Economic recovery from Covid and the threat of inflation

The fear of rising inflation in countries emerging from the Covid-induced recession has been all over the financial and business press in recent days. This follows higher than expected price increases, particularly in the US. Some economists and commentators have argued that the increase is temporary, down to factors on the supply-side such as bottlenecks, in response to the ‘bounce back’ in consumer spending as households begin to spend accumulated savings, and significant fiscal stimulus. Plenty of demand and problems with supply offer a simple explanation of price rises. When demand exceeds supply, prices rise, and this can also be the case at the level of the economy as a whole.

When I was studying economics at school, textbooks proffered a variety of explanations of inflation, or sustained increases in the price level. There was ‘demand-pull’: too much spending hitting up against a lack of supply, whether of workers or other inputs to production; and ‘cost-push’: wages or other key inputs such as commodities like oil rising in price, which feeds through into the general price level. If trade unions have enough power to sustain their members’ real wages in the face of price increases, then an upward price-wage spiral is possible, even if the initial impetus to rising prices were, say, a temporary oil price shock. In a market economy, given time, relative prices and levels of output across different industries should adjust to sharp changes in the price of their inputs, but in the short term, bursts of general price inflation are possible.

The monetarist explanation of inflation, associated with Milton Friedman, offers a version of the demand-side story: too much money creation, attributed to the government, chasing limited and irresponsive supply, which could also be put down to excessive regulation or tax and spending, also blamed on the government. This theory is simplistic, and was popular in the days of Thatcher and Reagan. Although the macroeconomic policies based on it failed to work, it left a legacy of suspicion of government intervention and the belief that the state could not achieve and sustain full employment via macroeconomic policy, which would only generate a damaging inflation. Full employment could instead be achieved by the deregulation of labour and product markets. This prescription was the opposite of the post-war Keynesian belief in promoting full employment via monetary and fiscal policy, and controlling inflation via microeconomic regulation, such as a wages policy resulting from periodic negotiations between unions, employers and the state.

Under Thatcher and Reagan, inflation did come down, but largely due to major recessions induced by restrictive monetary policy, and union-busting legislation. This also fueled a rise in inequality and wage stagnation, particularly in the US, so even as inflation came down, falling interest rates and financial deregulation promoted large increases in private debt, which reached their apotheosis with the global financial and economic crisis of 2008.

Fast forward to today, and many economists are concerned that the scale of fiscal stimulus in the US and elsewhere may prove a little too effective in inflating the economy. Higher inflation, if it rises above the target of the central bank may, according to today’s orthodoxy, become embedded in expectations, and become permanent, unless monetary and fiscal policy are tightened once again.

Alternatives to the orthodox theory of inflation can be found in the leftist post-Keynesian and classical schools. The former has given rise, broadly speaking, to an approach which emphasises conflict between capitalists and workers over incomes in the form of profits and wages. When firms increase prices faster than the wages they pay to workers this may be contested by the latter group who will push for higher wages and, depending on the balance of power in the workplace, may achieve this. If aggregate spending in the economy is rising fast enough, this will allow firms to respond by increasing prices once again, potentially giving rise to a wage-price spiral and higher sustained price inflation. Should productivity rise sufficiently quickly however, both profits and wages can rise together, leaving less need for such a conflict-driven inflation, and less need for firms to increase prices even as they pay higher wages while achieving satisfactory profits. If productivity growth is insufficient, and contrary to the beliefs (and certainly wishes) of some post-Keynesians, this kind of inflation can be ‘broken’ by deflationary monetary or fiscal policies, though a brutal slowdown or recession and rising unemployment are also a likely outcome.

The ‘classical’ theory of inflation, as put forward by Anwar Shaikh in his magnum opus Capitalism, places more of an emphasis than other theories on the role of the rate of profit measured for the economy as a whole. Shaikh argues that new injections of purchasing power into the economy on the demand-side, and the ‘tightness’ of the economy on the supply-side as regulated by the rate of profit, give rise to a particular inflation rate. Increases in aggregate demand or purchasing power can come from any source, whether private, government or foreign. He defines the tightness of the economy on the supply-side by the rate of profit itself, so that rising profitability will put downward pressure on inflation, and also by the relationship between investment and the rate of profit, so that the greater the share of retained profits are reinvested in new capacity, the more firms will come up against bottlenecks. He argues that the maximum rate of growth of the economy is equal to the profit rate, though it is generally below this.

Shaikh’s theory is able to explain the ‘stagflation’ of the 1970s, when slowing growth and rising unemployment coincided with rising inflation. As he argues:

“[I]t is possible that a falling rate of profit may lower growth and hence increase the unemployment rate. But if the growth rate fell by a lesser amount than the profit rate (say because of an accelerating stimulus from newly created purchasing power), then the economy would become more inflation-prone due to a rising rate of growth utilization. In other words, it becomes possible to have rising inflation alongside rising unemployment.”

All this gives rise to a negative Phillips curve-type relationship between inflation and the inverse of Shaikh’s ‘growth utilization’ rate, which in his book seems to offer a much stronger relationship than the traditional Phillips curve of the relationship between price or wage inflation and unemployment.

How does Shaikh’s classical theory relate to today’s events? There is no doubt that President Biden has embarked on a substantial fiscal stimulus, and there is a large backlog of consumer spending beginning as households reduce their accumulated savings back towards more normal levels. Monetary policy remains very loose. So there is no shortage of new purchasing power or aggregate demand. Whether this translates into much higher and more sustained inflation depends on the relationship between investment and profitability, the growth utilization rate. If the rate of economic growth increases faster than the profit rate due to the sharp increase in demand, then the economy will move closer to its supply-side constraint and become more inflation-prone. But Keynesians might say ‘hold on’, increases in demand might increase the profit rate itself, thus easing the constraint according to Shaikh’s theory. This must be a possibility. Still, all sorts of bottlenecks are likely to arise during the initial sharp recovery in demand, which will have at least temporary effects on relative prices across all sorts of industries. The trick will be allowing or even encouraging the necessary structural economic change to take place, as the pandemic and the associated lockdowns are surely having a mix of both temporary and more permanent effects on the economy.

Another impact of much looser fiscal policy may be increases in interest rates, which could in turn deflate the prices of financial assets, from stocks to housing. This is surely long overdue, though it could be painful for many. Given the accumulated debt of households and firms, it would lead to a rise in bankruptcy as the burden of debt repayments rises. But for the economy as whole, the inflation of financial assets alongside historically weak growth in wages has contributed to the growing inequality of income and wealth. This is one of the more insidious consequences of a reliance on monetary policy to support demand in recent decades. A reversal of this would be healthy in the longer term, as consumption shifts to being supported more by wages than by the unsustainable accumulation of private debt. Perhaps some form of debt jubilee which writes off household debt would be necessary.

More generally, ways could be found of redistributing income to poorer and middle-class households, whether by boosting wages, increasing the progressivity of the tax system or strengthening the welfare state. All this would give those in greater need more ability to pay down debt by supporting the share of household income in GDP, even as many firms are forced into bankruptcy or periods of restructuring.

A major restructuring of many economies will be part of the legacy of the pandemic. Temporary rises in inflation are one potential outcome of the adjustments. Whether or not this becomes a problem is inevitably on the minds of policymakers. But the imbalances generated by a combination of policy-driven financial inflation and wage stagnation for the majority in the US and elsewhere need to be overcome in order to reduce inequality and strengthen democracy and political stability. This could take time, but the shift of expansion away from financial markets towards markets for goods and services, from Wall Street to Main Street, will take a progressive, imaginative and pro-active state, and one committed to more sustainable development, in all its aspects. In the most difficult of circumstances, there is always an opportunity to improve things.

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