(4) Why Isn't Inflation Higher?

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Further to Why Isn't Inflation Higher? Bill Mitchell explains the government's ability (and duty) to balance the economy, i.e. to ensure full employment, or — put differently — the absence of underutilised and fully idle resources that could be mobilised to increase output, and the absence of the kind of inflation that is created when nominal demand exceeds the capacities available in the economy.

So a low level of inflation may well be indicative of insufficient government spending — insufficient in so far as the economy is left languishing below the level of full employment (of all resources human and non-human), with the non-government sector being unable to generate enough effective demand to move the economy back to the point of full employment equilibrium.

Writes Bil Mitchell:

In this blog post – The full employment fiscal deficit condition (April 13, 2011) – which I consider to be core MMT, I showed the conditions that determine the fiscal deficit, once the government assumes its responsibility to achieve and sustain full employment. 

The lessons, in summary are  

1. A macroeconomy is in a steady-state (that is, at rest or in equilibrium) when the sum of the injections equals the sum of the leakages. The point is that whenever this relationship is disturbed (by a change in the level of injections, however sourced), national income adjusts and brings the income-sensitive spending drains into line with the new level of injections. At that point the system is at rest. 

2. The injections come from export spending, investment spending (capital formation) and government spending. 

3. The leakages are household saving, taxation and import spending. 

4. An economy at rest is not necessarily one that coincides with full employment. 

5. When an economy is ‘at rest’ and there is high unemployment, there must be a spending gap given that mass unemployment is the result of deficient demand (in relation to the spending required to provide enough jobs overall). 

6. If there is no dynamic which would lead to an increase in private (or non-government) spending then the only way the economy will increase its level of activity is if there is increased net government spending – this means that the injection via increasing government spending (G) has to more than offset the increased drain (leakage) coming from taxation revenue (T). 

So in sectoral balance parlance, the following rule hold. 

To sustain full employment the condition for stable national income defines what I named the [f]ull-employment fiscal deficit condition: 

(G – T) = S(Yf) + M(Yf) – I(Yf) – X 

The sum of the terms S(Yf) and M(Yf) represent drains on aggregate demand when the economy is at full employment and the sum of the terms I(Yf) and X represents spending injections at full employment. 

If the drains outweigh the injections then for national income to remain stable, there has to be a fiscal deficit (G – T) sufficient to offset that gap in aggregate demand. 

If the fiscal deficit is not sufficient, then national income will fall and full employment will be lost. If the government tries to expand the fiscal deficit beyond the full employment limit (G – T)(Yf) then nominal spending will outstrip the capacity of the economy to respond by increasing real output and while income will rise it will be all due to price effects (that is, inflation would occur). 

What that means in relation to the issues I identified above is that there is a difficulty in defining pro-cyclicality in terms of a given fiscal balance. 

It is nonsensical to say a fiscal surplus is always pro-cyclical and a deficit is always counter-cyclical. It all depends on the spending and saving patterns of the non-government sector. 

We can only really appraise the impact of the fiscal balance in terms of changes at specific points in the cycle. 

So if an economy was at full employment and the fiscal deficit was, say 2 per cent of GDP and that satisfied the condition specified above. 

That is not a pro-cyclical position even if the economy is growing – it is maintaining a steady-state growth path. 

Should the government, with no other changes evident, increase its net spending to say 3 per cent of GDP, under those circumstances, we might consider that a pro-cyclical policy change because it is pushing the cycle beyond its full employment steady-state growth path. 

So the fact there is a fiscal deficit coinciding with strong GDP growth should not be taken as a case of irresponsible and dangerous policy. 

What about running surpluses when recovery is apparent? 

The same logic holds. It might be that the non-government spending and saving decisions drive overall spending so fast that total spending then starts to outstrip capacity.
Then, to restore the full employment steady-state (and this also requires stable inflation), the fiscal stance has to [be] contractionary – which might require a fiscal surplus. 

For example, nations such as Norway will typically solve the [f]ull-employment fiscal deficit condition with a fiscal surplus given how strong their external sector is (energy resources).