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Day four - sizing up inflation

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Business succeeds rat her better than the State in imposing its restraint upon individuals, because its imperatives are disguised as choices.


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‘We are all Keynesians now’, as Milton Friedman was heard to say some years back. And Keynes’s ideas were indeed to dominate the economic scene from the Second World War right up to the mid 1970s - a period when most of us could be certain about getting a job.

But then things started to go wrong. After about 1975 the Keynesian tricks no longer seemed to work so well. Keynes died thirty years before. Now his ideas were passing away too - to judge by their gloomy obituaries in the financial pages of the daily press.

You mean all that stuff about multipliers and demand was just a waste of time?

Not at all - would I do that to you? The multiplier effect still happens and there are politicians all over the world struggling to manipulate demand. But economic thinking has had to develop to keep abreast of changing circumstances.

The biggest changes have been taking place in the market itself. Keynes wanted to keep the free market going at full tilt. He was a great believer in it. Indeed he made a lot of money playing the stock market and speculating in currencies.

But the sort of free market that consisted of lots of small soap factories or bakeries competing vigorously had gradually been disappearing. By the mid seventies such companies found themselves working in the shadow of a cluster of huge corporations - Shell, ITT, IBM, Proctor and Gamble - giant enterprises which straddled the globe and often even dwarfed national economies.

Some government-owned corporations too had reached something of the same scale - in their own countries at least. British coal mines, for example, are run by a government Board and you can only buy electricity in Canada from nationally owned power companies. The sheer size of such operations moves them out of reach of normal market forces. Keynes’ success was based on intervention in a free market - keeping it going whenever it faltered. But, as we shall see, the giants in the market don’t respond in the same way so his measures don’t have the same effect. And one result of this in recent years has been record levels of inflation.

Come on - inflation is hardly anything new.

No there has always been inflation of one kind or another. But the inflation nowadays is quite a different animal - one that can survive during a recession. The traditional inflation that you can see in a free market only appears when there is fall employment. For, in Keynesian terms, as well as having too little demand you can also get too much. When investors are confident about the future and are sure they are going to sell more TVs and dishwashers they might well want to build more new factories than usual. But where do they find the builders if everyone is already employed? How would they persuade you to work for them if you already had a job?

In my case they’d offer a more fulfilling and satisfying post. But I suppose other people would move just for more money.

Quite right. And companies can borrow from the banks to pay them more. The result will be inflation because the quantity of goods being produced won’t have increased yet even though there is more spending power chasing them.

Keynes’s answer at this point would be ‘deflation’ - taking money out of those bricklayers’ pockets through taxation, for example, or making it harder for the investors to get credit in the first place. All of this is aimed at bringing demand back in line with supply.

But think what would happen if there were high unemployment. Bricklayers would be standing on street corners with nothing to do so they should if anything offer themselves at less than the going rate just to get a job. Average wages should fall. And since sales drop when people are out of work the manufacturers too should be prepared to reduce their prices to keep in business.

In the last ten years however we have had high unemployment and inflation - a deadly combination.

This is because prices nowadays are determined not by millions of small bargains in the market-place with prices and wages, rising and falling from day to day, but through negotiations between three huge power blocks: the corporations, the governments and the trade unions.

Where did they suddenly appear from? How come the companies got so big?

They wanted to avoid free competition and free enterprise: the more control you have over the market, the less the risk of failure. Have you ever heard of a company called Unilever?

Vaguely, what do they make?

Almost everything you are likely to eat or wash with. Take margarines for example - their marketing of margarine is a classic example of risk avoidance. Unilever controls trough its plantations and other operations some 80 per cent of the world’s trade in palm oil - a key ingredient. Its shipping line brings the oil to markets like the UK where it manufactures all the brands you are likely to have heard of: Stork, Blue Brand, Flora. Its distribution company, SPD, transports the produce to the shops and it even owns the Liptons supermarket chain, not to mention MacFisheries. All these brands and companies have different names and Unilever, whose name appears on none of them, would claim that they are all operating independently in the market-place. You might reasonably be sceptical about this and think that by’ supplying their own materials and selling different brands they were trying to avoid competition.

Maybe. But you’re knocking the multinationals again, based on one case. How about coffee for example?

True. If you want to buy coffee, chances are you will have a choice between Nescafe and Maxwell House (produced by General Foods). These do compete in most ways but not in the one that matters - price.

They will run fierce promotions they will run blitz advertising campaigns, they will package their products to look distinctive and attractive. But they will not try to undercut each other.

And you can’t blame them. If the major competitor drops his price and you follow suite you are both back where you started from but with a lower profit. Better to confine competition to the safer areas of TV advertising, free gifts, and temporary price offers.

Such companies know in any’ case they can attract customers on criteria other than price. Consumer loyalty can be purchased through advertising and packaging. Price differences between products then become less important than identification with the brand. It will come as no surprise to learn that Unilever also owns an advertising agency.

So rare has price competition become nowadays that when it does happen - as occasionally between oil companies - we are all so surprised that we call it a ‘price war’.

I thought this was going to be about inflation. When are you going to get to the point?

Now. When any of these companies finds themselves under any pressure the easiest thing to do is push up the price. A raw material price increase, a wage demand from the workforce, or pressure from the shareholders for more profits - whatever the problem it can now be passed on to the customer at the checkout. The consumer has, after all, been educated to prefer the brand even when the price is a bit higher. But the company also knows their major competitors know the rules of the game and will bring their prices up in line.

Government corporations are in an even stronger position to set prices. In the UK it is not possible to buy telephone calls from anyone except the government. And in the United States and Canada where phones can be in the private hands of Bell Telephone they are still a monopoly and their prices have to he negotiated with the government. In no real sense therefore are their prices dictated by market forces.

Then, set against the governments and the corporations you have the trade unions. Just as the corporations try to avoid competition wherever possible so do their workforces. The United Auto Workers in Northern America or the National Union of Miners in the UK will negotiate en bloc with the organizations they have to face up to.

The consumer is not normally represented at the negotiations when there is pressure from shareholders or trade unions. So the easiest thing to do is to concede that wages or profits should rise - and, with them, prices.

Increased prices will, of course, drive up wages and shareholders’ need for income again the next time round. So have a kind of ratchet effect lifting everything ever upwards and there is no particular reason why it should stop. This would not matter too much if everyone’s income rose in parallel with the prices they had to pay. But the effects are very unevenly distributed. Managers who can set their own wages, and the strongest trade unions, will manage to keep ahead. But those living on fixed pensions or who are non-unionised will be very hard hit. So inflation is unpopular and governments try to get rid of it.

Is this where we get to monetarism then?

Yes, but hang on just a bit longer. There are actually two main ways of stopping inflation in an economy which is based on private enterprise - and they correspond to two distinct political ideologies, liberal and conservative. I should add that there is also a socialist alternative which involves changing the economy completely. But for the time being let’s look at how we cope with capitalism as it is today.

The liberal approach is to control wages and prices through government intervention. The government steps in between the competing power blocs and sets limits to wage and price rises. The limits may be enforced through legislation or through voluntary agreement. In Liberal-ruled Canada today, for example, the government is trying to limit wage rises to five per cent per year.

In the UK there was a ‘social contract negotiated between government, business and unions in the late 1970s. And though it eventually’ broke down it had, in its various forms, brought inflation down from a horrifying 24 per cent to a more manageable nine per cent by the time the Labour government was voted out of office in 1979.

But it was universally reviled. British union leaders felt that they had delivered their part of the bargain only to see prices and company profits continuing to go up. Businessmen felt that such bureaucratic interference took no account of the realities of commercial life.

Those on the right of the political spectrum also have a more deep seated objection to this approach. It is an affront to the freedom of the individual and a form of creeping socialism that will stifle the enterprise and initiative that is needed to create wealth.

Temporary competition.
Photo: Camera Press

So what is their solution?


At last.

I thought you’d like that. But first a note of caution. Monetarism is a particular approach to inflation. Its proponents would not claim that it is a way of directly promoting economic growth. For this you have to couple it with a philosophy which goes under the name of ‘supply-side’ economics, which is something that we will come to shortly.

Stop telling me what you’re going to tell me, and tell me what monetarism is.

If you insist. Monetarism is a theory usually associated with Professor Milton Friedman and the University of Chicago. Friedman’s thesis is that if you look back in history you will see that at times of low inflation the growth in the amount of money of all kinds kept closely in line with the growth in the amount of buying and selling going on. When there is high inflation this is, he claims, because too much money is being created compared with the number of transactions. What the government must do at this point, he says, is to restrict the money supply.

But if you remember the end of the discussion we bad, a couple of days ago on money you should be objecting to this on the grounds that the velocity of circulation would have to keep steady for this to be true. And you would be in very good company. A report about to be published by the Bank of England has shown that Friedman’s efforts to prove that the velocity had remained steady had only been achieved by cooking the statistical books.

The monetarist thesis remains unproved. But it is simple to express: ‘too much money chasing too few goods’ so it has great popular appeal. It is also easier to understand then Keynesianism.

You can say that again.

Still, monetarism itself is not a right-wing theory. It is merely a technical proposition. It does appeal to politicians on the right, however, because it offers a way to control inflation with much less state interference than a full-blooded prices and incomes policy.

But surely the monetarists have brought down inflation.

Yes they have. But not necessarily in the way they intended. Mrs Thatcher in the United Kingdom, President Reagan in the USA and even President Pinochet in Chile have all been ardent followers of the ‘Chicago Boys’ and have cut back the money supply chiefly by restricting credit and having high interest rates.

The restrictions did not, however, have any immediate effect on prices. When Mrs Thatcher took over from Labour in 1979, for example, she found that inflation climbed steadily up again.

This was because the ratchet that caused inflation in the first place was still operating. Inflation only started to fall much later. By the end of her first term in office it was back to the nine per cent she had started out with.

What happened was that companies had started to go bust. A furniture factory whose customers were slow at paying for example might need a bank loan to keep it going but could no longer keep up the interest payments. Workers making cornflakes found it more difficult to buy a new house on credit and so sales dropped. Bankrupt companies and reduced purchases engaged the familiar multiplier with a vengeance and the economy went into recession.

Ironically those corporations least touched by the recession were the huge corporations. They usually had the money to finance their own activities, so relied less on external loans. And when they did run short of cash for any reason they would probably work with forms of IOU. Shell or General Motors are usually considered good credit risks by their suppliers.

But as demand dropped ever more steeply they too were affected by the overall decline. Rather than drop prices, however (for the reasons suggested earlier) they’ cut back on production and laid people off. Those people still employed got their wage increases as before.

It was only when employment reached massive proportions that the corporations and the trade unions felt the need to restrain themselves. There are now three million people unemployed in the United Kingdom (12.5 per cent of the workforce). Inflation is down to around five per cent. But it is unemployment that has caused the fall rather than monetary restraint. So there you have the two ways of dealing with inflation. Both have their advantages and disadvantages. The one that you choose will depend on your political philosophy.

I take it that you are entirely dispassionate about the alternatives.

Well as you might have gathered, the conservative solution to inflation does not correspond very well to the basic cause of inflation which I gave earlier - the three power blocks. This is because conservatives who are ideologically attached to the free market do not like to accept that it is disappearing. They will therefore have the problem that, since monetary restraint has only slowed inflation by causing recession, then as soon as the economy picks up again so will inflation. The corporations are still there, so is the government, and so are the trade unions.

How on earth is the economy ever going to pick up again?

Once again there are two possible ways forward, liberal and conservative. The liberals at this point turn to Keynes again and propose revitalising the economy in the tried and trusted ways - particularly by stepping up government expenditure to increase demand and put people back to work. This might mean building more roads or just increasing welfare payments.

But won’t inflation start again?

Almost certainly. So any liberal approach has to build into it the seeds of some kind of prices and incomes policy and it has to rally popular support behind it.

OK. Now let’s have the conservative line - and be as convincing as you can

This is where we get to the ‘supply-side’ economics. Conservatives argue that what causes economic progress is risk-taking by entrepreneurs. So everything that restrains such enterprise should be removed and things will move forwards again. This means that taxes should be reduced to offer glittering incentives for success and government restrictions should be removed wherever possible. Cutting taxes means, however, that you also have to cut public expenditure, which can be a little painful.

But I can’t be very’ convincing when putting this argument since it bears little relation to the changes in the market that I outlined earlier. The last thing large corporations want to do is take risks, so even offering them tax-cut incentives to do so is unlikely to work. But where free enterprise is a matter of faith it can be sustained in spite of the contradictions all around.

The ‘supply-side’ nature of their approach lies in the notion that if you increase supply through production this in turn will put money in people’s pockets and creates the demand. So in general terms you could say that liberal economists favour promoting demand through government action while conservatives want to promote supply through private enterprise.

Does ‘supply-side’ economics work?

Well there are two test-beds you could look at: the USA and the United Kingdom. Neither of them has got very far along the lines which Milton Friedman and the ‘supply-siders’ would like and they as a result disown them as true experiments, but they are the best we have.

In the United Kingdom monetarism has been followed by recession. But Mrs Thatcher has had to pay out huge sums in unemployment benefit and been unable to go onto reduce taxes. The ‘supply-side’ part of the philosophy therefore has not been tested. So unemployment remains at record levels and growth is minimal.

President Reagan also found that he could not afford to reduce taxes, though in his case because of his substantial defence budget. But he cut taxes any way on principle, so he is now running an enormous budget deficit. The 1984 budget involves borrowing $180 billions which is almost precisely’ what the entire private savings in the USA come to. He is spending all the nation’s savings single-handed.

I must be getting this wrong now. Isn’t this the Keynesian way out of recession?

Indeed it is. And the US economy is currently booming as a result. Keynes however is unlikely’ to get the credit he deserves for this bizarre turn of events. Anyway, this has been very hard work and though I’m sure you’re anxious to hear more, frankly I’m exhausted.

Multinational corporations, trade unions and government agencies are the power blocs which now overshadow the market-place.

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They are insulated from market pressures so bargains struck between them tend to produce ‘ratchet inflation’.

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Conservatives attack this inflation through ‘monetarism’, and succeed by causing recession.

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Liberals prefer government intervention to control prices and incomes directly.

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Conservatives want to revitalise the economy by giving incentives to producers - emphasising the ‘supply’ side.

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Liberals prefer to promote demand through Keynesian expansion of spending.