COVID and inflation

Is inflation going to rise once the lockdowns from the pandemic have been relaxed?  Mainstream economics has no idea.  For a start, the rate of inflation in the prices of goods and services in the major capitalist economies has been falling as a trend since the 1980s.  And this is despite the attempts of central banks to boost the money supply in order to stimulate demand and reach a certain inflation target.

Indeed, just before the COVID pandemic broke, inflation rates were falling well short of the target rate (usually around 2% a year) aimed at by central banks.  Monetary policy was not working in terms of sustaining a moderate rate of inflation; instead money/credit was flowing into financial assets and property, driving up prices in those assets to new record highs.

But why do we care what the rate of inflation is?  Well, workers and their families do not want prices in the shops or for utilities and other services to be rising faster than their wages and benefits.  On the other hand, businesses do not want collapsing prices, so that profits are squeezed and employers are forced to stop production or go bankrupt.  So it has become a conventional wisdom that moderate inflation is good for capitalist production; as against hyper-inflation nor deflation.

During the pandemic lockdowns, inflation of prices in most goods and services (not all) slowed or even fell, as people were locked down, furloughed or lost their jobs.  So spending, particularly on travel, entertainment and other ‘discretionary’ items was curtailed.  Supply may have slumped at an unprecedented amount, but so did demand.

But what will happen, if and when business revives?  Will deflation take over as firms go bust or will hyperinflation emerge because of the huge amount of credit-backed ‘pent-up’ demand inspired by central banks that cannot be met by supply?

As I say, the mainstream has no idea.  As Wolfgang Munchau in the FT put it: “central bankers do not really understand how inflation works. There are lots of theories and approaches, theoretical and statistical, but none that has been able to explain persistently what is going on in the real world.  In the case of the ECB, that lack of understanding is best symbolised by the almost comical failure of its inflation forecasts. The forecast went wrong because of a false belief that inflation would eventually return to the 2 per cent target. A random number generator, a monkey with a dartboard, or even a horoscope would have outperformed the ECB here.”

Munchau went on: “The problem is not that somebody got a forecast wrong. We all do, all the time. The troubling bit is that these forecasts reveal a basic lack of understanding of the underlying inflation process. There is some recent evidence that globalisation may have changed the inflation process. Even if true, this is not necessarily a helpful observation either. We do not know exactly what kind of period we are entering.”

The reason that mainstream economics is floundering is because its two main theories for accounting for inflation in capitalist economies have been found wanting.  The first of these starts from the demand side of the price equation.  Demand is provided by the money in our pockets or in our bank accounts (whether households or businesses).  Thus, we have the monetarist theory of inflation based on the quantity theory of money.

The theory has a simple formula: MV=PT, where M = the quantity of money in the economy; V = the rate of circulation of that money through the economy, its velocity, P = prices of goods and services and T = the number of transactions in the market.

The argument goes, as from its most famous modern exponent, Milton Friedman, that “inflation is always and everywhere a monetary phenomenon” (Milton Friedman, Inflation Causes and Consequences, Asian Publishing House, 1963.)  Leaving out V and T for a moment, then if money quantity rises, prices will rise and vice versa.  Or, if you like, if the quantity of money rises faster than the production of goods and services (nominal GDP), then there will be inflation.

The first thing to say against this simple theory is that the formula also includes V and T and if the velocity of money should fall sharply and transactions drop off dramatically, that could counteract any increase in money supply.  And that is indeed what happens when economies slow down sharply, particularly in slumps.  So the pace of economic transactions can act to slow or reverse any rise in money supply.  And that is happening now.  In 2020, money supply growth has rocketed to over 25% yoy, but inflation in most countries stays well below 2% a year.

The velocity of money has slowed sharply since the end of the Great Recession and has now dived during the pandemic.

Also, the historical evidence is against the theory that inflation is driven by the quantity of money.  For a start, Friedman and Schwarz’s empirical analysis of money supply and real GDP growth in the 1930s Great Depression was fraught with errors and ‘heroic’ assumptions.  

And if we look at consumer price inflation over the last 30 years (I am using US data here, but it applies to the other major economies too), the rate has trended downwards and yet money supply growth has been stable or rising.  Between 1993 and 2019, M2 money supply rose at an average rate of 6.7% a year, but CPI inflation rose at only 2.3%.  And from the Great Recession in 2008, money supply growth accelerated to 9.6% a year as central banks applied ‘quantitative easing’, but CPI inflation slowed to 1.8% a year.

The other mainstream theory is that of the Keynesians.  They come from the supply side of the price equation.  Price inflation comes from rising raw material prices and from rising wages.  As long as there is ‘slack’ in the economy (lack of demand), then more unemployed can be put to work and unused capacity in factories and stocks can be utilised and inflation will not rise.  But if there is full employment, then supply cannot be increased and workers can drive up wages, forcing companies to raise prices in a wage-price spiral.  So there is trade-off between the level of unemployment and prices.  This trade-off can be characterised in a graphic curve, named after AW Phillips.

Unfortunately, the evidence of history runs against the Phillips curve as an explanation of the degree of inflation.  In the 1970s, price inflation reached post-war highs, but economic growth slowed and unemployment rose.  Most major economies experienced ‘stagflation’.  And since the end of the Great Recession, unemployment rates in the major economies have dropped to post-war lows, but inflation has also slowed to lows.  The Phillips curve has flattened to non-existence (see the brown dots ‘curve’ in the graph of unemployment against inflation in the advanced economies below).

So the mainstream is ‘puzzled’. Indeed, ECB board member Benoit Coeure  recently commented “Economics is indeed struggling with inflation theory. Monetary aggregates and monetarism have been correctly abandoned. Domestic slack explanations (the Phillips curve) have been under attack but are still a bit alive”  And while “there are tons of econometric papers trying to bury or defend a significant slope coefficient in complex reduced-form regressions that forecast inflation (also called Phillips curves to add to the confusion) or in PC embedded in models. Econometric results always insufficient.” Coeure concludes: “Anyone can feel lost in this ambiguity of econometrics” And Janet Yellen, former chair of the US Federal commented: “Our framework for understanding inflation dynamics could be ‘misspecified’ in some fundamental way.

The mainstream answer to whether inflation will return as economies end lockdowns and stage some sort of economic recovery is: ‘we don’t know, but maybe at some point’.  Can Marxist political economy offer an alternative and more effective theory of inflation?  I shall discuss this in the next post.

10 thoughts on “COVID and inflation

  1. Inflation is the barometer of class struggle. When the class struggle ebbs so too does price inflation, and when the class struggle surges, so that workers win wages which exceed the growth in productivity, then prices rise once again. This is the experience of the 70s and early 80s, followed by the long decline in price inflation thereafter.

    If profits are theft because they represent non-payment for labour, then inflation is fraud, because workers are being paid by with a depreciating currency.

    Why the 2% target, this ideal, exalted, mesmerising target. Well it just so happens that it coincides with the average annual post war increase in non-farm productivity. What a novel way to cheat workers of their productivity because a marginal pay rise under these conditions allows the capitalists to pocket the rest. On the other hand, were prices not to rise, then the capitalists, to achieve the same result, would have to force down wages.

    The vulgar economists who necessarily turn their back on the class struggle and seek thereby to endow money with special qualities will never understand inflation.

    p.s. cheap imports from Asia also helped but this was not the main cause.

    1. We all are eagerly waiting for the next post on this interesting and important topic.
      Can you please add some considerations on inflation in non-developed part of the world.
      Here we in the Iran, are experiencing an unprecedented rate of inflation in prices and a stagflation just like England and other advanced capitalist countries in 1970s.
      Chris Harman in his article “do wages causes inflation?” (1979) brilliantly argued that unlike non-monopolistic capitalism, capitalism in his age of concentration and monopolies reacte differently toward slump-boom cycle. In non-monopolistic capitalism, capital in time of slump lowering of prices leads to devaluation of capital and decreasing of organic composition of capital which open a door to a new boom. But in the monopoly capitalism, in the times of slump, monopolistic sectors of national economy do not feel the pressure to lower prices under non-competitive conditions, and not deflation but inflation continue to exist in the times of slump.
      Statics shows that countries like Iran has monopolistic structure, and the reaction of capital to falling rate of profit, has been inflation.
      But why advanced capitalist countries which also have monopolistic capitalism don’t experience inflation as something characteristic of monopoly capitalism and its peculiar transition from value to prices in monopoly capitalism?
      I would love to see what is your comprehensive answer to this question, but i think the answer must be found in the global trade and economy. From the beginning of 1980s onward we witnessed a globalization of capital among advanced capitalist countries, which Harman called it trans-state capitalism.
      Now, both less advanced countries like Iran and advanced countries like US are obliged to realize a part of their surplus value in the global economy. I think there must be a super-profit that advanced countries enjoy in international trade. Because the advanced countries exploite mainly the relative surplus value produced by their national working class, and national economy of less developed countries are mainly dependent on absolute surplus value, and the realization of a part of its surplus value in international circulation, is necessary for holistic reproduction of the whole national economy. So the result of persistence of global economy for advanced capitalist countries is the they can continue to exploit their working classes and reproduce their national economy while they pay lesser value for means of subsistence of their working class because they have advanced technology and therefore can be dependent mainly on relative surplus value. In contrast the result of unavoidable taking part of less developed countries is that they can continue to be dependent mainly on absolute surplus value they have exploited from their working class. So the the structural result of global economy is reproduction of their national economies. And this difference between absolute and relative surplus value, in my opinion, can give a clue to explain different functions of inflation in developed and non-developed parts of global capitalism.
      Can you explain more about it. Thank you

      1. Greetings Farid,

        I am sure Michael, who is better read than me is more conversant with economic conditions in Iran. At a more general level of theory I would disagree with Harman’s observation that monopolies are able to react to falling rates of profit by seeking to raise their prices. I would also disagree with his observation that monopolies can overcome the cyclical movement in prices caused by the industrial (business) cycle. I appreciate these were popular views at the time.

        I do not wish to take up too much time on this site so will limit my own observations. There are a number of reasons for inflation. The one I addressed in my original observation is limited to central bank induced systemic inflation which has clearly failed in the world of commodity production and circulation but not in the realm of fictitious capital pricing.

        The second is the one you refer to, namely cyclical inflation. Marx identified 6 periods in the industrial cycle but in only two periods is inflation found, that is with the period of prosperity and overproduction (forced production). In the latter there is an element of truth about large corporations seeking to consciously raise prices and succeeding because of the level of demand. But this occurs only in this intense but short period, and, in no other regardless of the centralisation of capital. The fundamental reason why raising prices does not reverse the fall in profit margins, is that one capitalist’s selling price, is another capitalist’s buying in price. Thus, the effect of forcing up selling prices is a corresponding rise in cost prices which tend to contra each other out.

        Finally, with regard to Iran, there is a specific form of inflation which results from the collapse in the exchange rate of a national currency. Fiat money is highly sensitive to exchange rates because all economies are integrated into the world economy. In order to respond to you I did a bit of research into the divergence of the official exchange rate and the so called black market rate of the Rial. This growing divergence post-2018 corresponds to the growth in inflation within Iran.

        On a final point. I intend to do a retrospective article next year on Modern Monetary Theory to see how Covid led fiscal measures affected prices. If further rises in infection rates, particularly in the dominant economies, leads to a combination of additional lockdowns and additional fiscal injections, and should a significant proportion of these injections be directed towards workers, then I believe we will face tremendous inflationary pressures with dire consequences for the major bond and share markets. Already the disproportionate measures taken by the US FED and Congress has led to a significant weakening of the dollar which appear to be adding to emerging inflationary pressures there.

        Brian Green

  2. Is there a difference between inflation and rising prices? Let’s assume that our prices go up, but wages remain unchanged. There is a redistribution of part of the money supply from workers to capitalists, but on the whole it does not grow. With inflation, the rise in prices is compensated by the rise in wages and the money supply as a whole increases. Is this assumption correct?

  3. I will look forward to Michael Roberts’ next post on this issue. Meanwhile, though, I do have some questions on his statistics here. What he doesn’t account for is that the way of calculating the CPI (inflation) in the US has changed since the 1980s in such a way as to underestimate inflation. Below is a link that shows that if the old method of calculating the CPI were used, it would be at around 4% rather than under 1%. Further, I think that there has been massive inflation, but just not in consumer goods so much. The inflation has been in investment arenas, especially the stock market prices, but also in real estate. My view: the massive increase in money supply has gone in the main to the investors and therefore where they spend their money – stocks as well as real estate – has seen huge price increases. See:

  4. I’m also looking forward to the next posting. I have one small contribution mabe: When goods and services that have been given out for free starts to cost money, the the need to have money to pay with and therby value of money rises. On the other end when money is used as capital, its immidiate value is the income it generates for the owner. Wherby tax reductions works as deflation?

  5. The lack of inflation is explained by Marx’s theory of surplus value. This money that was distributed was part of the unpaid work of the employees. Explained by the unfair ratio between employees ‘salaries and owners’ profits … … ….

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