Inflation is high, what should we do with government spending?

NPO 1, Podcast De Dag
Erasmus School of Economics

Corona, the war in Ukraine and high energy prices: these are all causes of the sharp rise in inflation. Some draw the comparison with the 1970s, when inflation was a scourge on the economy. To what extent is this comparison correct and are there lessons to be learned from the past? In a podcast of De Dag, Bas Jacobs, Professor of Public Economics at Erasmus School of Economics, explains the situation.

High oil prices and the oil crisis led to high inflation in the 1970s. In collective agreements, wages automatically followed prices. The result? A wage-price spiral, in which prices rose because of a rise in wages, which in turn meant that wages had to rise because of the rise in prices. Internationally, the Netherlands became expensive; as a result, companies no longer found it attractive to invest in the Netherlands. Jacobs: 'In the background, a factor was that the Netherlands started to build up its welfare state in the 1970s; the Disablement Insurance Act (WAO) was being built up. Due to the increase in labour costs, many workers were discharged and disappeared from the labour market'. Long-term growth was damaged by all sorts of supply problems. The government stimulated the economy strongly, which was unwise in those circumstances, according to Jacobs. One should in fact try to increase supply, but with the stimulating budgetary policy of the time, the government actually increased demand, causing inflation to rise further. Supply was also further reduced, because if the government borrowed more money, there was less money that could be lent out to companies to make investments.

Turnaround

Jacobs: 'The reverse effect was only reversed during the time of the Lubbers cabinets, which started to implement major restructuring of government finances. Central banks pushed interest rates high to choke off inflation, the Wassenaar agreement was concluded whereby wages were moderated, and only then did the economy start to stabilise. Benefits were decoupled from wages. There are similarities between then and now: energy prices and inflation are very high. Jacobs also mentions as a similarity that fiscal and monetary policy is very loose. However, there are also differences: inflation expectations in the euro area are not rising, wages are not so much on the rise. In real terms, therefore, there is a decline in purchasing power, so there is no indication that we will end up in a wage-price spiral. According to Jacobs, the current high inflation rate of 9.7% will fall quickly and market players also expect that in the longer term inflation will only be slightly above the European Central Bank's inflation target of 2%.

Professor
More information

You can listen to the podcast De Dag, 14 April 2022, here.

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