X unemployment and Inflation


Unemployment and Inflation – Part 13



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Unemployment and Inflation – Part 13

Posted on Friday, April 12, 2013 by bill

X.10 The Conflict Theory of Inflation

The Conflict Theory of Inflation beds the analytical approach in the power relations within the capitalist system. It brings together social, political and economic considerations into a generalised view of the inflation cycle.

The conflict theory derives directly from cost-push theories referred to above. Conflict theory recognises that the money supply is endogenous, which is in contradistinction to the Monetarist’s Quantity Theory of Money that erroneously considers that the money supply is exogenously controlled by the central bank.

The conflict theory assumes that firms and trade unions have some degree of market power (that is, they can influence prices and wage outcomes) without much correspondence to the state of the economy. They are assumed to both desire some targeted real output share and use their capacity to influence nominal prices and wages to extract that real share.

In each period, the economy produces a given real output (real GDP), which is shared between the groups with distributional claims in the form of wages, profits, taxes etc. In the following discussion, we assume away the other claimants and concentrate only on the split between wages and profits. Later, we will introduce a change in an exogenous claimant in the form of a rise in a significant raw material price.

If the desired real output shares of the workers and firms is consistent with the available real output produced then there is no incompatibility and there will be no inflationary pressures. The available real output is distributed each period in the form of wages and profits, which satisfy the respective claimants.

The problem arises when the sum of the distributional claims (expressed in nominal terms – money wage demands and mark-ups) are greater than the real output available. In those circumstances, inflation can occur via the wage-price or price-wage spiral mechanisms noted above.

The wage-price spiral might also become a wage-wage-price spiral as one section of the workforce seeks to restore relativities after another group of workers succeed in their nominal wage demands.

The role of government is also implicated. While it is the distributional conflict over available real output which initiates the inflationary spiral, government policy has to be compliant for the nascent inflation to persist.

Business firms will typically access credit (for example, overdrafts) to “finance” their working capital needs in advance of realisation via sales. In an inflationary spiral, as workers seek higher nominal wages, firms will judge whether the costs of industrial action in the form of lost output and sales are higher than the costs of accessing credit to fund the higher wages bill. Typically, the latter option will be cheaper.

If credit conditions become tighter and loans become more expensive then firms will be less able to pay the higher money wages demanded by workers. The impact of the higher interest rates may thus lead to a squeeze on real wages with the consequent negative impact on consumption spending. Firms will also be less willing to invest in new projects given the cost of funds is higher.

As a consequence, if monetary policy becomes tighter there will be some point where real production growth declines and the workers who are in weaker bargaining positions are laid off. The rising unemployment, in turn, eventually discourages the workers from pursuing their on-going demand for wage increases and ultimately the inflationary process is choked off.

The Conflict Theory of Inflation thus hypothesises a trade-off between inflation and unemployment.

The alternative policy stance is for the central bank to accommodate the inflationary struggle by leaving its monetary policy settings (interest rates) unchanged. This accommodation would also likely see the fiscal authorities maintaining existing tax rates and spending growth.

From an operational perspective, the commercial banks would be extending loans and, in the process, creating deposits in the accounts of its business clients. The central bank would then ensure that there were sufficient reserves in the banking system to maintain stability in the payments system. The nominal wage-price spiral would thus fuel the demand for more loans with little disciplining forces.

There are also strong alignments between the conflict theory of inflation and Hyman Minksy’s financial instability notion. Both theories consider that behavioural dynamics are variable across the business cycle. When economic activity is strong, the risk-averseness of banks declines and they become more willing to extend credit to marginal borrowers. Equally, firms will be more willing to pass on nominal wage demands because it becomes harder to find labour and the costs of an industrial dispute in terms of lost sales and profits are high. Workers also have more bargaining power due to the buoyant conditions.

At low levels of economic activity, the rising unemployment and falling sales militates against wage demands and profit push. It also is associated with higher loan delinquency rates and banks become more conservative in their lending practices.

Conflict Theory of Inflation and Inflationary Biases

There was a series of articles in the journal Marxism Today in 1974 which advanced the notion of inflation being the result of a distributional conflict between workers and capital.

As an aside, you can view an limited archive of Marxism Today since 1977 here - http://www.amielandmelburn.org.uk/collections/mt/index_frame.htm , which is a very valuable resource.

The article by – introduced the notion that inflation was a structural construct. He said (Devine, 1974: 80):

The phenomenon in need of explanation is not inflation in the abstract but inflation in the world of state monopoly capitalism in the period since the second world war. Two questions arise. First, throughout this period inflation has been chronic in all the major capitalist countries; why has it replaced depression as the principle “economic” problem confronting the capitalist system as a whole? Second, within this overall framework, why has the rate of inflation varied between countries and at different times?

He argued that the increased bargaining power of workers (that accompanied the long period of full employment in the post Second World War period) and the declining productivity in the early 1970s imparted a structural bias towards inflation which manifested in the inflation breakout in the mid-1970s which he says “ended the golden age”.

In this context, the “relatively full employment” has meant that (Devine, 1974: 80):

… money wages (earnings) have risen continuously, although at varying rates, for a prolonged period unprecedented in the history of capitalism. This has had far reaching effects on the functioning of the capitalist system. Faced with rising money wages, capitalists have sought to contain the increase in real wages and fend off pressure on profits by increasing prices.

On the industry side, large, oligopolistic firms with price-setting power competed against each other in non-price forms (for example, product quality, etc). The firms, however, were interdependent because market share was sensitive to their pricing strategies. When a firm was faced with nominal wage demands, the management knew that its rivals would be similarly pressured and their competitive positions would not depend on the absolute price level. Rather, a firm could lose market share if they increased prices, while other firms maintained lower prices.

But in an environment where the firms considered that the government would continue to ensure that effective demand was sufficient to maintain full employment there was no reason to assume that rising prices would damage their sales.

As a result, firms had little incentive to resist the wage demands of their workers and strong incentives to protect their market share and profits by passing on the demands in the form of higher prices.

This structural depiction of inflation – embedded in the class dynamics of capital and labour, both of which had increasing capacity to set prices and defend their real shares of production – implicates Keynesian-style approaches to full employment.

There was also an international component to the structural theory. It was argued that the Bretton Woods system imparted deflationary forces on economies that were experiencing strong domestic demand growth. As national income rose and imports increased, central banks were obliged to tighten monetary policy to maintain the agreed exchange rate parity and the constraints on monetary growth acted to choke off incompatible nominal claims on the available real income.

However, when the Bretton Woods system of convertible currencies and fixed exchange rates collapsed in 1971 the structural biases towards inflation came to the fore.

Devine (1974: 86) argued that:

… floating exchange rates have been used as an additional weapon available to the state. Given domestic inflation, floating rates provide a degree of flexibility in dealing with the resultant pressure on the external payments position. However, if a float is to be effective in stabilising a payments imbalance it is likely to involve lower real incomes at home. If a reduction in real wages (or their rate of growth) is not acquiesced in there will then be additional pressure for higher money wages and if this cannot be contained the rate of inflation will increase and there will be further depreciation.

The structuralist view also noted that the mid-1970s crisis – which marked the end of the Keynesian period – was not only marked by rising inflation but also by an on-going profit squeeze due to declining productivity and increasing external competition for market share. The profit squeeze led to firms reducing their rate of investment (which reduced aggregate demand growth) which combined with harsh contractions in monetary and fiscal policy created the stagflation that bedevilled the world in the second half of the 1970s.

The resolution to the “structural bias” proposed by economists depended on their ideological persuasion. On the one hand, those who identified themselves as Keynesians proposed incomes policies as a way of mediating the distributional struggle and rendering nominal income claims compatible with real output.

On the other hand, the emerging Monetarists considered the problem to be an abuse of market power by the trade unions and this motivated demands for policy makers to legislate to reduce the bargaining power of workers. The rising unemployment was also not opposed by capital because it was seen as a vehicle for undermining the capacity of the trade unions to make wage demands.

[NOTE: A SMALL DISCUSSION ON INCOMES POLICIES WILL BE HERE - NEXT WEEK]

From the mid-1970s, the combined weight of persistently high unemployment and increased policy attacks on trade unions in many advanced nations reduced the inflation spiral as workers were unable to pursue real wages growth and productivity growth outstripped real wages growth. As a result, there was a substantial redistribution of real income towards profits during this period.

The rise of Thatcherism in the UK exemplified this increasing dominance of the Monetarist view in the 1980s.

Unemployment and Inflation – Part 14

Posted on Friday, April 19, 2013 by bill

X.11 Incomes Policies

Governments facing wage-price spiral and reluctant to introduce a sharp contraction in the economy, which might otherwise discipline the combatants in the distribution struggle, have, from time to time, considered the use of so-called incomes policies.

These policies have been introduced, in various forms, in many countries as a way of reducing supply-side cost pressures and allowing employment to stay at all levels.

Incomes policies, in general, are measures that are aimed to control the rate at which wages and prices rise, typically as the economy moves towards, or is at full employment.

In the context of the Phillips curve, incomes policies were seen as a way of flattening the Phillips curve and reducing the inflationary impact of a reduction in unemployment.

Many countries have at various times introduced these type of policies.

For example, in 1962 the US government introduced wage-price guideposts, which allowed for an average rate of nominal wage increase equal to the average annual rate of productivity growth in the overall economy. Other nominal incomes, including profits, were to be tied to this rule.

Taken together, it was considered that this rule would stabilise the growth in nominal incomes and reduce any inflationary pressures associated with the maintenance of full employment.

The rule also sought to distribute productivity gains across all income earners and thus reduce the distributional conflict, which may instigate a wage-price spiral.

For a time, the guidelines seemed to work. But as the US government expenditure grew as a result of its prosecution of the Vietnam war effort and unemployment fell below four percent, wage increases began to exceed average productivity growth. By 1996, the guidelines provided no discipline on the growth of nominal incomes in the US.

It was clear that the US government was unable to compel employers to follow the guideposts in the wage bargaining process.

Despite the failure of the wage-price guideposts, the Republican administration under Nixon reintroduced an incomes policy in 1971. Initially, this was in the form of a 90-day freeze on wages and other nominal incomes. Later, compulsory growth guidelines were set for wages and prices growth and these were replaced with a voluntary mechanism.

Soon after (in 1973), the government introduced yet another freeze on prices, followed by sector-by sector price rises in line with cost increases with a freeze on profit margins. The experiment ended in April 1974.

It is thought that the same institutional structures that made economies more susceptible to distributional conflict in the late 1960s and early 1970s – for example, highly concentrated industries with large firms exercising significant price-setting how interacting with strong trade unions – also named the operation of incomes policies difficult.

Powerful firms are in a strong position to pass on wage demands in the form of higher prices and governments are reluctant, or are unable constitutionally, to mandate strict wage-price controls in normal times.

The other problem with average productivity rules is that they undercompensate workers in above-average productivity growth sectors and overcompensate workers in below-average sectors.

However, incomes policies have worked more effectively in some European nations, for example, Austria and in Scandinavian countries. Such nations have long records of collective bargaining and are more attuned to tri-partite negotiations than the English-speaking nations.

A good example of a successful income policy approach, where wages and prices growth was driven by productivity growth in certain sectors, is the so-called Scandinavian Model (SM) of inflation.

This model, originally developed for fixed exchange rates, dichotomises the economy into a competitive sector (C-sector) and a sheltered sector (S-sector). The C-sector produces products, which are traded on world markets, and its prices follow the general movements in world prices. The C-sector serves as the leader in wage settlements. The S-sector does not trade its goods externally.

Under fixed exchange rates, the C-sector maintains price competitiveness if the growth in money wages in its sector is equal to the rate of change in its labour productivity (assumed to be superior to S-sector productivity) plus the growth in prices of foreign goods. Price inflation in the C-sector is equal to the foreign inflation rate if the above rule is applied. The wage norm established in the C-sector spills over into wages growth throughout the economy.

The S-sector inflation rate thus equals the wage norm less its own productivity growth rate. Hence, aggregate price inflation is equal to the world inflation rate plus the difference between the productivity growth rates in the C- and S-sectors weighted by the S-sector share in total output. The domestic inflation rate can be higher than the rate of growth in foreign prices without damaging competitiveness, as long as the rate of C-sector inflation is less than or equal to the world inflation rate.

In equilibrium, nominal labour costs in the C-sector will grow at a rate equal to the room (the sum of the growth in world prices and the C-sector productivity). Where non-wage costs are positive (taxes, social security and other benefits extracted from the employers), nominal wages would have to grow at a lower rate. The long-run tendency is for nominal wages to absorb the room provided. However in the short-run, labour costs can diverge from the permitted growth path. This disequilibrium must emanate from domestic factors.

The main features of the SM can be summarised as follows:


  • The domestic currency price of C-sector output is exogenously determined by world market prices and the exchange rate.

  • The surplus available for distribution between profits and wages in the C-sector is thus determined by the world inflation rate, the exchange rate and the productivity performance of industries in the C-sector.

  • The wage outcome in the C-sector is spread to the S-sector industries either by design (solidarity) or through competition.

  • The price of output in the S-sector is determined (usually by a mark-up) by the unit labour costs in that sector. The wage outcome in the C-sector and the productivity performance in the S-sector determine unit labour costs.

An incomes policy would establish wage guidelines which would set national wages growth according to trends in world prices (adjusted for exchange rate changes) and productivity in the C-sector. This would help to maintain a stable level of profits in the C-sector.

Whether this was an equilibrium level depends on the distribution of factor shares prevailing at the time the guidelines were first applied.

Clearly, the outcomes could be different from those suggested by the model if a short-run adjustment in factor shares was required. Once a normal share of profits was achieved the guidelines could be enforced to maintain this distribution.

A major criticism of the SM as a general theory of inflation is that it ignores the demand side. Uncoordinated collective bargaining and/or significant growth in non-wage components of labour costs may push costs above the permitted path. Where domestic pressures create divergences from the equilibrium path of nominal wage and costs there is some rationale for pursuing a consensus based incomes policy.

An incomes policy, by minimising domestic cost fluctuations faced by the exposed sector, could reduce the possibility of a C-sector profit squeeze, help maintain C-sector competitiveness, and avoid employment losses. Significant contributions to the general cost level and hence prices can originate from the actions by government. Payroll taxation, various government charges and the like may in fact be more detrimental to the exposed sector than increased wage demands from the labour market.

Although the SM was originally developed for fixed exchange rates, it can accommodate flexible exchange rates. Exchange rate movements can compensate for world price changes and local price rises. The domestic price level can be completely insulated from the world inflation rate if the exchange rate continuously appreciates (at a rate equal to the sum of the world inflation rate and C-sector productivity growth).

Similarly, if local price rises occur, a stable domestic inflation rate can still be maintained if a corresponding decrease in C-sector prices occur. An appreciating exchange rate discounts the foreign price in domestic currency terms.

What about terms of trade changes? Terms of trade changes, which in the SM justify wage rises, also (in practice) stimulate sympathetic exchange rate changes. This combination locks the economy into an uncompetitive bind because of the relative fixity of nominal wages. Unless the exchange rate depreciates far enough to offset both the price fall and the wage rise, profitability in the C-sector will be squeezed.

It was considered appropriate to ameliorate this problem through an incomes policy. Such a policy could be designed to prevent the destabilising wage movements, which respond to terms of trade improvements. In other words, wage bargaining, consistent with the mechanisms defined by the SM may be detrimental to both the domestic inflation target and the competitiveness of the C-sector, and may need to be supplemented by a formal incomes policy to restore or retain consistency.

By the 1970s, with the rising dominance of Monetarism, which eschewed institutional solutions to distributional conflict in favour of market-based approaches, incomes policies lost favour in most countries.

The Monetarist approach combined the use of persistently high unemployment and increased policy attacks on trade unions in many advanced nations to reduce the bargaining power of workers. This reduced the inflationary tendency because workers were unable to pursue real wages growth and as a result productivity growth outstripped real wages growth. This led to a substantial redistribution of real income towards profits during this period.

The rise of Thatcherism in the UK exemplified this increasing dominance of the Monetarist view in the 1980s.



X.12 Raw Material Price Rises

Up until now we have been concentrating on workers pursuing nominal wage increases in order to gain higher real wages and/or firms pushing profit margins up to gain a greater profit share of real income as the main drivers of an inflationary process.

However, raw material price shocks can also trigger off a cost-push inflation. These cost shocks may be imported (for example, an oil-dependent nation might face higher energy prices if world oil prices rise) or domestically-sourced (for example, a nation may experience a drought which increases the costs of food which impact on all food processing industries).

Take for example a price rise for an essential imported resource. The imported resource price shock amounts to a loss of real income for the nation in question. That is, there is less real income to distribute to domestic claimants.

The question then is who will bear this loss? With less real income being available for distribution domestically, the reactions of the claimants is crucial to the way in which the economy responds to the impost.

The loss has to be shared or borne by one of the claimants or another. If local firms pass the raw material cost increases on in the form of high prices, then workers would endure a cut in their real wages.

If workers resist this erosion of their real wages and push for higher nominal wages growth then firms can either accept the squeeze on their profit margin or resist.

You can see that the dynamics of the Conflict Theory of Inflation are triggered by the raw material price rise.

The government can employ a number of strategies when faced with this dynamic. It can maintain the existing nominal demand growth which would be very likely to reinforce the spiral.

Alternatively, it can use a combination of strategies to discipline the inflation process including the tightening of fiscal and monetary policy to create unemployment (the NAIRU strategy); the development of consensual incomes policies and/or the imposition of wage-price guidelines (without consensus).

Ultimately, if the claimants on real income try to pass the raw material price rise onto each other then it is likely that contractionary government policy will be introduced and unemployment will rise.

Summary

A cost-push inflation requires certain aggregate demand conditions to continue for a wage-price spiral to lead to an accelerating inflation. In this regard, the concept of a supply-side inflation blurs with the demand-pull inflation although their originating forces might be quite different.

For example, an imported raw material shock means that a nation’s real income that is available for distribution to domestic claimants is lower. This will not be inflationary unless it triggers an on-going distributional conflict as domestic claimants (workers and capital) try to pass the real loss onto each other.

However, that conflict needs “oxygen” in the form of on-going economic activity in sectors where the spiral is robust. In that sense, the conditions that will lead to an accelerating inflation – high levels of economic activity – will also sustain an inflationary spiral emanating from the demand-side.

In the next Chapter we will introduce the concept of buffer stocks in a macroeconomy (employment and unemployment) and analyse how they can be manipulated by policy to maintain price stability.

References

Bancroft, G. (1950) 'The Census Bureau Estimates of Unemployment'”, The Review of Economics and Statistics, February, pp. 59-65.

Brown, A.J (1955) The Great Inflation, 1939-51, Oxford University Press: Oxford

Devine, P. (1974) ‘Inflation and Marxist Theory’, Marxism Today, March, 79–92, available at: https://docs.google.com/viewer?url=http://64.62.200.70/PERIODICAL/PDF/MarxismToday-1974mar/17-31/.

Dunlop, J.T (1950) 'Estimates of Unemployment: Some Unresolved Problems', Review of Economics and Statistics, February, pp. 77-79.

Friedman, M. (1968) 'The Role of Monetary Policy', The American Economic Review, 58(10), March, 1-17

Hume, D. (1752), ‘Of Money’ – MORE DETAILS NEEDED HERE – LINK HAS ARTICLE ONLY NOT WHERE IT APPEARED.

Keynes, J.M. (1940) How to Pay for the War: A radical plan for the Chancellor of the Exchequer, London, Macmillan]



Keynes, J.M. (General Theory – CHECK OTHER CHAPTERS FOR THIS)

Klein, L. (1985)

Abba Lerner's 1951 book - Economics of Employment

Mitchell, W.F. (1987) ‘NAIRU, Structural Imbalance and the Macroequilibrium Unemployment Rate’, Australian Economic Papers, 26(48), June, 101-118.

Phillips, A.W. (1958) 'The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957', Economica, 25(100), 283-299.

Samuelson, P.A. and Solow, R.M. (1960) 'Analytical Aspects of Anti-Inflation Policy', American Economic Review, 50(2), Papers and Proceedings of the Seventy-second Annual Meeting of the American Economic Association, May, 177-194.

Slichter, S. (1950) 'Comment on the Papers on Employment and Unemployment', Review of Economics and Statistics, February, pp. 74-77.]

Sultan, P. (1957) – MORE DETTAILS NEEDED HERE

Thirlwall, T. (2003)

Thurow, L. (1983) Dangerous Currents, Oxford University Press; First Edition.



Tinbergen, J. (1939)



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