Suddenly, inflation is back in the global headlines after a long period when it seemed to drop out of the policy discussion in advanced capitalist economies and did not seem to be much of an issue even in many low- and middle-income countries. This was the period described as “The Great Moderation”, roughly between the mid 1980s and the years leading up to the Global Financial Crisis of 2008, when fluctuations in economic activity in the developed world were reduced and less severe, and when inflation rates were low and sometimes even negative in many economies. Of course, this was not the case in all parts of the world: some countries experienced very rapid inflation in certain years (such as Russia in the early 1990s, or the Democratic Republic of Congo, or Venezuela) or even hyperinflation (like Zimbabwe).
Inflation refers to a general increase in prices—not just in specific goods and services, but an all-round increase that is spread across different sectors. It matters to ordinary people, particularly when their money incomes do not go up as fast as prices do, which is described as a loss of purchasing power. This is described as a decline in real income or real wages, which can happen even when money incomes are increasing.
Globally, prices of essential commodities such as foodgrains and of fuel or energy, which enters directly into prices of all other goods and services, have been rising since the middle of 2021, and have accelerated sharply since the Ukraine war. As a result of this, advanced economies have experienced rates of overall inflation that are higher than they have been for decades. Things may be worse for low- and middle-income countries even when their inflation rates do not appear to have increased so much, because money incomes of workers, peasants, and other self-employed people have barely increased, and in many cases have fallen.
The debate on the causes of inflation has divided economists and policymakers for at least a century, if not longer. Traditional monetarist economists have tended to believe that inflation results from excess money supply creation: “too much money chasing too few goods”. They argue that increases in credit creation or “liquidity” will result in higher inflation rates, since the level of economic activity by real supply is determined by other factors. So the way to control inflation is to limit the creation of credit in an economy, by curbing the expansion of “reserve money”, reducing credit to government and limiting banks’ ability to extend credit. According to them, this would reduce the amount of money in circulation and thereby force prices down.
Conceptual flaws
There are at least two basic conceptual flaws in this argument. The first is the idea that the total economic activity (or supply) is given exogenously, by available labour and institutional factors, so that it cannot be affected by macroeconomic policy. Instead, since most economies are not at full employment, macroeconomic policies can affect the level of economic activity. The second flaw in the idea is that the total money supply is a stock that can be fixed by policy. In reality, governments can affect only the base or reserve money and some of the credit provided by the banking system. In general, once that is determined, economic activity determines the actual amount of credit or liquidity in the system, by changing the “velocity of circulation” or the number of times the base money directly or indirectly changes hands through different transactions. So the final supply of money or liquidity in the system is an outcome of the economy’s functioning, not a policy variable in the hands of the central bank or the government. What the central bank can and does do is change its base interest rate, which is the floor for all other interest rates in the economy.
That is why other economists, especially those with Keynesian and structuralist perspectives, take a completely different view on the causes of inflation. In the Keynesian approach, inflation reflects the excess of spending over income at the macroeconomic level. This imbalance can result in either a balance of payments deficit or domestic inflation. So if there are supply constraints or bottlenecks that prevent output from rising when there is more demand in the system, but total spending does not adjust accordingly, that can cause inflation.
Upward spiral
Structuralists point out that inflation results when different groups in the economy fight over their shares in national income: firms, workers, agriculturalists, and other primary producers, and governments. For example, if imported input costs rise, firms may try to increase their output prices to maintain their profit margins. But if workers who feel that their real wages would fall as a result of this are able to fight to increase their money wages, then that adds further to costs, and firms could seek to increase prices further as a result. This can lead to an upward spiral if both groups are able to seek to maintain their real incomes. This is more likely when such groups are stronger, and if more incomes are “indexed” to the inflation rate, as it sometimes happens when unions are able to build this into their wage bargains, or when businesses are able to insist on maintaining their profit margin by raising their prices.
High inflation rates are obviously very destabilising, but they can reflect the ability of more sections of the economy to fight back to at least maintain their real incomes. When expectations of inflation become more widespread, then all groups that can do so try to raise their own prices so as not to lose out in real income terms. This can generate inflationary spirals because such expectations become self-fulfilling.
By contrast, in economies like India with a very large proportion of informal workers with little or no bargaining power, such increases in production costs and prices just get passed on to workers who are not able to demand higher money incomes as a result. This means the inflation rate may remain relatively lower, but it would have possibly a worse impact on living standards because real incomes fall.
Inflationary episodes
Different inflationary episodes can be classified according to whether they are “demand-pull” or “cost-push”. The distinction is important because it should affect how governments respond. Demand-pull inflation is when the money demand for goods and services rises too fast relative to available supply (sometimes called “overheating”). Usually, this is seen to call for a rise in central bank interest rates or tighter monetary policy that will make it more expensive or difficult to access credit, thereby reducing spending. Cost-push inflation can result from specific costs going up, possibly because of supply bottlenecks in specific sectors, or rising prices of imported inputs (either because of world price changes or exchange rate depreciation). In this case, raising interest rates will not address the cause of inflation, but instead can cause economic activity to decelerate and even decline. In the worst case, this policy can generate stagflation: the combination of slow or falling economic activity and rising price levels.
The period from the Global Financial Crisis to 2021 should have conclusively refuted the monetarist argument that just releasing liquidity into an economy will generate inflation. Since that crisis, just four major banks (the United States Federal Reserve, the European Central Bank, the Bank of England, and the Bank of Japan) released unprecedented amounts of liquidity, such that their total assets increased from around $4 trillion in January 2008 to more than $26 trillion in 2021 (https://www.un.org/development/desa/dpad/publication/un-desa-policy-brief-no-129-the-monetary-policy-response-to-covid-19-the-role-of-asset-purchase-programmes/). But throughout this entire period, until mid 2021, inflation rates remained low in the advanced economies, declining and even turning negative in some countries.
The recent inflation in the advanced economies—and therefore in the global markets—originated with cost-push factors, specifically the supply chain issues that originated in COVID-19-related lockdowns and closures. The Ukraine war made matters worse, by affecting oil, wheat, and fertilizer supplies and impacting on certain established trading routes. But these are not enough to explain the significant rise in prices: it has also been driven by corporate profiteering and accelerated by financial speculation in commodity futures markets. Oil companies have seized the opportunity to push up prices beyond what is justified by their own cost increases (just like Big Pharma companies profiteered from the COVID-19 pandemic). Meanwhile, financial activity in commodity futures markets increased substantially between January and March 2022, driving up futures prices in wheat and other commodities and thus affecting current spot prices as well.
This pattern is clearly evident in the United States. In the three decades 1979-2019, when inflation rates were not so high, rising unit labour costs (which reflect rising wages) contributed to 62 per cent of the total price increase, compared with 27 per cent because of other input price increases, and 11 per cent because of more profits. But in the recent and ongoing inflation, the ratios have been reversed. Between April-June 2020 and October-December 2021, when inflation has accelerated to much higher levels, corporate profits accounted for 54 per cent of the total price rise, while labour costs contributed only 8 per cent and other inputs costs 38 per cent. (Source: Economic Policy Institute)
This suggests that the current macroeconomic policy responses to inflation in the advanced economies, which are all about tightening monetary policy and raising interest rates, are wrongly directed. They do not address the real causes of this inflation. They are more likely to cause economic recessions, and will also generate more financial volatility. Low- and middle-income countries will once again be the worst affected, as they will experience capital outflows in addition to all their other current woes.
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