Inflation and financial risk

Is inflation coming back in the major capitalist economies?  As the US economy (in particular) and other major economies begin to rebound from the COVID slump of 2020, the talk among mainstream economists is whether inflation in the prices for goods and services in those economies is going to accelerate to the point where central banks have to tighten monetary policy (ie stop injecting credit into the banking system and raise interest rates).  And if that were to happen, would it cause a collapse in the stock and bond markets and bankruptcies for many weaker companies as the cost of servicing corporate debt rises?

The current mainstream theory for explaining and measuring inflation is ‘inflation expectations’.  Here is how one mainstream economic paper put it in relation to the US: “Over the longer-term, a key determinant of lasting price pressures is inflation expectations. When businesses, for example, expect long-run prices to stay around the Federal Reserve’s 2 percent inflation target, they may be less likely to adjust prices and wages due to the types of temporary factors discussed earlier. If, however, inflationary expectations become untethered from that target, prices may rise in a more lasting manner.”

But expectations must be based on something.  People are not stupid; businesses and households’ expectations of whether prices are going rise (faster) depend on some guesses or estimates of how prices are moving and why.  Moreover, expectations of price rises do not explain the price rises themselves.

There is a reason why mainstream economics has been driven into this ‘subjective’ corner in explaining and forecasting inflation.  It’s because previous mainstream theories of inflation have been proven wrong.  The main theory of the post-war period was the monetarist one, which I have discussed before.  Its basic hypothesis is that price inflation in the ‘real’ economy occurs and accelerates if the money supply rises much faster than production in an economy.  Inflation is essentially a monetary phenomenon (Milton Friedman) and is caused by central banks and monetary authorities interfering in the harmonious expansion of the capitalist economy. 

But the monetarist theory has been proven wrong, particularly during the COVID slump.  During 2020, money supply entering the banking system rose over 25% and yet consumer price inflation hardly budged and even slowed.

Monetarist theory has been proven wrong because it starts from the wrong hypothesis: that money supply drives prices of goods and services.  But the opposite is the case: it is changes in prices and output that drives money supply.

Take the monetarist formula: MV=PT, where M is the money supply; V is the velocity of money (the rate of turnover of money exchanges); P = prices of goods and services and T = transactions or actual real production activity.

Monetarist theory assumes that the velocity of money (V) is constant but this is just not true, especially during slumps and the COVID slump in particular.

The huge rise in money supply (M) has been dissipated by the unprecedented fall in the velocity of money (V).  So MV, the left-hand side of the monetarist equation, has not moved up much at all.  Contrary to monetarist theory, prices of goods and services have not been driven by the money credit injections. 

But has this money disappeared then?  No, it’s still there, but the money injections by the Federal Reserve and other central banks, mainly achieved by ‘printing money’ and purchasing huge quantities of government and corporate bonds, as well as making loans and grants, have ended up, on the whole, not in the hands of businesses and households to spend, but in the deposits of banks and other financial institutions. This money has been hoarded or used to fund speculation in financial assets (a booming stock market and investment in hedge funds etc).  So the velocity of money (V) in goods and services transactions has plummeted.

The alternative mainstream theory of inflation is the Keynesian one.  This is fundamentally a ‘cost-push’ theory, namely that companies push up their prices when their costs of production rise, particularly wages, the largest part of costs of production.  In effect, Keynesian theory is a wage-push theory. Inflation depends on the relative demand for and supply of labour forcing up wages.  So the argument goes: the lower the unemployment rate and the higher the demand for labour relative to the available supply, the more wages and then prices will be forced up.  Keynesian theory sees inflation as being caused by workers getting too high wage increases (and eventually losing out in real terms as price rises eat into wage increases).

The usual Keynesian way to estimate likely changes in inflation is to use the so-called Phillips curve: the curve of the statistical relation between unemployment rate and the price inflation rate.  Again, however, this theory has proven to be false.  The ‘curve’ does not hold or is so ‘flat’ as to provide no guide to inflation.  Indeed, since the Great Recession of 2008-9, unemployment rates in the major economies have dropped to near all-time lows and yet wage rises have been relatively moderate and inflation rates have slowed.  This is the mirror image of the 1970s when unemployment rates rose to highs but so did inflation and we had what was called ‘stagflation’.  Both examples show that the Keynesian cost push theory is false.  In the Figure below, based on monthly data, the blue line shows where the Keynesian Phillips curve should be if it works; and the red line shows where it actually is.  Indeed, the red line shows that falling unemployment leads to slowing inflation, at least since 2010!

The problem with Keynesian inflation theory is that it assumes that profits comes from investment and not from the exploitation of labour power.  Keynesian theory says that S (surplus value) is the result of C (capital stock) and not V (labour power).  So if C is steady, then S is steady and any price rises must come from V (wages rises).  Marx’s view was different.  In his speech to trade unionists in 1865, he argued against the view that wage rises cause inflation.  In his view, a rise in V will generally lead to a fall in S (profits), not a price rise.  That is why capitalists oppose wage rises vehemently.

And there is no wage push inflation.  Indeed, over the last 20 years until the year of the COVID, real weekly wages rose just 0.4% a year on average, less even that the average annual real GDP growth of around 2%+.  It’s the share of GDP growth going to profits that rose (as Marx argued in 1865).

If there is going to be any ‘cost-push’ this year, it’s going to come from companies hiking prices as the cost of raw materials, commodities and other inputs rise, partly due to ‘supply-chain’ disruption from COVID.  The FT reports that “price rises have emerged as a dominant theme in the quarterly earnings season which kicked off in the US this month. Executives at Coca-Cola, Chipotle and appliance maker Whirlpool, as well as household brand behemoths Procter & Gamble and Kimberly-Clark, all told analysts in earnings calls last week that they were preparing to raise prices to offset rising input costs, particularly of commodities.”

To really get a grip on what causes inflation and whether it is coming back after COVID, we must return to Marx’s value theory.  The demand for goods and services in a capitalist economy depends on the new value created by labour and appropriated by capital.  Capital appropriates surplus value from exploiting labour power and buys capital goods with that surplus value.  Labour gets wages and buys necessities with those wages.  Thus it is wages PLUS profits that determines demand (investment and consumption). 

Going back to the monetarist formula MV=PT. If MV is unchanged as it broadly was in the COVID slump, then any change in P (prices) will depend on any change in T (the new value of goods and services produced). 

Over the longer term, growth in T tends to slow. Why? Because T is based on capitalist production for profit and as capitalists tend to try and raise profits through mechanisation and the replacement of labour, there is a relative decline in new value produced (because only labour can create value, not machines).  If the growth of T slows, then there is a tendency for price inflation to slow.  And that is proven empirically.  As the rate of profit began to fall in most major economies after the late 1990s and growth in new value dropped, particularly in the last decade, so price rises have ebbed. 

Now workers don’t want inflation as it eats into real living standards.  But capital does like some inflation, as price rises enable companies to expand production and increase profits at the expense of wages.  Thus central banks and monetary authorities try to combat the long-term tendency for price inflation to ebb by injecting money and credit (more M).  Money supply acts as a countertendency to slowing value creation. Thus the rate of inflation (P) depends on both M and T. Of course, in practice the Fed and other central banks cannot ‘manage’ inflation as it depends on what is happening in capitalist production.  Indeed, for the last 20 years, central banks have failed to achieve their target rate of inflation of around 2% a year with monetary zig zags on interest rates and monetary controls.

A Marxist model of inflation, which I have outlined before in a previous post, suggests that it is the movement of profits and investment demand along with money supply growth that will drive price inflation this year and next.  So assuming sharp rises in profits and continued injections of money supply (if at a slower pace), this model forecasts US consumer inflation will go over 3% this year and next.

In the short term, inflation of goods and services could rise anyway because of ‘base effects’ (statistical blips), ‘supply chain’ disruption from COVID or so-called ‘pent-up demand’.  But these factors are probably transitory, as the Fed Chair Jay Powell argues.  But if inflation does go well above the Fed’s 2% annual target rate for some time, that could lead to a significant rise in yields (interest rates) on bonds, which are not under the control of the Fed.  US Treasury secretary Janet Yellen, the former Fed chief, hinted that if inflation did pick up more than expected, the Fed would act to control it through ‘tighter’ monetary policy which would also drive up yields.

This raises the odds that weaker parts of the corporate sector in the major economies will get into difficulties and invoke a debt crisis.  Remember: business debt relative to output is at its highest ever in the major economies.

In its recent Financial Stability Report, the US Federal Reserve warned that existing measures of hedge fund leverage “may not be capturing important risks”, pointing to the collapse of Archegos Capital as an example of hidden vulnerabilities in the global financial system. The Fed found that some asset valuations are “elevated relative to historical norms” and “may be vulnerable to significant declines should risk appetite fall”. In other words, a stock and bond market collapse is possible.

Borrowing cheap money hoarded by the banks to speculate on financial markets is called ‘margin debt’.  According to the US Financial Industry Regulatory Authority, margin debt hit $822bn by the end of March — just after Archegos had failed. That was almost double the $479bn level of March 2020, when the pandemic lockdowns started and the Fed pumped in credit. And it’s far more than the around $400bn peak that margin debt reached in 2007, just before the financial crisis.

So any significant return of inflation in goods and services may bring down the house of cards that is the financial sector.  What happens in the productive sectors of the capitalist economy still remains decisive.

31 thoughts on “Inflation and financial risk

    1. No, because it shows profit per unit of output ie P/GDP while the rate of profit is profit over the stock of capital invested. P/C+V. The Profit per unit rising suggests a rising rate of surplus value but not a rising rate of profit.

  1. “central banks have to tighten monetary policy (ie stop injecting credit into the banking system and raise interest rates).” 
    where do they get the money from, with which they are injecting credit into the system?
    They invent it (?)
    One day it doesn’t exist, the next day the banks are able to lend against this “asset”

    1. Jo Amazing is it not? Central banks have the authority to ‘print’ money. What that means is that the Fed or ECB buys bonds from the banks with money it has created and this money then appears as reserves in the banks. The CBs could even just put money in bank reserves without buying any bonds as collateral. The Fed creates dollars and the ECB euros etc.

  2. Michael,

    You wrote this last year:

    “This post in no way covers all the points and arguments in the Value Theory of Inflation. They will be developed in detail in an upcoming academic paper and as part of the jointly authored book, Through the Prism of Value that Carchedi and I will publish next year.”

    Has the paper been published?

  3. It’s not so clear to me that central bankers “like” inflation. Historically, people with money dislike inflation because it is easier for debtors to repay. (Insofar as a worker is a debtor, inflation has its blessings, so it’s not so clear that inflation is anti-worker either.) What is called “populism” in the nineteenth century favored bimetallism, low interest rates, easy credit, antitrust for finance/”banksters” for this reason. In particular, the role of money as a store of value seems to me to be exceedingly important in the powerful desires of central bankers for balanced budgets for government, austerity for government, tight credit for government, however generous with credit the central bankers may be with private banks, NBFIs, the stock market, etc.

    Stepping back, looking at it in a broader perspective, it seems to me that any theory of inflation is more or less a theory of deflation in reverse?

    Lastly, a question about what P=MV-T means? I’m not even sure that MV-T does mean the quantity of money times the rate of turnover of money, whose product is divided by the transactions. I don’t understand how T is only new transactions. V seems to be an estimate of the number of times the money supply turns over, a kind of double-counting coefficient. But it seems to depend on the rate with which credit is created and the rate at which money is hoarded, neither of which seems to be directly explained by the quantity of money. T seems to be the number of exchanges in a given period of time, that is, the amount of money expended. (Isn’t this is better measure of “velocity?”) It’s been decades since I took math, and I discover I’ve forgotten when an identity can be algebraically manipulated like an equation.

  4. how do you get from MV=PT to P = MV-T?
    And would not a slowing rise in T suggest that prices increase? Because T is being subtracted?

  5. Question – obviously not an economist BUT the explanation for inflation in 16th C. Spain (and diffused to trading partners in Europe thereafter) was the huge influx of S. American Silver (and some gold) i.e. expansion of money supply without expansion of productive capacity?????

      1. The accounting formula, P=MV/T, is an _inverse_ relation between P and T (assuming MV is kept constant). Yet you seem to argue the opposite, saying, if I understand correctly, that the tendency of T to stagnate implies that (or at least is observed to be correlated with) price stagnation (less inflation). If so, then this direct relation does not follow from the accounting formula.

        I’d suggest that P=MV/T has little explanatory value in itself. It simply serves to focus any theory of inflation on describing the relations among changes in M, V, and T due to social relations, eg, the present conditions under which surplus value is extracted. I was not able to follow if your theory does that.

        (Mathematical aside: forgive me if this is obvious! P=MV/T implies a decrease in T would lead to an increase in P (again, with MV fixed). Likewise, working in terms of rates, a decrease in the rate of growth of T would lead to an increase in the rate of growth of P. More formally, taking rates (differentiating the logarithm of the formula with respect to time) P=MV/T implies the following relation among rates of change: r(P) = r(MV) – r(T). Here r(X) := (dX/dt)/X is meant to denote the rate of change of the quantity X.)

      2. Yes Philip. I agree that the way I phrased that section was poor. I have attempted to rephrase to avoid the mathematical error you expose. I shall try and get it right
        Again I agree that identities like MV=PT have little explanatory value on their own but I used it to show that the causal sequence is from transactions to money not money to transactions and prices as the monetarist argue. But I have not got this section clear yet. It will be in the final academic paper later this year.

  6. It is correct for you to point out that the contradictions are coming home to roost. If inflation goes up dragging interest rates with it, this will collapse the share markets, and this collapse will end inflation.

    However, I do not think your article addresses the real causes of price movements. In aggregate, supply and demand is organised around the current production of value (supply) and the previous monetization of value in their revenue forms, profit, rent, interest, wages and tax. In turn these revenue streams and their disposition or not informs demand. Two things stand out. Because demand is generally based on revenue, it is constricted and all that revenue in any case may not be spent productively or unproductively. Now it can be argued that if demand or more precisely, the revenue it is based on, has emerged from prior production and therefore more expensive production (the productivity differential between now and then), then it can support current prices. However, because these cycles are very close this phenomenon is unlikely. So we have to look elsewhere. Here are a few. A precipitous fall in current value production, say caused by a natural disaster, can lead to price rises as aggregate revenue exceeds diminished value production. Credit money creation (net new loans) at around 5% of GDP can add to aggregate demand as will deficit spending by governments which injects extra real money into the economy. Together they will cause a degree of inflation, because in both cases they tend to be spent, some by the borrower and always by the state.

    The last bit is the most important. In the US, the government and FED have pumped about $8 trillion into the economy. You are quite right to demonstrate that some of this has gone into bank accounts and the various casinos such as Bitcoin. But a portion has gone into workers’ pockets who do not have the luxury of not spending it, so it is supplementing wage revenue at a time when value production remains dislocated. So yes this is inflationary but I suspect it has nothing to do with your formula.

    I doubt there will be more relief funds in the pipeline. That is why the second half of the year is going to be so decisive. And you are again right to point to insolvent companies. (I dislike the term Zombie companies). It is axiomatic that a fall in the rate of profit over time will increase the density of insolvent companies. Since 2014 the underlying rate of profit has fallen 35% for non-financial corporates in the USA, and because, inter-alia the rate of profit includes the rate of return on assets, it means it is increasingly difficult to service any debt acquired in acquiring those assets. Thus the rate of profit and the mass of debt are always caught in the most intimate of tangos.

    Which is why recessions, and the resolution of this contradiction, is not an option but a necessity for capitalism.

    1. Can I correct a statement please given its importance. “Now it can be argued that if demand or more precisely, the revenue it is based on, has emerged from prior production and therefore more expensive production (the productivity differential between now and then), then it can support current prices. However, because these cycles are very close this phenomenon is unlikely.” It should read that the value from prior production, representing more expensive production, supports current prices but cannot elevate them because the cycles are too close. This is the basis of MMMT or Modern Marxist Monetary Theory where value meets value in their commodity (current) and monetary (legacy) form allowing token money to act as the intermediary.

  7. Going back to the monetarist formula MV=PT, let’s switch it around, so that P = MV-T. Now if MV is unchanged as it broadly was in the COVID slump, then any change in P (prices) will depend on any change in T (the new value of goods and services produced).

    But to switch around would must be P = MV / T (a division). Not?

  8. The Federal Reserve balance sheet rose by $3.6 trillion (up from $4.1 to $7.8 tr since March 2020). The extra federal expenditures, above the previous year, was $2.7 trillion. The GDP slumped 4.5%, or $945 billion, call it a $1trillion. Of the Fed’s gift to banks virtually none of it enters the economy, though studies claim these injections ($120 billion per month or $1.44 trillion per year) raise GDP by 1%. And we are looking to pass the American Jobs Plan and the American Families plan, I think about $4.1 trillion. Will that be inflationary? That’s spread over 6 years, it comes (including the American Rescue Plan already passed), to $750 billion per year. And the THRIVE plan pushed by progressive Dems comes to $1 tr. per year for 10 years. The two unpassed Biden jobs and families plan amount to 3.6% of GDP spending, bringing federal spending from 21% to almost 25% of GDP. Inflationary?
    I’m an advocate of “financial repression” which if I have it right, required banks and financial operations to invest in government low-yielding bonds. It was a successful plan. Currently it is much needed, as over 90% of corporate profits of the S&P 500 go dividends and stock buybacks, as professor Lazonick has demonstrated, fueling massive increases in financial wealth (hoarding). Proposals have been put forward for a “National Investment Authority” which would be a source of safe assets, low-yielding bonds, and would finance the Green New Deal, and many of the other government projects. If this bank was large enough it would definitely counterbalance the effect of rising interest rates. There is also an abundance of hoarded money sitting about. The total “household net worth” surpasses $130 trillion, and it is so far all untaxed. Total net worth has doubled in the past 12 years, up 124% since Jan. 2009 (inflation adjusted). Wages rose by 8% and GDP by 23%. A financial transaction tax, and a wealth tax could draw down this excess wealth. Also price controls could be instituted on corporations. And this is a short list. Keynes did propose a national investment council with powers to make the significant majority of investments in a nation, a democratized industrial policy (read the book “Keynes Against Capitalism” by James Crotty), he advocated very strict international capital controls, a tax on chronic export nations’ trade surpluses, and control of the interest rate or credit spread, among other taboos. I’m reading again the book The Production of Money by Ann Pettifor, I recommend it.

  9. If US inflation forces rates to rise, how are emerging markets placed to weather a corresponding rise in the US dollar?

  10. If there is a breaker in the zombies, the big ones buy them to close them and to be able to increase their prices, so I think that the inflation forecast may reach more than 3%.

  11. Hi Michael

    In this blog there is a sentence:

    Thus the rate of inflation (P) depends on both MT

    Should this be:

    Thus the rate of inflation (P) depends on both M and T

    Thanks, Dave

    On Sun, 9 May 2021 at 10:09, Michael Roberts Blog wrote:

    > michael roberts posted: ” Is inflation coming back in the major capitalist > economies? As the US economy (in particular) and other major economies > begin to rebound from the COVID slump of 2020, the talk among mainstream > economists is whether inflation in the prices for goods and ” >

  12. Well, i think that the text downplays the role of ‘hide unemployment’ in repressing wages and thus avoiding the overheating of labor markets which would raise the wages. Even before the pandemic the US economy still had a relevant share of population out of the labor force. The sluggish wage increases is explained by this ‘structural’ unemployment or, in marxian terms, the so called the ‘reserve army of labor’. The downsizing in the wake of globalization and new technologies has been crucial to maintain labor in a vulnerable position relative to a empowered capital, which tends to preclude a sustainable increase in real wages. The secret of monetary stability of recent decades is located in the expansion of the ‘global labor reserve’ and in the ascension of China as large-scale producer of industrial inputs at low cost employing cheap and disciplined labor. I think that pandemic has changed this conditions, but i’m not sure if will cause a permanently inflationary pressure that would force the FED to tightening the credit.

    Also, the relation among inflation, profits and accumulation is complex. Paul Mattick used to say that inflation happens when the unproductive consumption of the State starts to reduces the total ‘mass of surplus value’; so as reaction capitalists begin to increase prices to retain their share in the declining mass of surplus value. This provokes a spiral of prices and wages as everyone from capitalistas to workers try to put the pressure on each other by increasing their prices and wages. Therefore inflation ensues. As the modern banking system is based upon a credit-money the increasing prices are ‘sanctioned’ by liquidity expansion.

    We have to see if US fiscal package will realize these hypothetical scenario painted by Mattick or if it will manage to exporting inflationary pressure to the world by flooding the world financial system with printed dollars or if it will get a share of ‘global mass of surplus value’ at expense of others( China?) in the global competitive struggle, as US did in the late 80’s and middle 90’s when it did put the ‘burden’ on economies such as Japan and Germany. Well, let’s see.

  13. This is slightly tangential, but what do you think about Anwar Shaikh’s theory of inflation being dependent on the growth rate utilization?

    1. Shaikh’s theory of inflation has merits as it starts by using the relation between the organic composition of capital, the rate of profit and price inflation, but i think it lacks a connection to value. Inflation for him is the result of ‘cost push’ when capacity cannot match demand, as opposed to the result of changes in new value created relative to money supply, which is the basis of the theory argued here. But both approaches do start from the movement of the organic composition of capital. I shall return to a discussion of Shaikh’s approach soon.

  14. Hello! Really like your work, I’m a fellow marxist from Brazil and have been following it closely. So, a few things got me wondering here, but, particularly, I didnt really understand why you said T = new value produced. “If MV is unchanged any changes in P must derive from changes in T”. Sure, mathmatically it makes sense, but even so, I read T not as “value”, but as the quantity of things that circulated, in this sense total transactions would be = total quantity of things, lets say, Q.

    P*T (or P*Q) = Total Value; (P = individual value / Q = total things / PT = total value)

    So, prices rising, if we pressupose MV constant, would just mean less things being sold. Indeed, since MV is constant, and we take MV = PT, then PT (which means total value circulated) is constant, not declining. Just the individual cost of those things got hiked up.

    This leads me to another commentary: it really bugs me that in the “inflation” category every phomenoma that drives up prices are put in the same basket. Prices may rise because of technical changes, market condition or because of monetary representation change , which would be ubiquitous but would change the relative prices of the commodities.

    It’s a daring topic, I dont rly understand completely the determinants of the changes on the monetary representation. I feel like it would be due to changes in the value of money, but Ive never studied the relation between changes in the value of gold (social time required to produce it) and the changes of the pattern of prices. Indeed, I’m not even sure it ever worked like that, let alone after gold was sidelined by the US which imposed the dollar as the general equivalent.

    I’m sure that’s a lot to unpack, and I felt like commenting a bit further on the inflation topic, but really the main question here would be the 1st one I posed, concerning taking “T” as total value.

    Btw “World In Crisis” is one of the most important works I’ve seen, since the law of falling profits is such an important one and the empirical work there is great, not to talk about some theoretical insights that were rly valuable and the analysis not only of the secular phenomena, but of the economic cycle itself.

    Thanks for all your work!

  15. Hi! don’t you mix the Velocity of money with the reflux of money-capital to hoarding? As credit-money created cancels previous debt and stays in hoarding (and credits over hoarding retracts) is the same to say that velocity plumped down that the reflux became inmediate?

  16. Hello Michael,

    I share and synthesize your writings in France and I have just received an astonishing criticism from a liberal economist (Alexandre Lohmann). It concerns the first graph of the article:
    « This graph doesn’t make sense. 1) It represents only a small part of GDP prices taking the CPI. 2) It compares a series in level and a series in growth rate. It is statistically and absurd »

    A reaction to that?

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