Even though economists are at variance to explain the workings of inflation, we think we know inflation when we see it. When things we buy every day feel all of a sudden expensive, we start to worry. Since almost everything we consume these days has become more expensive, we start to talk about inflation and what to do about it.
What we actually suffer from are not higher prices, but that our salaries – or profits – have not risen to an equal extend. If all prices moved upwards at the same time all the time, we would not be bothered. The problem is that economic transactions are sequenced. We go shopping after the pay cheque arrived or get paid for our services or deliveries only after we have completed them to find out that we have been short-changed in the meantime.
The salary we got yesterday buys only half the strawberries of today. And the strawberries we sold on the farmers market today cost twice as much to produce them tomorrow as we have sold them for. Soon the farmer will raise strawberry prices and the strawberry eaters will demand higher pay.
Someone somewhere has started to raise prices, and gets away with it because there’s no immediate alternative. All the others in the chain of production and consumption will have to raise prices too if they don’t want to lose out. If it were the price of a diamond ring, this would not matter.
If it is the cost of energy, like gas from Russia or oil from Saudi Arabia, it will matter a lot, as everything else is affected by it. Transport, heating, fertilisers, you name it. And, very quickly, it will become an all-out war of musical chairs. No one wants to be the one saddled with the losses.
MIT economist Oliver Blanchard therefore describes inflation as “the outcome of the distributional conflict between firms, workers and taxpayers”. Such conflict, as he sees it, can only stop “when the various players are forced to accept the outcome”. It is a very simplified model. Broadly rising prices need monetary accommodation, as otherwise “the stock of money would be sharply reduced” (Adam Tooze), by logic impeding all economic activity.
Thus creditors have also skin in the game: bondholders, share owners and banks will all partake in the scramble for lucre. Consumers can go on strike too and refuse what’s on offer. By and large, it’s a raucous affair where, habitually, central banks decide when the fist fight is over.
Fat profit margins starting point of today’s price spiral- Andreas Weitzer
The current bout of inflation, unforeseen and unexpected, started with corporations taking advantage of consumers flush with cash and deprived of consumption during the pandemic. Fat profit margins were the starting point of today’s price spiral, when companies exploited supply deficits and waved ever higher pay cheques to a tired and diminished workforce. The energy crisis came later, yet with brutal force.
The state can play a decisive role as a referee in this distributional struggle. It can tax “excess profits”, it can strengthen anti-competitive measures to fight corporate greed; it can provide relief for struggling households with tax cuts and subsidies.
But the state can also lean back and enjoy higher VAT revenues which come with higher prices and higher income taxes as salaries go up. And it can enjoy the steady melt of its liabilities as inflation eats away sovereign debt in real terms. The state can also fuel inflation by ill-timed investment, tax cuts, or by splashing about unemployment benefits. War and all the expenditure which comes with it is always inflationary.
At the end of the day, it falls to central banks to “take away the punch bowl”. CBs will aim to slow monetary accommodation by raising interest rates. This will diminish wealth and make credit more expensive, curbing investment and consumption. The hoped-for outcome is to stun labour into accepting a bad outcome for themselves.
Central bankers fear that inflation becomes “entrenched”, leading to a “wage-price spiral”, when workers demand regular wage resets. They believe in the “Phillips Curve”, the allegedly firm relationship between inflation and too little unemployment. They purport, quite cynically, that a basic rate of unemployment is necessary to guarantee price stability.
This is, of course, a very vague, perhaps dubious, concept. In the UK, insufficiently paid public employees like nurses, teachers, judges or ambulance drivers are denied a higher salary despite the fact that their “product”, the public services they provide, is essentially free and thus cannot be wage-inflated.
Galloping inflation is equally possible when workers show exemplary restraint. In a highly automated world, labour is not the all-deciding cost factor anymore. And then, as financial journalist Matt Klein has pointed out, a fired employee living on the dole might consume less, but consume he or she will. See the currently quickly rising credit card debt in the US. Yet he or she will produce nothing, thus exacerbating inflationary scarcity.
At the end of the day, with monetary conditions getting tighter, consumption will be curbed by the effects of inflation itself. Rents in the US are coming down and house prices are falling. Used-car prices have normalised and new cars, even Tesla’s, are offered at a discount.
Yet we are hardly persuaded to buy big-ticket items, no matter the discount. We feel the impoverishing effects of inflation and hold back with our expenditure. We as a family take enormous pride to turn down the heating and refrain from excessive consumption. It was a Christmas with gifts costing less.
Price hikes are always an expression of deficits (while full warehouses are the harbinger of discounts). In a world of geopolitical rivalry, “nearshoring” and a relentless scramble for raw materials to engineer our energy transition and the digitalisation of things, a lot of stuff will get scarcer and therefore more expensive from time to time.
Without automation, labour too will be a deficit factor with birth rates falling. We have to prepare for such imbalances in a more holistic way. If our only answer to new spikes of supply deficits is to every time strangle the economy, it will be highly destabilising. A fairer system of problem sharing will be asked for.
As we stand today, money has gotten already painfully more expensive, while interest rates keep rising. This will give governments less fiscal leeway as it forces them to raise debt at higher cost. Corporate earnings will shrink, pulling down share valuations even further. For a while, bond prices will keep falling in tandem, as long as interest rates are still nudged up by CBs.
Discussions about a soft, or not so soft, landing look academic to me. By any measure, the economy is already in retreat on all fronts. The year 2023 will get worse before it gets better. The markets will call it a recession when GDP contracts for two consecutive quarters. How arbitrary. Then interest rates will come down and investment grade bondholders will be winners. We would be ill-advised to try to time this inevitable change of direction.
Matt Klein https://open.substack.com/pub/matthewklein/p/is-the-job-market-disinflationary?
Follow Oliver Blanchard on Twitter #ojblanchnard1.
Andreas Weitzer is an independent journalist based in Malta.
The purpose of this column is to broaden readers’ general financial knowledge and it should not be interpreted as presenting investment advice, or advice on the buying and selling of financial products.
andreas.weitzer@timesofmalta.com