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June 22, 2008

Inflation and Wages -- Another Dangerous Economic Fallacy
by Gerard Jackson

Economic fallacies are like dormant microbes, sooner or later they once again become active. However, the view that wages can cause inflation is one fallacy that never seems to go away. There are economists in the US, the UK and Australia warning that wage rises could trigger an inflationary surge. Nothing new here. In early 2005 Mark Whitehouse and Kemba Dunham of the Wall Street Journal complained that too much job growth generated inflation. In their view good job numbers would probably "fuel fears of higher inflation and cause bond prices to fall and interest rates to rise".

What Whitehouse and Dunham preached is a terrible economic fallacy. What was really worrying at time is that Alan Greenspan seemed to have taken it on board. In a 1999 speech he stated that if GDP continued to expand "in excess of trends of potential output, the economy could be expected to eventually overheat, with inflation and interest rates moving up". But even as he was speaking the rate of increase in GDP was slowing. Furthermore, he must have known that manufacturing was shedding jobs. Yet he still argued that the demand for labour would have to slow "if inflationary forces are to continue to be contained".

Some will argue that what mattered at the time was aggregate employment and not employment by sectors. This is a Keynesian argument and a very dangerous one at that. Putting it somewhat simply, forcing the rate of interest below the market rate stimulated manufacturing. However, as nominal incomes rose and moved down the production structure the old time-preference ratio reasserted itself and demand at the consumption stages of production started shifted resources downwards while exerting pressure on producer prices.

The result was that manufacturing started to shed labour. But because of rising monetary demand at the lower stages of production the resulting increase in the demand for labour offset for a time the fall in manufacturing jobs. (I believe the situation was also aggravated by the amount of credit that went directly into consumption). This process is caused by credit expansion and always results in a recession. It's important to bear this in mind because some of those who took Greenspan to task on this matterfelln pray to another dangerous fallacy -- that inflation means too much money chasing too few goods. This is basically a "structural" view of inflation and one that Arthur W. Marget scathingly condemned:

. . . there have always been economic illiterates to cry that the difficulty was due to a "shortage of goods", than an expansion in the quantity of money. . . (Arthur W. Marget, The Theory of Prices, Prentice-Hall, Inc., 1938, p. 93).

When we say that inflation is a monetary phenomenon we should mean that it is caused by monetary expansion. Nineteenth century Britain experienced two huge declines in prices. The first one was from the end of the Napoleonic Wars to the gold discoveries of 1848. The second was from about 1873 to 1896. These periods have been inexcusably described as deflationary. They were nothing of the kind. Deflation means an absolute fall in the quantity of money. As Britain was on the gold standard a deflation would obviously mean a fall in the quantity of gold. No one to my knowledge was ever foolish enough to suggest that this was the case. (Strictly speaking Britain was on a quasi-gold standard in the sense that fractional banking often destabilised the economy).

The price declines were due to increasing productivity. As unit costs fell more goods exchanged against the same amount of gold leading to a general fall in prices. This process ensured that the benefits of growth were dispersed in away that accorded with the theory of marginal productivity. So-called orthodox economic theory completely misconstrues this process, arguing that the quantity of money should be increased at the same rate as economic growth so that prices can be stabilised and price margins (differences between costs and selling prices) maintained.

This is an economic absurdity. It is not the quantity of money that maintains price margins but the market process. Costs are determined by consumer preferences and discounted by the social rate of time preference. Therefore in a situation of general equilibrium price margins would not only equal the rate of interest they would be the rate of interest.

In the real world entrepreneurship married to ingenuity constantly reduces the costs of production by investing in capital goods that embody new technology. The result is a constant downward pressure on prices. One can see this with the remarkable decline that has occurred with all electronic devices, particularly computers, during the last 20 years. And this is what happened during the nineteenth century. Hence the view that business can only be kept solvent by manipulating the money supply has been thoroughly discredited by economic history.

Furthermore, money is not neutral. This means that attempts by central banks to stabilise prices distorts the pattern of production and triggers off the so-called boom-bust cycle. From this we can deduce that even when the CPI is apparently stable inflation can still be rampant beneath the monetary surface. Those who think otherwise have not learnt the fundamental lesson of the 1920s.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2009 Gerard Jackson

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