Who’s afraid of the Inflation Genie?

Alex Wadsley

AS WAYNE SWAN prepares for an inflation fighting budget that cuts from the rich to give to the poor, sprinkles some tax cut confetti and takes back Liberal spending promises it is time to ask why? Why are we so afraid of inflation?

Inflation is bad, right? All the politicians and central bankers tell us inflations bad. All the business leaders tell us inflations bad. But why?

In Neo-Classical economics there is the principal of money neutrality (also known as the Classical Dichotomy) which says that price labels don’t matter, it’s only relative prices and how they support or distort the economy that matters. Twenty years of microeconomic reform have attempted to create price flexibility in ports, super markets, airlines and everything else. This should make price changes more ‘neutral’ than in the past.

In Keynesian economics there is inflation-unemployment trade-off, also known as the Phillips Curve. This tells you that inflation may be bad, but it can have its benefits. That is higher inflation is associated with low unemployment, so some inflation may be good.

Then comes Friedman’s Monetarists with their inflation genie. The problem is not with inflation, but with inflationary expectations, which rob the Phillip’s Curve of its potency so that higher and higher inflationary increases are requires to achieve the same unemployment rate. The problem is that unions continually require pay rises to match previous rounds of price rises, so that employers never have an incentive to put on extra staff. Indexation is the fundamental problem.

Hawke and Keating fought the Inflation Genie, first with the Accords with the unions which limited wage indexation in return for tax cuts, and then the ‘recession we had to have’ which knocked everybody’s inflation expectations to zero. You didn’t demand a pay rise, you were lucky to have a job.

Then followed the Golden Nineties, low inflation, full employment, strong economic growth, rising asset prices…

But inflation is back.

The growth of China and other Asian economies reduced international prices for manufactured goods and high saving rates kept real interest rates low. Now the growth of these economies is putting pressure on commodity prices, from iron ore, copper, food and oil.

Western central banks followed an easy money policy which funnelled the high savings of Asia and the Baby Boomer generation into asset bubbles in stocks and property. Now these bubbles have either crashed, or in property, stabilised. You can’t use rising asset prices to supplement your income, your income won’t support the debt on your assets. Economic calamity beckons…Oops!

Along comes inflation. Inflation could solve the debt crisis, by raising incomes relative to asset prices and debts, but inflation is bad, right?

The inflation is bad argument rests on a number of assumptions. The question the government and the reserve bank should be asking is: in the 21st Century information age are the assumptions still valid? Part of the rhetorical argument for the sustainability of growth in the 1990s was that information technology allowed economies to grow faster. Might something similar be true for inflation?

Classic examples of the cost of inflation are menu costs. These are the costs of changing prices, reprinting labels, price lists and restaurant menus. These are really no longer valid, while these might have been a major cost once, the easy availability of printing technology and the internet has significantly reduced the real cost of changing prices. There are also major real cost drivers in the current inflationary cycle which demand price changes anyway, the changing relative prices of petrol, food, and electronic goods. Microeconomic reform was also intended to increase the flexibility of prices, which implies more changes.

Another cost is the distortion of the tax system. If you save $100 in the bank and earn $5 interest then you pay tax on $5. If Inflation is 5% you save $100, earn $10 interest but the $100 you saved only buys $95 worth of stuff. If you pay tax on $10 then you are significantly worse off. The current tax system is unfair for an inflationary environment, but it could easily be changed by incorporating features of the previous capital gains tax systems which allowed the indexation of investments for inflation.

A theoretical cost for economists is the real money balances effect. If you work and consume, you need to hold money. If you choose leisure you don’t need money. As inflation increases, there is a real cost to holding money as its value declines, so you might choose more leisure and less work. This impact might have been theoretically valid fifty or even twenty years ago, but today wages can be paid directly into interest bearing accounts and consumption can be from electronic accounts and credit cards. Electronic systems can adjust the interest rate for inflation so that there is no loss in money value. This effect has been made obsolete by technology.

One sector which still deals in lots of cash is criminal enterprise. Presumably the RBA is not working on their behalf.

Another cost of inflation is shoe-leather costs, the costs of continually re-assessing and negotiating prices. First off, relative prices are changing anyway, similarly for the menu cost argument. Secondly technology is making it easier, particularly with the internet, but also schemes like the federal fuel watch.

A more complex argument is presented by wage disputation. If there are strikes this has a real impact on the economy but clearly if costs are rising, real wages are falling so unions need to fight for higher wages. On the other hand, if prices are rising anyway, then unions should fight for their members and it is the refusal of employers to acknowledge the cost increases that causes the strike. Perhaps it is inflation fighting that causes the strikes, not the inflation itself. Another solution is indexation clauses that raise wages automatically in response to price inflation. The problem with this is that indexation is at the heart of the inflation genie break out … it is price rises feeding on themselves.

This brings us to the public servants pay claim in Tasmania. Asking for parity is akin to indexation, locking Tasmania into ever increasing public service costs as Victoria, New South Wales and other states raise their wages. Yes public servants need a pay rise to cover the increase in the cost of living and stop their wages falling in real terms, but parity is unsustainable. Uncontrolled rises in public spending is at the heart of California’s perennial budget problems and what caused Tasmania‘s debt disaster in the Robin Gray years.

For the national economic managers, Swan’s Treasury and the Reserve Bank, a bit of balance is required. Part of Australia’s inflationary problem is due to the central bank failing to recognise the long-run inflationary implications of unsustainable house price rises. They raised rates too late, and now they’re in danger of pushing them too high. The other part is caused by the commodity price boom which helps exporters but is now costing households. While we don’t want to recreate an inflationary spiral, it may not be as bad as it seems, and a loosening of prices and wages may allow the economy to adjust to real shocks better than a rigid fixation on low inflation.

We don’t need a recession to fight an imaginary genie of the past.

Alex Wadsley