In this final part of the series on the causes of inflation, Roberts considers the period since the end of the pandemic slump in 2020.
Michael Roberts is an Economist in the City of London and a prolific blogger.
Cross-posted from Michael Roberts’ blog
Photo: Wikimedia Commons
Disinflation ended with the pandemic and inflation has returned. The average annual rise in US consumer price inflation has been 3.9% in the 2020s and that rate is likely to rise further given the impact of the Iran war on the global price of energy, food and other commodities. This rise in the 2020s so far is more than twice the rate of the disinflationary 2010s and the highest since the 1980s.
The US Fed sets an inflation target of 2% a year. It has miserably failed to achieve it. Since January 2020, the official consumer price inflation index has risen at a 4.0% annualised rate and is now 13% above the 2% inflation trend. That demonstrates a massive failure of mainstream economic theory and policy on inflation.
But mainstream economics and the monetary system managers continue to cite the same causes of inflation and adopt the same policy actions as they did before 2020. At first, they argued, like Jay Powell, then head of the US Federal Reserve, that the rise in inflation was temporary, caused by the ‘shock’ of the bottlenecks in the global production and trade in goods and services. Later, they began to recognise that inflation, far from subsiding, was accelerating and permanent. So the same old mainstream causes of inflation were reinvoked – despite, as we saw in part one of this series, both the monetarist and Keynesian theories having been found wanting.
Bank of England chief economist Huw Pill reiterated the mainstream policy solution of central banks for getting inflation rates down post-pandemic: “Interest rate rises in the US and UK over the past year were designed to cool spending power and the ability of companies and people to pass on the pain of inflation to others”. Exactly who was taking on the pain, he did not say; but it is clear that it was workers’ real incomes.
Leading Keynesian macroeconomist Gauti Eggertsson did his best to revive the failed Phillips curve (namely that if unemployment falls towards full employment, this will push up wages and that will lead to increased inflation). Eggertsson agreed that the traditional Phillips curve did not apply to current inflation, BUT, you see, the curve has become ‘non-linear’ ie unemployment can fall straight down without any impact on inflation and then suddenly turn a corner and inflation then jumps – so, in effect, no ‘curve’ at all.
The monetarists also tried to reinvoke their theory to explain the post-pandemic inflation spike. John Taylor, author of the Taylor rule, which supposedly sets limits on how to avoid inflation or unemployment by manipulating the ‘right’ interest rate to be set by the Fed. Taylor reckoned that the inflationary spiral was due to the Fed being too slow on hiking rates before the pandemic and then not following his Taylor rule. However when the Fed did hike its policy rate, it failed to bring inflation down to its target (as we see above).
A variant on both the monetarist and Keynesian theories was that the inflationary burst was caused by ‘too much’ government spending. Robert Barro, a conservative economist from Harvard, who has always been obsessed with reducing government spending, which he sees as ‘crowding out’ the private sector, presented evidence for 37 OECD countries that “fiscal expansion underlies the surge in inflation for 2020-2022.” Christopher Sims from Princeton University also promoted this ‘fiscal theory of inflation’, as against the Keynesians. He argued that, since 1950 the US had suffered three bouts of high inflation and they were caused by ‘fiscal expansions’: it’s overspending by governments that causes high inflation, not lax monetary policy (as opposed to Taylor above). This is a classic case of not recognizing the causal direction. Government spending and budget deficits rose sharply relative to total output during the pandemic because economies were closed down and total output fell. When economies began to recover, the size of annual budget deficits compared to GDP fell back.
Finally, the theory of inflation expectations was revived. The IMF under then director Gita Gopinath, having recognised that the monetarist, fiscal and Phillips curves theories did not explain the recent inflation, turned yet again to ‘inflation expectations’. The IMF economists claimed that since 2020, ‘near-term inflation expectations’ had been the biggest driver of price increases in advanced economies and the second biggest factor in emerging markets. MIT professor Ivan Werning reckoned that rising inflation was the result of ‘irrational expectations’ by consumers. Thus the theory of inflation was again reduced to psychology.
If you look at the evidence for ‘expectations’ in the IMF graph above, you can see that ‘other factors (eg supply blockages and other mysterious factors – grey block) were the main cause kicking off rising inflation. ‘Expectations’ (blue block) only came later, once people realized that prices were going to continue to rise sharply – expectations began to fall back when the inflation rate dropped. So expectations followed real causes, not vice versa.
As Keynesian Larry Summers summed it all up: “The theory to which many economists are gravitating to is that the Phillips curve is basically flat, inflation is set by inflation expectations, and inflation expectations are set by the people who form inflation expectations. And that’s a little bit like the theory that the planets go around the universe because of the orbital force. It’s kind of a naming theory rather than an actual theory. So I think inflation theory is in very substantial disarray, both because of the Phillips curve problems and because we don’t have a hugely convincing successor to monetarist-type theory.”
Werning attempted to come up with an inflation theory that covered all the bases. Inflation rises when there is excessive demand caused by too much money injections from the central bank and by too much government spending. Then there are various rigidities (monopolies, trade unions etc) that push up prices and by energy price shocks; and finally inflationary expectations. This cocktail of causes leaves with us with no explanation at all. No wonder Werning summed his work with the words: “that often we end up knowing less than we knew before.”!
In a recent mea culpa, former Bank of England governor Mervyn King reversed his previous views and admitted that “central banks no longer have a theory of inflation. The current popular characteristic of inflation targets is totally different from [their] original purpose.” Economist Milton Friedman used to argue that “inflation is always and everywhere a monetary phenomenon”, shaped by central bank money creation. However, this monetarist approach is limited “since the velocity of monetary circulation can change and private players create money.” (echoes of our argument that we made in part one of this series). King also attacked ‘expectations’ theory: “This is the King Canute theory of inflation,” invoking the 11th-century English monarch who is purported to have tried — and failed — to control waves with words, “Or, to use another metaphor, shamans, using verbal intervention to shape prices.”
Last year, Michael Bordo of the Bank for International Settlements produced a massive paper for the Bank of England to explain post-pandemic inflation in the UK. After a mountain of pages and graphs, he did not seem to reach any significant conclusion. Inflation, it seems, took place because the supply-side of the UK economy was unproductive and could not deliver “a low-inflation economy capable of delivering sustained growth… This leads us to more fundamental questions in the conclusion to this paper. How much of the inflation experience was inevitable given the collapse of Bretton Woods as a disciplining device, the structural supply side problems facing the UK and the openness of the economy, making the UK vulnerable to shocks from abroad? How much of this was a failure of the institutional framework of monetary and fiscal policy in the UK to adapt to those changes quickly enough? How much was it the slowness of policymakers and politicians to grasp and absorb the major changes in economic thought occurring in the 1960s?” Answers to these questions, there were none.
Heterodox economists also looked to their previous theories to explain post-pandemic inflation. The post-Keynesians turned to profit mark-ups. It was the ability of (monopoly) corporations to mark up prices and engage in price gouging that caused post-pandemic inflation. But as we argued in part two of our series, monopoly or oligopoly cartels have existed since the development of mature capitalism. There has been an increasing degree of concentration and centralisation of capital, as Marx predicted, but that has not always been followed by accelerating inflation. Higher inflation can occur both with fairly competitive or oligopolistic market structures. In the late 19th century, the so-called Gilded Age Era was characterized by the rise of cartels, but with deflation in prices; and the 1990s, often seen as a second Gilded Age with increasing market concentration, experienced a so-called Great Moderation in price inflation ie disinflation. Indeed, in the last big inflationary spiral of the 1970s, profits actually fell.
Also the mark-up theory of inflation is not born out by the evidence. As James Crotty put it: “the constant-mark-up Kalecki model of profit determination” used by post-Keynesian hero Minsky ”is evidently unsatisfactory.” According to Crotty: “The bulk of evidence demonstrates that there is significant cyclical variation in the mark-up and the profit share”. In other words, the ability of corporations to raise prices and gain more profit share varies according to the rate of expansion in the economy. Before the pandemic slump, corporate profits made up only 11% of changes in unit prices.
The most significant heterodox explanation of the post-pandemic inflation burst came from Isabella Weber and Evan Wasner. They point out that, before the pandemic, there was a long period of relative macroeconomic price stability, with low inflation and generally shared growth in nominal value added between wages and profits. It was only in the post-pandemic period of the last two years that profits usurped a greater share of the value in price increases per unit of output. But as their table (below) shows, in the first part of 2020, it was wages that gained most from price rises as profits dived in the pandemic slump. Through 2021 those relative shares were gradually reversed and profits reaped the lion’s share. But by 2022, the wage-profit share in the value of price rises was pretty even. Indeed, by Q3 2022, labour’s share in price rises was greater.
So it all depends on the point in the cycle of expansion and contraction that a capitalist economy is undergoing, not on the ability of monopolies to ‘price gouge’ as such. The data suggest that, in the period of supply chain blockages and sharply rising basic commodity prices (food, energy), firms with pricing power hiked prices to sustain and even increase profits (2020-21). But as supply blockages subsided and production picked up in 2021-22, competition increased and further profit mark-ups could not be sustained.
In placing the cause of rising inflation on rising profits, Weber and other leftists have argued for the introduction of price controls as the alternative to central bank monetary policies. But controlling energy prices at the domestic consumer end would not solve price rises at the producer end, but simply drive private energy distributors into bankruptcy. That would force governments to end controls or take over failing companies. Indeed, the latter solution poses the best policy answer: public ownership of the international energy and food companies that operate throughout the global supply chain. But that policy is not on the agenda of the heterodox.
What is not answered by the mainstream or heterodox theories is why did the major economies fail to cope with the energy and food ‘shocks’ caused by the post-COVID ‘scarring’ of supply chains and trade linkages? The answer lies in the general slowing of productivity growth and productive investment that had taken place over the previous two decades and particularly in the period leading up to the COVID slump. The point here is that the major capitalist economies were already close to a slump even before the COVID pandemic struck. So the supply-side was already weak when the global supply blockages started to emerge.
This is one of several key insights that Marxist economist, Paul Mattick Jnr makes in his excellent short book on the cause of the post-pandemic inflationary spiral. Mattick also wrote the best short book on the causes of global financial crash and the Great Recession in 2011. In his new book, Mattick makes the same point that Carchedi and I did with our value theory of inflation, namely that increased productivity of labour tends to reduce prices. But productivity growth comes into conflict with profitability. If profitability slows then productive investment slows and productivity growth slows. The monetary authorities and the financial system expand credit to compensate, but this just fuels inflation. “It is the tendential decline of global profitability, evidenced by the general drop in growth rates since the 1970s, maintained at their actual levels only by a steady increase in public, corporate, and private indebtedness, that I invoke to explain the inflationary tendency of capitalism since World War II.” https://www.endnotes.org.uk/palabre/paul-mattick-preface-to-the-german-edition-of-the-return-of-inflation
This brings us back to our value theory of inflation as outlined in part three of this series. We found that average rate of the value rate of inflation over the period 1949-2019 was around double that of the official rates (CPI and GDP deflator). That suggests that the official measures of price inflation are hugely biased downwards. Corbin Trent analysed real incomes in the US using a different measure of price inflation. The US government statistics show average real wages have increased 252% since 1950. But Trent argues that actually real incomes have lost 61% of purchasing power in 1950. Why is this? It’s because the official statisticians ‘adjust’ the prices of many goods to take into account their improved productivity i.e better performance. These ‘hedonic’ adjustments cut roughly 50-60% off actual inflation. Also, the ‘basket’ of goods and services is biased towards goods where prices are falling and away from services where prices are rising.
Instead, Trent analysed income after inflation according to the hours of work necessary to buy goods and services. “ I stripped away the statistical games. No hedonic adjustments. No theoretical rental equivalents. No basket reweighting. Just straight math. How much do we make and how much do the basics cost? I looked at official government data. Median incomes from the IRS and Census Bureau. Actual prices for essentials from HUD and federal records. Then I asked one simple question. How many years, weeks, or months of work does it take to buy what we need?”
Thus Trent calculated the impact of price inflation on incomes, based how much labour time is needed to purchase goods and services. Doing that reveals that to match the essentials that Americans’ grandparents could actually buy in 1950, 2023’s official median income of $42,220 would need to be $102,024. So there was a 60% loss in real income using the value measure.
Our value rate of inflation theory uses a similar approach. According to official data, US real median family income rose 62% from 1960 to 2024, but given the value rate of inflation to deduct from nominal income, real income was lower by 20% compared to 1960. Indeed, only in the so-called golden age of 1960-73 did real incomes rise on our value measure. In the neo-liberal period (1974-00), real incomes fell 14% and in the period of the long depression (2000-19), incomes declined another 10%. In the post-pandemic period, there was virtually no increase, even on official data.. No wonder US consumer confidence is near all-time lows.
The value rate of inflation recorded a sharp rise to nearly 11% in 2022 and so did the GDP deflator. The adjusted M2 money supply rose over 14% in 2022 as monetary injections went mostly into circulation. At the same time, growth in hours worked slowed, so that the VRI rose sharply. In the subsequent years of 2023 and 2024, the monetary authorities tightened money supply growth ie going from quantitative easing (QE) in 2020-21 to quantitative tightening (QT). The subsequent decline in the VRI in 2023 and 2024 was matched by similar decline in the official rate of inflation, but both inflation measures remain well above pre-pandemic levels and above the official Federal Reserve target of 2% a year.
Is inflation here to stay? Let’s remind outselves of the key factors in causing inflation, as outlined in part three of this series. The value rate of inflation theory argues that the rate of inflation depends on the difference between the change in the growth of money in circulation and the growth in hours worked in the productive sectors of the economy. The latter depends on the expansion of investment in productive capital and labour (in turn, this will be affected the rate of profit on the capital). Hours worked are currently rising at about 0.5% a year, slowing as employment growth has slowed. But money in circulation is now rising at over 8% a year, having slowed to about 4.5% in 2024. So the value rate of inflation is likely to average 7.5% in 2026. That would suggest an official price inflation rate of 4.5-5.0% by 2027. With US economic growth at just 1.5% or so this year, ‘stagflation’ (low or zero growth with high and rising inflation) has returned.
There are caveats to this forecast. The profitability of US capital has risen since 2020. This should promote a rise in investment growth and hours worked. But much of this increased profitability has been concentrated in just a few sectors: information technology, energy and finance. The broad swathe of US non-financial sectors are not experiencing significant rises in profitability. And as argued in previous posts, the sustained rise in investment and productivity growth now depends alomost totally on AI. Current Fed chair Kevin Warsh puts all his eggs into the AI basket. “AI is perhaps the most significant change in our economy in my adult lifetime. AI will be a significant disinflationary force, increasing productivity and bolstering American competitiveness.”
If that does not happen, then the current level of monetary expansion and a slowing economy will ensure that higher inflation is here to stay. Holders of bonds fear inflation most because bond holders are paid a fixed rate of interest on their bond and if inflation rises, that eats into the real return on their investment. The current rise in bond yields indicates that bond investors are insisting on paying less for their bond purchases because they fear the real return will fall over the long term.
That’s why US government bond yields have made a sharp turn upwards since 2020. Financial investors do not believe Kevin Warsh is right.
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