The Economist magazine recently published a special report on the world economy, looking at the ‘problem’ of low inflation. More than ten years have passed since the beginning of the Global Financial Crisis and Great Recession, and inflation is now strikingly low in many rich economies. This is despite unemployment falling to historically low levels in countries such as the US, UK and Germany, although it remains much higher in a number of European countries that have yet to recover from the worst of the eurozone crisis.
Normally economists expect wages to rise faster as unemployment falls below some critical level and the labour market tightens, and at some point this has tended, at least in the past, to lead to higher inflation.
In the US and UK, wage growth has been picking up, but inflation has remained low, and has even undershot central banks’ inflation targets. Wage increases are relatively good news for workers after a decade of sluggish or stagnant earnings growth, but remain weak compared to those seen prior to the recession.
Low inflation, or negative inflation (falling prices), can be a problem for the economy, as they tend to slow growth in consumption when consumers forgo purchases as they wait for prices to fall further. Moderately rising prices will tend to have the opposite effect, stimulating demand. They also result in a redistribution of wealth from borrowers to savers, and increase the debt burden. All in all, low or negative inflation can become self-perpetuating as expectations adjust downwards and demand weakens.
From stagflation to inflation targets
In the post-war period, and particularly from the late 1960s through to the early 1980s, rich world economies experienced the dismal combination of inflation and unemployment rising together, what came be called stagflation. At the beginning of this period, orthodox economic theory relied on the Phillips’ Curve to explain the relationship between inflation and unemployment. It posited a negative relationship between the two, so that if economic policy pushed unemployment to low levels, inflation would be expected to rise, and vice versa. The original Phillips’ Curve was therefore unable to explain stagflation.
From the 1980s, macroeconomic theory and policy shifted from an emphasis on keeping unemployment low to fighting inflation, as it became influenced by free market economists, firstly the monetarists, whose standard-bearer was Milton Friedman, followed by the New Classicals. They argued that unemployment was not a macroeconomic problem due to insufficiency of aggregate demand, but a microeconomic one, caused by imperfections in the labour market. Inflation was the macroeconomic problem that needed to be contained, principally via monetary policy, whether this was through managing the money supply, which ultimately proved unachievable, or through managing interest rates to achieve an inflation target, which is more or less where policymakers found themselves on the eve of the recession.
Today’s policymakers in Europe and the US are increasingly worried about the current failure to meet inflation targets through price rises apparently apparently being too low, rather than too high. In the US, the old style Phillips’ Curve has been almost flat over the last decade, so that falling unemployment has produced little in the way of rising inflation. Of course, low unemployment figures there are somewhat misleading due to the relatively low labour participation rate, which has fallen during the recovery, but indicates that there is still some labour market slack which is disguised by looking at unemployment rates alone.
Meanwhile, in the UK, productivity has barely grown since the recession. A possible reason for this is weak demand, exacerbated by austerity, and the vaunted ‘flexibility’ of the labour market, which has produced rising employment rates alongside weak wage and productivity growth. If these factors indicate a form of disguised unemployment, a significant boost to demand could improve matters as workers are reallocated to more productive positions and sectors.
With regard to inflation rates, these may be even lower than current measures indicate. This may to due to the difficulty in measuring the impact of new technologies on consumption. Consumer price inflation is typically measured using a representative basket of goods. The composition of this basket will change as consumption patterns evolve over time. Falling prices and improving quality in new products, such as today’s smartphones, social media and online streaming, can be missed in statisticians’ measurements of inflation.
Lower inflation than actually recorded would mean that GDP and productivity are higher than currently measured, which is a positive in economic terms. But the problem of lower inflation remains and may therefore be even worse!
The shift to a world of low inflation
The low inflation world of today is surely due in part to the attacks on organised labour in the form of trade unions since the 1980s, particularly in the Anglo-Saxon economies of the US and UK, and rather less so in continental Europe. This was justified by free market economists’ aforementioned theories of market imperfections. Thus labour market regulations, hard won by trade unions, and collective bargaining, were seen as obstacles to market efficiency, to be removed as far as practicable.
Deregulation of labour markets, the attacks on trade union power, alongside the decline of the latter due to structural changes such as the shift of employment away from manufacturing and towards service industries, while uneven across the rich world, have surely played a major role in the rise of income inequality since the 1980s. And it is also likely to have helped bring down inflation rates. But at what cost? It is no doubt helpful to right wing politicians to stylise workers’ rights as market imperfections, implying that their removal is a step towards perfectly efficient markets, and providing a persuasive platform for changing the balance of power in society away from labour and towards capital.
These changes have been helped along the way by the forces of globalisation, shaped in no small part by the integration of China, India, much of East Asia, and the economies of the former Soviet Union and Eastern Europe into the world economy. These events, which also gathered pace from the 1980s onwards, have resulted in a vast expansion of the potential global labour supply, and a huge shift of manufacturing capacity and employment away from the richest countries. This has helped to put downward pressure on wages and prices across the world, weakening the bargaining power of labour. While consumers in rich countries have benefited from the cheaper goods available, many have lost out as production has moved to countries with lower labour costs.
A glut of savings
Another possible explanation for today’s low inflation rates is the global savings glut hypothesis. An excess of savings over investment in economies such as China, Germany and Japan, as indicated by their current account surpluses, has weakened global demand and reduced interest rates, at first domestically and then worldwide. These savings were exported to economies with deep and liquid financial markets such as the US and UK, as well as peripheral European economies such as Spain, and created debt-fueled asset price bubbles, particularly in housing. While this temporarily boosted consumption, ultimately it increased the debt burden. When the bubbles began to deflate, this triggered the financial crisis and the deleveraging which drove economies across the world into a deep recession.
The savings glut has been caused by structurally weak demand due to rising inequality, which has supressed consumption, since poorer households tend to spend a larger proportion of their income than rich ones. Broadly speaking, this produced two possible outcomes in recent decades: rising debt to compensate for weak demand, which boosted growth for a time, as seen in the US, the UK and peripheral Europe; or a growing dependency on export-led growth, as seen in Germany, some smaller economies in Northern Europe, and East Asia.
Growth of demand in the debt-led economies tended to produce current account deficits, the flipside of the current account surpluses in the export-dependent economies. This pattern has continued for some time, but ultimately the structurally weak demand has reasserted itself, leading to weakening growth, the increased likelihood of recession, and low inflation.
If the savings glut is a key reason for weak inflation, then the solution is to tackle the inequality of income and wealth through redistribution towards poorer households, and possibly strengthening the influence of trade unions where necessary in order to encourage a faster growth in wages for the majority of workers.
The aim of such policies would be to increase household income as a share of GDP and raise consumption growth in a way that makes it far less dependent on rising debt. In the surplus economies such as Germany, this would help to grow domestic demand and reduce dependence on exports. In the deficit countries, it would help to maintain growth while reducing its dependence on rising debt. If economies such as Germany are able to rebalance in a way that reduces their current account surpluses without constraining overall demand and growth, this would boost exports in the deficit countries helping them to rebalance growth towards external demand. A sufficiently fast growth in global demand and GDP would be likely to raise inflation back towards central bank targets, and reduce the risk of deflation occurring.
Anwar Shaikh’s classical theory of inflation
One more potential explanation for the causes of inflation comes from Anwar Shaikh, an economist working in what he terms the classical tradition, drawing particularly on Marx, but also on Smith and Ricardo, as well as Keynes to some degree. In his magnum opus, Capitalism, he discusses theory and empirical evidence for this.
For Shaikh, inflation is positively related to net injections of purchasing power into the economy (in the form of demand), negatively related to the overall rate of profit (when the profit on new investment rises inflation will tend to weaken), and also positively related to the ‘tightness’ of the economy on the supply-side, as represented by the share of investment in profit. This last factor reaches its limit when profits are completely reinvested in production; in other words, the investment share in profit is 100%.
The investment share in profit can also be described as the ratio of the growth rate to the profit rate. The implication for inflation and the tightness of supply is that when the profit rate is falling faster than the growth rate, this tightness increases and makes the economy more prone to rising inflation. A boost to the economy from increasing demand, whether this comes from the private, public or foreign sectors, is then more likely to increase inflation instead of real output.
Shaikh’s theory provides a good explanation for the stagflation of the 1970s mentioned above. Falling profit rates led to a tightening of the supply constraint and began to drag down investment, growth and employment. When governments tried to boost demand with fiscal and monetary policies, this increasingly raised inflation rates rather than reduce unemployment.
The policy response to stagflation ranged from right wing attacks on labour to more consensus-based incomes policies between government, business and unions, which proved more successful in Germany and the Scandinavian countries. Either way, they tried to reduce wage growth relative to productivity and restore profit rates, although this aim was not always explicit.
Shaikh and some Marxist economists place a great deal of emphasis on trends in the average rate of profit in the economy and see major recessions or depressions as the result of it falling. A full recovery will only be possible if profit rates rise again, which is meant to stimulate investment. This could be achieved through a restructuring of the economy, eliminating weaker and less profitable firms and sectors so that resources flow to stronger or more profitable ones. This need not be left to the market: state industrial and regional policies can help, alongside a sufficiently generous and responsive welfare state to support laid-off workers and the reallocation of employment.
A meeting of minds?
At first reading, Shaikh’s theory and the savings glut theory seem to lead in different directions for policies to raise inflation and boost growth, wages and employment: one looks to raise profit rates, possibly through falling wages and economic restructuring, while the other looks to boost demand through more directly raising wages and household income. The latter could reduce profit rates, even if it raises investment.
For those persuaded by the idea of a savings glut, some of the investment taking place in China, Germany and Japan is either excessive or misallocated and therefore unproductive. Productive investment is constrained by weak growth in household income and consumption as a share of GDP, the main source of which is income from wages.
In Germany and Japan, corporate savings relative to investment are too high and need to fall as household income and consumption increase. This should at some point stimulate investment in new capacity in sectors which produce consumption goods, as well as a stronger demand for imports. In China and Japan, higher household income and consumption shares in GDP would reduce the savings and investment shares, while improving the latter’s allocation and productivity.
Countries like the UK and US in which domestic savings are less than domestic investment would benefit from a faster growth in external demand and reduced net inflows of capital, two outcomes which would be mutually supportive. Consumption demand would also benefit from lower inequality. Achieving these outcomes is easier said than done, both politically and economically.
The supply-side aspect of Shaikh’s theory of inflation in the form of the investment share in profit has some overlap with the savings glut story. A lower investment share in profit reduces the tightness of the economy on the supply-side and puts downward pressure on inflation, other things being equal. The same is true when there is a savings glut, which as we have seen can take the form of a low investment share relative to business savings, which are drawn from total business profits. Higher business profits for the economy as a whole need not lead to higher investment if expected future sales are insufficient. The uninvested surplus can either be absorbed by government deficits, as it has been to some extent in Japan, or exported abroad as in Germany, which now insists on more or less permanently balanced budgets. Capital exports can support higher investment abroad if there are unmet productive investment needs, unproductive investment in the form of financial speculation, lower savings and higher debt as consumption rises, higher unemployment, or some combination of all four.
The upshot of all this is that weakening global growth is likely to continue to put downward pressure on inflation, and that a sufficiently ambitious policy response will to some degree have to reverse rising trends in inequality. In the absence of significant global policy cooperation and coordination, which is a challenge at the best (or worst) of times, the largest economies will have to lead the way with domestic reforms, which could perhaps prove contagious.
Government fiscal expansion to fund productive infrastructure and redistribute income in a progressive fashion, where needed, would also take some of the burden away from central banks in the largest economies. Despite interest rates at record lows and quantitative easing, inflation remains stubbornly low. The necessary response is more difficult politically, as it involves going against much of the broad thrust of policy orthodoxy since the 1980s: redistribution and wage increases for poor and middle income earners, the possibility of capital controls, and fiscal expansion rather than austerity. But this does not negate its necessity.