Economic theory needs to account for the phenomenon of inflation. This post draws on Chapter 15 in Professor Anwar Shaikh’s recently published book Capitalism in which he outlines his theory of inflation under modern fiat money (state-backed money not fixed in value to gold or another commodity). He contrasts it with neoclassical and Keynesian theories, and provides empirical evidence to support his ideas.
The essence of Shaikh’s model is quite simple. Inflation, a rise in the overall price level in an economy, is determined by aggregate demand and supply, and these are influenced by three factors having either a positive or a negative effect on it: new purchasing power (PP), net profitability (the rate of profit minus the interest rate, rr) and the so-called ‘growth utilization rate’ (u).
PP is a demand-side factor, and the other two factors operate on the supply-side. PP is influenced by private and public sector credit, or a rise in borrowing to fuel greater spending in an economy. Note that this can be generated domestically or from abroad, for example through a rise in net exports. In theory, under modern fiat money, the amount of PP generated by the government ‘printing money’ has no limit, and history shows that in wartime, governments have often financed the extra demands on their activities through the creation of new money, which has given rise to inflation. This source of inflation, generated from the demand-side, seems similar to monetarist theory, in which the state is to blame via its intervention in the economy and its creation of an excessive growth of the money supply, and trying to keep unemployment below its ‘natural rate’.
Inflation generated by excess demand is also linked to the original Phillips’ curve, which appeared to show a trade-off between unemployment and inflation. Some western governments of the 1960s felt that they could exploit this trade-off by choosing lower unemployment at the cost of higher inflation, to be achieved through expansionary monetary and fiscal policy. The apparent trade-off broke down in the 1970s and Keynesian economists of the time fell out of favour, to be replaced for a time by the monetarists, led by Milton Friedman.
But Shaikh’s model, as already mentioned, accounts for the interaction between demand and supply. Inflation responds negatively to increases in rr (net profitability). If rr rises, inflation will tend to fall, other things being equal.
Finally, inflation responds positively to u, the growth utilization rate, a measure of supply resistance. For Shaikh, the maximum rate of growth is equal to the profit rate. This occurs because, in this model, firms as a whole cannot invest more than the total value of their profits. They can either invest this value or less, but no more. If they invest less, then growth will be lower. u is the investment share in total profits, or u=I/P, where I equals investment and P equals total profits. When u=1, firms will be investing all of their profits and the maximum growth rate will be achieved. If u<1, they will be investing less than this.
Growth utilization u is a measure of the limits to the expansion of supply. The higher is u, the ‘tighter’ the economy will be and the less will supply increase in response to higher PP or demand as new purchasing power. Note that Shaikh makes no claim that this supply will correspond to full employment, as in Keynesian theory, or a natural rate of unemployment, as in monetarist and new classical theory. Shaikh’s theory holds that a surplus rate of involuntary unemployment is in fact normal under capitalism. Full employment will tend to be temporary, although a weakening of labour’s bargaining power over wages or forms of incomes policy under corporatist-type policies can improve matters, though with different outcomes in terms of income inequality.
Shaikh’s framework receives empirical support in his book, and can be used to explain periods of hyperinflation and stagflation (unemployment and inflation rising together). The latter phenomenon afflicted the western world in the late 1960s and 1970s, and led to the breakdown of the Keynesian consensus in policymaking and the rise of neo-liberalism and more free market ideas.
Stagflation occurs when the profit rate is falling faster than the growth rate, so that growth utilization u rises and the economy faces a tightening supply constraint. A falling profit rate will tend to reduce the growth rate and lead to rising unemployment. Keynesian policy might respond to rising unemployment by raising purchasing power PP through monetary and fiscal means. But this ‘pumping up’ of demand in the economy will not increase employment if the profit rate is falling and will instead lead to higher inflation. So it is possible to have rising rates of inflation and unemployment at the same time, and so it proved.
Hyperinflation tends to be caused when, as mentioned above, governments attempt to meet their financing needs by massively expanding PP when the economy may be performing poorly. A supply constraint may already be present, but fiat money allows PP to be raised potentially without limit, so that in these cases there will be a close relationship between the increase in PP and inflation.
Shaikh compares empirically the original Phillips’ curve and his Classical curve for the post-war period, showing that the former broke down completely in the 1970s, while the latter provides quite a good fit. PP and rr are shift factors for a curve which links inflation with u.
Comparing the mainstream neoclassical theory of the ‘natural’ rate of unemployment, it is similar to Shaikh’s theory in that they both incorporate a theory of a limit to supply and a measure of ‘slack’ in the economy. However, the mainstream theory of supply assumes that the unemployment rate at which inflation is stable is effectively full employment, with no involuntary unemployment. Neoclassical theory tends to blame state intervention for inflation, an idea that calls for independent central banks and attacks on collective bargaining, wages and working conditions. Post-Keynesians look at institutional and cost-push factors in the labour market to explain inflation. This would require incomes policies which attempt to reduce it by reducing wage growth collectively.
Shaikh’s theory does not assume full employment but instead suggests that there is a normal rate of involuntary unemployment, which is systemic, and tends to be restored despite fluctuations around it in both directions, driven by both free competition and policy intervention.
To sum up: Shaikh’s Classical theory of inflation holds that it is determined by the demand ‘pull’ from new purchasing power, and a supply resistance from the limits to growth set by the net profit rate. The book shows the clear empirical evidence for this argument, which rejects both mainstream neoclassical and heterodox post-Keynesian ideas.