Key Takeaways
- Inflation can be viewed not just as a monetary phenomenon but as a fiscal one, where excessive, unfunded government spending effectively acts as a ‘stealth tax’ by devaluing currency and public debt.
- Historical precedents, such as post-war Britain and the 1970s, demonstrate a strong link between fiscal expansion and inflation, though external shocks often act as accelerators.
- The post-2020 inflationary surge was unique due to the combination of massive direct-to-consumer fiscal stimulus and simultaneous global supply-side constraints, a departure from the post-2008 playbook.
- For investors, an environment of potential fiscal dominance necessitates a strategic shift away from traditional fixed-income towards real assets, commodities, and equities with demonstrable pricing power.
- The primary forward-looking risk may not be persistent inflation itself, but a policy error where central banks over-tighten in response, triggering a severe recessionary downturn.
The notion that inflation serves as a pernicious and clandestine tax, driven primarily by state expenditure, has found renewed voice in public discourse, notably amplified by figures such as Elon Musk. This perspective reframes inflation not merely as a technical matter for central bankers, but as a direct consequence of fiscal policy, where governments finance spending not through transparent taxation but through the debasement of the currency itself. In an era defined by unprecedented fiscal responses to successive crises, grasping this dynamic has become fundamental for navigating capital markets and preserving wealth against an insidious erosion of value.
The Fiscal Theory Revisited
For decades, the monetarist view, popularised by Milton Friedman, that inflation is “always and everywhere a monetary phenomenon” has dominated economic thought. Yet, a complementary and increasingly relevant school of thought is the Fiscal Theory of the Price Level (FTPL). In simple terms, this theory posits that the value of money is determined by the government’s overall budget constraint. If a government engages in persistent deficit spending without a credible plan to raise future taxes or cut spending, the public will eventually anticipate that the outstanding debt will be paid for through money creation, thus devaluing the currency and driving up the price level.
This is not an arcane academic debate. It provides a robust framework for understanding why the vast monetary expansion following the 2008 financial crisis did not immediately trigger rampant inflation. Much of that newly created money remained within the banking system as reserves. The post-2020 environment was starkly different. Fiscal policy took the lead, delivering trillions of dollars directly into the hands of households and businesses through stimulus cheques, grants, and forgivable loans. This spending occurred alongside severe supply-side disruptions, creating a perfect storm where a tsunami of new, spendable money chased a diminished pool of goods and services.
A Glance at the Data
While correlation does not imply causation, the relationship between surges in government spending and subsequent inflation is difficult to ignore. The recent American experience provides a compelling case study. Examining federal expenditure as a percentage of GDP against the annual inflation rate reveals a distinct pattern following the pandemic-era fiscal interventions.
| Period | US Federal Spending (% of GDP) | US Annual Inflation Rate (CPI Average, %) |
|---|---|---|
| 2019 (Pre-Pandemic) | 21.0% | 1.8% |
| 2020 | 31.2% | 1.2% |
| 2021 | 26.9% | 4.7% |
| 2022 | 24.8% | 8.0% |
| 2023 | 22.7% | 4.1% |
Sources: U.S. Bureau of Economic Analysis (BEA), U.S. Bureau of Labor Statistics (BLS). Retrieved via FRED.
The data illustrates a notable lag. The spending spike in 2020, driven by the CARES Act, preceded the inflationary surge that began in earnest in 2021 and peaked in 2022. This lag is typical, as it takes time for the new money to circulate through the economy and for price expectations to adjust. The key takeaway is the sheer scale of the fiscal impulse, which dwarfed the response to the 2008 crisis and was injected far more directly into the real economy.
Portfolio Implications in an Era of Fiscal Dominance
Viewing inflation through a fiscal lens has profound implications for asset allocation. The ‘stealth tax’ disproportionately harms those who hold cash and nominal bonds, as their real value is systematically eroded. Conversely, the largest beneficiary is the debtor with the largest liabilities: the government itself. This creates a powerful incentive for policymakers to favour inflationary policies, a moral hazard that prudent investors must acknowledge.
This environment challenges the foundations of traditional portfolio construction, particularly the 60/40 stock/bond model, which relies on bonds to provide a reliable hedge during equity downturns. When inflation is high, bonds and equities can become positively correlated, both falling as central banks are forced to tighten policy.
Strategic Adjustments for Consideration:
- Real Assets: Property, infrastructure, and commodities have historically performed well during inflationary periods, as their intrinsic value tends to rise with the general price level.
- Equities with Pricing Power: Companies with strong brands, limited competition, and inelastic demand for their products can pass on rising input costs to consumers, thereby protecting their profit margins.
- Inflation-Linked Bonds: Securities like Treasury Inflation-Protected Securities (TIPS) offer direct protection, as their principal value adjusts upwards with inflation. However, they are not a panacea, as their prices are also sensitive to changes in real interest rates.
A Contrarian Risk and Final Hypothesis
While preparing for persistent inflation seems the logical course, a significant contrarian risk looms: a policy misstep. Having been criticised for acting too slowly, central banks may now be tempted to overcompensate, raising interest rates too aggressively into an already slowing economy. Such a move could easily tip major economies from stagflation into a sharp recessionary downturn, causing a rapid disinflationary or even deflationary shock.
This presents a difficult balancing act for investors. The ultimate speculative hypothesis is this: the primary conflict for markets over the next decade will not be a simple tug-of-war between inflation and growth. Instead, it will be a struggle between fiscal dominance, where government spending dictates economic outcomes, and the restoration of monetary authority. In a world where the state’s balance sheet is the tool of first resort for every crisis, investors must prepare for structurally higher volatility in both inflation and growth, forcing a permanent re-evaluation of what constitutes a ‘safe’ asset.
References
unusual_whales. (2022, August 15). [Post summarising Elon Musk’s comment on inflation]. Retrieved from https://x.com/unusual_whales/status/1559175828524507136
U.S. Bureau of Economic Analysis, Federal Government Current Expenditures [FGEXPND], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FGEXPND, accessed October 2024.
U.S. Bureau of Economic Analysis, Gross Domestic Product [GDP], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GDP, accessed October 2024.
U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items in U.S. City Average [CPIAUCSL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CPIAUCSL, accessed October 2024.
BBC News. (2024). Elon Musk’s political donations and influence. Retrieved from https://www.bbc.com/news/articles/cdj38mekdkgo
CNBC. (2024). Musk comments on Trump administration tax and budget policies. Retrieved from https://www.cnbc.com/2024/06/30/musk-trump-tax-bill-deficit.html
Reuters. (2024). Elon Musk renews criticism of government spending. Retrieved from https://www.reuters.com/business/autos-transportation/elon-musk-renews-criticism-trump-spending-bill-calls-new-political-party-2024-06-30/
