Will Deficit Spending Lead to Inflation?

Research has found that the link between government debt and inflation is less powerful in developed markets than in developing countries
 

By Oskar Schulz

The US government has embarked on a massive spending binge to combat coronavirus, driving deficits and government debt to new heights. Some investors are worried that inflation will be the inevitable consequence of this government profligacy – that modern monetary theory and new Keynesianism pose a grave risk to the stability of the dollar.
 
But inflation did not result from the government’s massive economic stimulus during the 2008 financial crisis. In fact, deflation has been a bigger problem than inflation. And those who predicted inflation in 2009 now look like the boy who cried wolf.
 
A few IMF economists published a fascinating paper in 2009 that offers a new way to think about the relationship between government debt and inflation. The paper analyzed 71 countries spanning up to 43 years and found that the relationship between increasing public debt and inflation holds strongly in indebted developing countries, weakly in other developing countries, and generally does not hold in developed economies.
 
They found that for 25 net debtor countries, such as Albania, Brazil, and Morocco, a 1% increase in debt is linked to a roughly 0.3% increase in inflation (red box below). For less indebted developing countries like Argentina, Indonesia, and Lebanon, a 1% increase in debt corresponded to a 0.2% increase in inflation (orange box below). And there was no relationship between government debt and inflation in developed countries (green box below).
 
Figure 1: Correlation between Debt Growth and Inflation across Economies (1963-2004)

Source: IMF (2009)
 
The results, which controlled for money supply, show that fiscal policy is the dominant factor driving inflation in highly indebted developing countries. The authors stress the importance of institutional and structural factors, such as fiscal rules, inflation targeting, and the depth and breadth of the financial sector, in mediating the linkage between government debt and inflation in more advanced economies.
 
The results are consistent with other empirical research on inflation, which finds a significant positive relationship between budget deficits and inflation in developing countries but virtually no short-term relationships between debt and inflation in developed countries.
 
We are in the early stages of a larger research project on growth and inflation. We are looking at how these macroeconomic variables relate to asset class performance, what variables best predict these macroeconomic conditions, and how investors should take these variables into account when doing asset allocation. We will share more of our research on the factors that drive inflation and deflation in developed markets in the months to come.
 
Acknowledgment: This note was authored by Verdad intern Oskar Schulz. Schulz is a rising junior at Harvard. He is majoring in economics and is interested in pursuing a career in investing.