Tuesday, March 1, 2011

Sticky Budgets and Inflation

One of the benefits touted for having an inflation rate higher than 0% (but lower than, say, double-digit inflation) is that it corrects for the “sticky wages” problem. In some sense, we’d like to have wages vary by the business cycle. Workers should get paid more when times are good. When times are bad, workers should get paid less (rather than simply firing some workers, and keeping the rest at the same wages). However, for a variety of reasons, wages tend to stay sticky. So instead we allow inflation to happen. Then, by employers keeping wages constant during recessions, we can get some wage flexibility by diminishing the real purchasing power of labor (presumably, allowing capital to fire fewer of them).

But many other prices in an economy are also sticky — in particular, many forms of government spending. Here, for instance, is a graph of defense spending via Marginal Revolution:

Defense spending is an extreme example, but another way of stating this is that the government rarely cuts the dollar amount going to most programs. So if you want to cut back one program, or shift resources from one government department to another; that’s impossible.

What you can do is manage this tradeoff when prices in general are rising. Then, merely by capping the budgetary allocations for defense, you can cut real defense spending — this is what happened during the ‘90s. Another example of this principle comes from the recent Indian budget. This budget actually increased government spending, by 3.3%. However, in the context of rapidly rising domestic prices (resulting in rapidly rising tax revenue as well), this amounts to a sizable cut in the budget deficit. Economic growth is strong too, which also makes this easier, but so does high inflation. In fact, as far as I can tell, the announced deficit cut here - 1.6% in one year - is larger than that most developed countries undergoing “austerity” budgets. This sort of fiscal balancing would be politically impossible to impose if prices were in fact constant. It’s true that, for several reasons, this degree of fiscal tightening may never happen. Yet the simple fact that it was entertained at all points to the power of inflation in enabling real government expenditure cuts.

One of the chief attractions of higher inflation, from a Tea Party point of view, is that it would make budget cutting that much easier. Right now, with low inflation, to get lower real government spending you actually have to cut programs. That’s hard. It’s easier to let prices rise, lower the real value of all government spending, and then cap the level of additional spending. That’s a whole lot easier.

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