Four Fallacies About Inflation

Although Marx gave the valid explanation of inflation, very few writers on the subject agree with him or even know what he wrote about it. But they cannot agree among themselves how to explain it. Among the currently popular theories on offer are that it is caused by high government spending; by government borrowing; by low interest rates; or by high wages.

That Too High Government Spending Causes Inflation

Those who use this argument measure government expenditure against the size of the National Income. A former Treasury official, Leo Pliatzy, (The Times, 16 February 1982) was very worried that government expenditure had been as high as 45 per cent of National Income in the year 1982-3 and hoped to see it brought down to 41.5 per cent or less. Enoch Powell in his Freedom and Necessity, having said that “the expenditure of government itself is the prime factor in causing inflation”, went on to indicate that the danger was “expenditure increasing beyond 40 per cent of national income”.

Events do not support the theory. Government spending in all the years 1948-1967 was below 40 per cent of National Income so there should not have been inflation. In fact prices rose between 1948 and 1967 by 113 per cent, an average of 4.5 per cent each year. And government expenditure has been brought down from the 45.5 per cent in 1982 which worried Pliatzky. The 1987 Tory Election Programme claimed that the Thatcher government “are engaged in steadily reducing the share of the National Income taken by the state”. Yet between January 1982 and December 1988 prices went up by 38 per cent and are still rising.

The theory itself is absurd. It assumes that prices are pushed up when the government spends more, because government expenditure increases total expenditure in the country as a whole. It does no such thing. If a government increases its expenditure by £1,000m a year it does so by taking £1,000m a year away from taxpayers and investors in the National Debt. Government expenditure goes up by £1,000m, but their expenditure on purchasing goods and services goes down by the same amount.

That Government Borrowing Causes Inflation

The economists and politicians who attribute inflation to government borrowing maintain that it does not matter how high government expenditure is provided that it is all raised without government borrowing. If a government raises all its revenue by taxation, with no borrowing, they say that the budget is balanced and there will be no inflation.

A budget which relies wholly or partly on borrowing is a deficit budget. A budget which raises more by taxation than total expenditure and uses the surplus to pay off the National Debt is a surplus budget.

In 1957 the Labour Party published some articles by Harold Wilson, who became Prime Minister in the Labour governments of 1964-70 and 1974-6, under the title Remedies for Inflation. In it he claimed that the proper policy “in inflationary times” is a “large Budget surplus”. He also said that the Tory Party, being Keynesian like the Labour Party, accepted the same policy for inflation though Tory governments sometimes were prepared to sacrifice it in order to get popular support.

The Thatcher government is now doing what Harold Wilson, in 1957, said they ought to do—running a large budget surplus. In his budget speech on 15 March 1988 the Chancellor, Nigel Lawson, said that the government aimed not only at a balanced budget (which had occurred only once since 1950) but at a budget surplus. He put the surplus at £3,000m for the year 1987-88, and expected the same surplus in 1988-9. In his 1989 budget speech he revised the figure for 1988-9 upwards to £14,000m. A budget surplus is expected to continue for at least the next two or three years.

If the theory held by Harold Wilson and others is correct, inflation should have halted and been reversed before March 1988. In fact between that month and December 1988 prices rose a further 6 per cent and are still rising despite the greater than expected budget surplus An article in the Financial Times (11 January 1989) had this to say:

    “The Chancellor has done exactly what the doctrine told him to do. Indeed he has overfulfilled the plan, and has been repaying the National Debt. Yet here we have inflation moving up towards 7 per cent.”

That Low Interest Rates Cause Inflation

This theory holds that inflation is caused by low interest rates and therefore can be halted by higher interest rates. In his budget speech in March 1988 Lawson said:

    “Short-term interest rates remain the essential instrument of monetary policy . . . I will continue to set interest rates at the level necessary to ensure downward pressure on inflation.”

This is still very much government policy. In March 1988 the bank minimum lending rate was 9 per cent. In the following months the Chancellor announced a series of increases so that by January 1989 it was 13 per cent. The mortgage interest paid by house mortgage-holders was correspondingly raised. Last June the bank minimum lending rate went up again, to 14 per cent.

The theory, as stated by the Chancellor and his supporters, is that when interest rates go up borrowers, including mortgage-holders, have to pay higher interest, which reduces the amount they can spend on other things and thus “damps down” the economy and holds back inflationary price rises. The theory fails to look at the other side of the transaction. The effect of higher interest rates being paid by borrowers is, of course, that they have less to spend on other things, but this is exactly balanced by the lenders’ income being increased. The combined purchasing power of lenders and borrowers is exactly the same as it was before interest rates went up.

If low interest rates cause inflation prices between 1870 and 1914 would have been rising fast because the bank rate then was far lower than it is now. It averaged about 3.5 per cent and never reached 5 per cent. Now it is 14 per cent and in 1980 it was 17 per cent. Yet prices in 1914 were 10 per cent lower than in 1870.

There is a relationship between inflation and interest rates but it is almost the opposite of the theory held by Lawson. The relationship is that when prices are rising, interest rates rise and when prices fall interest rates fall.

If prices are rising at 10 per cent a year it means that the purchasing power of the £ is falling by about 9 per cent a year. If, against that background, a lender lends £100 for a year at 10 per cent he receives £110 at the end of the year. But the purchasing power of the £110 is equal only to the purchasing power that that £100 had at the beginning of the year. In effect the lender has lent £100 for a year for no interest at all.

So, when prices are rising, lenders stand out for a higher rate of interest and succeed to some extent in protecting themselves against the rise of prices and consequent fall in the purchasing power of money. When prices are falling, and what money will buy is increasing, it is the borrowers who stand out for lower rates of interest.

That Wage Increases Cause Inflation

As employers have an interest in holding wages down as much as possible it is not surprising that they support the theory that wage increases cause inflation, but the theory is also supported by economists and members of governments, Labour as well as Tory (it was Harold Wilson who said “one man’s wage increase is another man’s price increase”). Many workers, especially those who have kept out of trade unions, support it.

It is easily shown to be fallacious. While the price level in 1914 was almost exactly the same as in 1850, average money wages rose by 90 per cent in that period. And in the years 1870 to 1914, while wages went up by 42 per cent, prices actually fell by 10 per cent. What was happening in those years was that fast growing membership and improved organisation enabled the unions to share in the small annual growth of output per worker and also to make inroads into profits.

The continuous inflation in the past 50 years has been caused by governments pushing excess currency into circulation, not by what has been happening to wages: it would have caused prices to multiply whatever course wages took.

Marx’s Explanation Vindicated

For Marx the key factor determining changes in the general level of prices is the amount of “money” (notes and coins) in circulation in relation to the amount needed in given conditions of production and trade. Writing about Britain in which the government, through the Bank of England, controls the issue of notes and coin, Marx showed that the government can adopt one or other of three policies: push more currency into circulation and raise the general price level—inflation: keep the amount of currency under control—a relatively stable price level as in the century before 1914: or reduce the amount of currency in circulation and so bring down prices—deflation. Marx set it out in Capital, Volume I, Chapter III, section 2. He based it on his law of value and used as his illustration the Gold Standard as it existed in Britain at that time.

In the past two centuries we have seen all these policies operated in the United Kingdom. Under the Gold Standard the amount of notes and coins in circulation was controlled, with the result that the price level in 1914 was almost exactly the same as in 1850. Between 1920 and 1925 the amount of notes and coins in circulation was reduced on the instruction of the Treasury to the Bank of England and prices fell by 29 per cent—deflation. Since 1938 the amount of notes and coin in circulation has been multiplied by 30 and is still rising, and the price level is now about 24 times what it was in 1938—inflation.

Several qualifying factors need to be taken into account.

Modern economists, both the Keynesians and the Monetarists, and the Treasury and the Bank of England use the term “money supply”, but they do not mean by it what Marx meant by money. For them “money supply” is predominantly bank deposits. They all reject the idea that notes and coins are a governing factor in determining the price level. A writer in the Financial Times (19 January 1989) referring to notes and coin in circulation wrote: “It is not the basis of anything. Nor does it cause anything to happen”.

A stable price level, as existed from 1850 to 1914, does not mean no price change at all. Prices rise moderately in booms and fall in depressions. Further, the “needed” amount of currency rises with growth of population and production and falls with monetary developments such as the growth of the banking system (to which Marx drew attention) and later on the use of credit cards, and the like. So Marx never subscribed to the theory that every change in the amount of currency produces an equal change in prices.

The only proof for any theory is that it does explain the course taken by the factors it sets out to explain. The Marx explanation of inflation, stable prices and deflation is the only one to pass the test.

Those who reject it, that is to say all the various schools of economic thought which deny the relationship between the price level and the amount of currency in circulation, cannot explain why prices were stable before 1914, why they have risen every year since 1938, and why prices fell between 1920 and 1925. Every Labour and Tory government since 1945 has proclaimed its intention to halt inflation and has put into operation policies supposed to achieve that end—and all of them without success.

The only policy none of them have tried is the policy of controlling the amount of currency in circulation. Confused by Keynes’ teaching that it is not necessary to control the amount of currency in circulation, modern governments and their advisers have forgotten something more or less clearly understood by governments in the 19th century and in 1920, before Keynes muddied the waters.

It would however be quite fallacious to assume that workers would necessarily be better off if inflation were to come to an end and prices fell. It might happen that way but it frequently does not. The only fall in prices this century was when the government in 1920 decided to reduce the amount of currency in circulation and so brought prices down by 29 per cent between 1920 and 1925. Wages fell by more than prices and the workers were worse off.

On the other hand, it is equally fallacious to assume that workers must be worse off when prices rise. During the past six years, with prices continually rising, average weekly wages have consistently risen by more than prices. When industry is trading profitably, as it has been in recent years, employers make concessions to union wage claims rather than have the flow of profits halted by strikes.

Edgar Hardcastle

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