Will Government Spending Lead to Inflation?

BY Paul Solman  September 6, 2010 at 4:02 PM EDT

Question: Roubini and Taleb may have gotten the crash right, but they apparently believe in letting the middle class do the penitence the banks refuse. I hope you intend to rectify this exaggerated debt fear with something from Paul Krugman, Brad DeLong, Dean Baker or other Keynesians. You might get a more coherent examination of the problem with a Krugman, DeLong or Thoma debate with Roubini or Taleb.

Paul Solman: This letter refers to an interview I did recently with gloomsters Nouriel Roubini and Nassim Taleb and maybe also to a web extra excerpt from the original longer sit-down with them.

This excerpt shows Roubini as something of a Keynesian himself: He thinks government HAS TO spend when consumers and businesses won’t. The overriding question is the timing: when does government stop?

Krugman, DeLong, Dean Baker and Mark Thoma each has a blog of his own (just Google their names); they can and do speak for themselves. But to elaborate simply for just a bit, the idea is truly basic: that economics is about maximizing your output from a given set of resources. Therefore, you want to utilize those resources to the max. In a period of economic contraction (a “recession”), resources are idled: factories, freight trains, other forms of capital investment and most especially, human labor. Why?

Because consumers have slowed their spending. Seeing consumers pull back, businesses have slowed their investing in a cloudy future. People are laid off, putting further pressure on spending and investing. Thus the idle resources remain on the sidelines.

Enter government, the spender of last resort, to goose the system and put the resources back to work. This is the Keynesian story.

The problem, of course, is that government spending is done with borrowed money, which costs (in the form of interest). And with newly CREATED money, which threatens to make the money already around worth LESS, aka “inflation.”

Not to worry, say the Keynesians. “Inflation” isn’t just a matter of how much money’s around; it depends upon how much money is being spent. Imagine instead that a dollar sits in a bank which then redeposits it at the Fed. That would be the equivalent of burying the dollar in your backyard. And in fact, that’s what’s happening right now with nearly $2 trillion, about the amount of new money the Fed has created since the crisis. So: no inflation.

Yes to worry, says Taleb and many others. That money will eventually work its way into the economy. In fact, as soon as things pick up, the banks will take those trillions out of their Fed accounts and lend them to people and businesses, and inflation will ensue.

There’s the debate — in a nutshell.