Filed under: Economics | Tags: Augusto Pinochet, Franco Modigliani, Inflation, Irving Fisher, John Kenneth Galbraith, Milton Friedman, NAIRU, Paul Krugman, Robert Solow
Generally speaking, inflation is the process of increasing prices and a decline in the value of money resulting in an ‘increase in the flow of money relative to the flow of commodities’ (Waage, 1949: 14). The only consensus within economics is that inflation has winners and losers. Winners are debtors and the losers are people on fixed incomes, savers and creditors who lose from the debtor’s fortune. When I write of inflation here, I am by no means describing the calamitous situation in places like Zimbabwe and around the third world where, because of poor government mismanagement, peoples lives have been destroyed. Rather, I am focused on the type of inflation that impacts developed economies, where undue panic is created over a problem that is not embedded in the economy. As Paul Krugman puts it, “inflation becomes a big problem if it becomes “embedded” in the economy, which makes it hard to restore more or less stable prices.”
In regards to the causes, most people lament greedy people, or what Robert Shiller calls the ‘bad-actor-sticky-price model’ (1997:57). Fundamentally, inflation is about economic stability and while macroeconomics is put in charge of creating stability, there is a lively debate surrounding the issue. Keynesians stress the role of fiscal policy while monetarists put the onus on monetary policy, for as Milton Friedman argued, ‘inflation is always and everywhere a phenomenon’ (1963: 17). Yet, what is missing in the debate is whether inflation should be the economic priority that it is. Increasingly, economies have adopted to make inflation public enemy #1, but is the focus warranted?
Keynesians believed that economic growth would come about by increasing government purchases, thereby rising the economy’s planned expenditure, or by cutting taxes, which would promote greater consumption. Freidman and his disciples saw things differently. What was essential was to expand the money supply at a steady rate of growth. Simply put, Friedman believed heavenly in Irving Fisher’s Quantity Theory of Money MV= PY, or that the amount of money * the velocity of money equaled the general price level times the output. The difference between monetarists and Keynesians has never been about whether the money supply matters but rather about the extent to which it matters. Even Keynes was a monetarist in that he believed the supply of money to be important.1 As put it:
Non-monetarists accept what I regard to be the fundamentally practical message of the General Theory: that a private enterprise economy using an intangible money needs to be stabilized, can be stabilized, and therefore should be stabilized by appropriate monetary policies. Monetarists by contrast take the view that there is no serious need to stabilize the economy; that even if there were a need, it could not be done, for stabilization polices would be more likely to increase than to decrease instability. (1977:1)
To counter Friedman’s observation that inflation was a monetary phenomenon, R.C. Leffingwell reminded us that ‘cheap money does not operate in a vacuum’ (Waage, 1949:3). There are a myriad of factors at play, including unions, wages, the profits of firms, government policy (monetary and fiscal), the handing the public debt. For example, the crop failure in the United States immediately after the Second World War created a shortage of animal feed. The shortage put upward pressure on the prices of grains, meat and poultry.
Supply shocks such as these, that create inflation, highlight the oversimplification inherent in monetarism, an oversimplification to a complex problem. How much of the rise in prices, in say pharmaceuticals, is caused by the desire of corporations to increase profits, specifically when demand is high (perhaps because of an epidemic) and supply is limited. Although inflation is an increase in the general price level, the actions of key sectors of the economy are likely to put considerable pressure on the inflationary process.
Political developments in the 60s and 70 allowed monetarists the chance to put their theories to the test. If economies suffered from high inflation, Freidmanites posited that it was because of misguided government policy that allowed too much money into the system. Since the market was self-regulating, what was needed was to allow the market to operate free of outside interference. The problem of course was that there was little in history to prove Freidman’s utopian economy would operate as he predicted. Since all economies are mixed (with a few command economies) and have always been so, there weren’t any examples to prove Friedman’s laissez-faire assertions.
Friedman employed econometrics to prove quantitatively what could not be proven qualitatively. One of Freidman’s Chicago Boy’s, known as the economic advisors to Chile’s Augusto Pinochet, put it adeptly, ‘to act against nature is counter-productive’ (Klein, 2007: 79) If economies that had adopted free market reform suffered inflation or a myriad of other possible economic ills, the reason was not liberalization but rather that the economy was not free enough and the government could not escape the urge to turn on the presses. Since the prospects of complete free-markets are socially and politically unpalatable, the monetarist, in theory, could never be proven wrong.
In Chile, where monetarism was best tested, unemployment rate went from 3 per cent under Salvador Allende to 20 per cent within the first year under the monetarists. By 1982, the figure had reached 30 per cent. One of the first actions of Pinochet was to free prices, which caused inflation to skyrocket to 605.9 per cent (Fortin, 1984: 312), the highest rate in the world at the time (Edwards, 1986: 535).
The government attempted to allay the problem with a cut in government spending and the contraction of demand. Within a year, inflation had dropped to the still unbearable level of 369.2 per cent. In the early 80’s, the Chilean economy was in a terrible state, in debt and facing hyperinflation. At this period in time, Pinochet began to reverse course and started the process of renationalization. The Chilean economic boom, which monetarism takes credit for, happened not under the tutelage of Freidman but as a consequence of policies diametrically opposed to those of Freidman.
In 1958, economist A. W. Phillips wrote about the inverse relationship between unemployment and the inflation of wages. His famous Phillips curve showed that there was a negative relationship between the two vital economic indicators. What explained this? Essentially, as unemployment fell, workers attained more bargaining power allowing them to push for higher wages. This invariably caused a rise in the general price level as firms passed the costs onto consumers. The trade-off suggested by the Phillips curve implied that policymakers could target low inflation or low unemployment, but not both simultaneously.
For ideological reasons, Keynesians emphasized unemployment and monetarists emphasized inflation going back to the fiscal vs. monetary argument. If there was a trade off, than it would be true that there could not exist a condition of both high inflation and high unemployment. Unfortunately, the economic downturn of the 1970’s put the curve into question. NAIRU, or the Non-Accelerating Inflation Rate of Unemployment, first put forth by Friedman and Edmund Phelps posited that there was a ‘natural rate’ of unemployment’ for which policy makers should aim for.
NAIRU explained that all economies have a natural rate of unemployment and that trying to go below that level would ostensibly cause inflation. Because the unemployed at the natural rate would only work at a certain wage above the prevailing wage levels, any fiscal or monetary policy aimed at getting raising employment would put upward pressure on the general price levels. Why was this rate ‘non-accelerating’? Because if broken, higher wages would cause higher prices, labor would pressure for more wage increases and this had the potential of going out of control. Institutional economist John Kenneth Galbraith, in his paper Time to Ditch the NAIRU asserted:
The concept of a natural rate of unemployment, or nonaccelerating inflation rate of unemployment (NAIRU), remains controversial after twenty-five years…First, the theoretical case for the natural rate is not compelling. Second, the evidence for a vertical Phillips curve and the associated accelerationist hypothesis that lowering unemployment past the NAIRU leads to unacceptable acceleration of inflation is weak. Third, economists have failed to reach professional consensus on estimating the NAIRU. Fourth, adherence to the concept as a guide to policy has major social costs but negligible benefits.
As Galbraith argued, the evidence for NAIRU was at best flimsy. NAIRI advocates never have presented historical data or studies to back up there postulation.
Inflation is not a monetary problem, rather is the product of social conflict that arises from the distribution of income. More so than money supply, it is the nation’s labor situation that is the impetus for price stability and inflation. Thus, as Robert Solow argued, inflation ‘is endemic to modern mixed capitalist societies’. Government action is not the key cause of inflation, and the idea that printing money is the cause of inflation is questionable. As students learn fairly early on, banks are the greatest source of making new money, primarily by taking liabilities in the form of loans.
The monetarist controversy was an attempt by free-market advocates to bring inflation to the forefront and put the onus on government to ‘keep-out’ as a means of achieving goals that had very little to do with inflation. In countries where stabilization occurred, poor nations with runaway inflation were forced, at the advice of Friedman and later Jeff Sachs, to sell their public companies. Inflation was a convenient excuse for the wealthy to put unemployment in the backseat.
Congdon, Tim. Keynes, the Keynians and Monetarism. Northhampton, MA: Edward Elgar, 2007.
Edwards, Sebastian. “Monetarism in Chile, 1973-1983: Some Economic Puzzles.” Economic Development and Cultural Change, Vol. 34, No. 3, Apr., 1986: 535-559.
Fisher, Irving. The Purchasing Power of Money: Its determination and Relation to Credit Interest. Norwood, MA: Norwood Press, 1911.
Fortin, Carlos. “The Failure of Repressive Monetarism: Chile, 1973-83.” Third World Quarterly, Vol. 6, No. 2., Apr., 1984: 310-326.
Friedman, Milton. Inflation: Caues and Consequences. New York: Asia Publishing House, 1963.
Galbraith, James K. “Time to Ditch the NAIRU.” The Journal of Economic Perspectives, Vol. 11, No. 1, Winter, 1997: 93-108.
Klein, Naomi. The Shock Doctrine: The Rise of Disaster Capitalism. New York: Metropolitan Books, 2007.
Shiller, Robert J. “Why Do People Dislike Inflation.” In Reducing Inflation: Motivation and Strategy, by Christina D. Romer and David H. Romer eds., 13-65. Chicago: University of Chicago Press, 1997.
Waage, Thomas O. Inflation: Causes and Cures. New York: The H.W. Wilson Company, 1949.
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