King, the previous Governor of the Bank of England, often pointed out that this was arguably the largest factor driving UK inflation and accounted for about half its level at that time .

3. Government sponsored borrowing. Governments can expand the money supply by encouraging the electorate to borrow more. This could be via student loan schemes but is often done through housing incentives. For example, in the UK there have been a number of recent schemes to assist homebuyers (such as “Help to Buy”) that have significantly increased the amount of mortgage loans and consumer credit . This has increased house prices, which have a direct impact on inflation measures such as RPI and indirect effects through increased money supply and enhanced consumer spending, which also boost prices.

4. Devaluations. Currency devaluations are another way in which governments can increase inflation. A lower currency means that imports (particularly commodities like oil) become more expensive and push up the inflation rate. Some have argued that the effect of devaluation on inflation is not that great in the UK as the imported element of goods manufactured here is quite small. Despite this, it is still a simple policy for a government to follow to foster some extra inflation and has been, for example, part of the strategy followed by Japan in 2013/2014.

5. Wage agreements. Governments are in direct control of public sector wages and have an indirect influence over other wage rises in the private sector. Wages are a key component of the prices of goods and services and so rises in wages can quickly flow into increases in retail prices. Although many governments curtailed public sector wage rises during the downturn, there will come a time when this changes and governments may well help trigger a wage-price spiral which increases inflation.

6. Increased government spending. Despite the current era of austerity, governments can also increase the money supply by investing in large infrastructure projects, which may not appear in the national accounts. For example, the UK government has recently sanctioned the construction of many new nuclear power stations (with funding provided by the private sector). Another large UK project recently agreed is the proposed high-speed railway between London and the north of England. All such large-scale projects add to inflationary pressure by competing for resources in an economy.