Understanding economics. Part 5 – the politics of inflation


Part 1 here:

Part 2 here:

Part 3 here:

Part 4 here:

Inflation is a real problem. For salary and wage earners they get less when they buy. Wage and salary increases lag behind inflation. 

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Neo liberal economists use monetary theory to explain inflation. They say all inflation is caused by the money supply and the government and Reserve bank control that. And this assertion is incredibility important for politics because it controls economic choices the government can make.  

And it is this assertion/theory that is currently being used by the Reserve Bank in raising interest rates to control inflation.  And nobody seems to be challenging this. Doubts are expressed about the amount raised, but that’s all. But there are many economists who do challenge the validity of this theory; but in practise it seems like none of them know what else to do. They are not visible in providing policy options.  

Inflation is simply the rising of prices and the theory say’s prices are determined by the interaction of three things. 

  1. velocity of money (the number of times it changes hands in a period of time ) 
  2. the amount of GDP in the economy – what is being produced in the society – the activity, 
  3. the money supply, the amount on money in the economy. 

They collect data that shows GDP doesn’t increase that much year on year. So quite stable. And the velocity of money on their data is quite consistent of around 7 transactions. Stable.  Therefore prices rising must be driven by the money supply. And they have charts that show a co-relation between rising inflation and an increasing money supply. Note: most of these examples are in third world nations. e.g. Argentina, Peru, Zimbabwe.  

Therefore the theory say’s that inflation is always a local problem; the controllers of the local currency printed too much money There is no other cause of inflation. 

Ergo the cause of inflation is government printing and spending money to help people. Or if the Reserve Bank  has interest rates too low, people and businesses can indulge and borrow too much. The demand side of the economy is the problem in this theory.  And once money is printed and in circulation the only way to take the money out of the system, and take that heat out of the economy that is pushing up prices, is to raise interest rates.

And the monetarist logically consistent argument continues with their explanation about what is happening with the money supply to start the inflation. They say the people who got the money go and buy things. The suppliers of goods and services say ‘great’ and invest more in the business, – hire more staff buy more product to sell (really? They don’t go on holiday or buy nice things?). But all the other shopkeepers have done the same and as they are each running out of product to sell, they go to buy new inputs to sell and the demand is up so the price is up so they in turn have to put up their prices. So prices go up, until you take away the demand sides purchasing power. 

The logical consequence of this monetary theory – there is a finite amount of money that can be in the financial system otherwise inflation will get out of control and ruin the economy and the wealth in it.  A finite amount of money goes right back to the gold standard concept. This monetary theory actively works to create a defacto gold standard. The suppliers are often actively told to worry about inflation so they raise prices in anticipation so by their actions inflation arrives. 

Therefore the ability of government to improve the lives of its citizens is curtailed by that limit.  They can’t give people money who desperately need it. They can’t stimulate the economy. This is the systemic problem Labour has bought into being by trying to be ‘economically credible’ within the theoretical framework of neo-liberalism. The Reserve Bank raising interest rates is deliberately trying to suppress demand and the bank is fine with a recession.  

Don’t forget! Labour like the Democrats in the US and people like Janet Yellan claim that they are different to neo-liberals, and claim they follow New Keysianism. This just shows they don’t understand Keynes, or the wider context in which he intended his theories to operate.  Keynes rejected the gold standard in his 1930 work ‘A treatise on Money’. The UK had to abandon gold in 1930, which Keynes celebrated. FDR in the US suspended the gold standard in 1933. The economies began recovering from the depression.. 

So we are still fighting a battle about defacto gold standards that was won almost 100 years ago!  Labour/Greens need to rethink their entire economic policy framework of facilitation of private enterprise.  This is especially so with the Emission Trading scheme, and the housing policy that encourages wasteful spending and massive increases in carbon emissions all while driving up housing prices. 

To find policies that won’t stimulate demand and but can appeal to voters and win an election in a recession is almost impossible for Labour within a neo-liberal market driven economic framework. But more importantly how can Labour look after the people of New Zealand? The National alternative of tax cuts and spend crazy on roads is an open attack on public services which means more climate change, invasive species coming in and expanding their range, lower quality education and health, etc. 

For Labour and the Greens they can’t win or look after people or the environment while staying within a neo-liberal market driven economic framework. Surely that awareness is the easy part. 

The hard question is how to deal with the fight to get back to Keynesian economics?  Keysianism famously did not cope with stagflation in the 1970’s but there were special problems that drove it. And there are ways to deal with it.  Inflation is a powerful political tool that can be used to hold back change. 

Note – the inflation restraint generally will not apply to National as they will squeeze govt expenditure. Inflation is the way National would attack the roading proposals. 


Points of criticism of monetary analysis

  • Friedman even speaks about imported inflation and then asserts because currencies float freely the value will reflect the strength of the currency so it can’t import inflation if there is proper control of the money supply – A clever argument but one without substance because inflation clearly can be imported.
  • The velocity of money is only inferred and is highly contested and strongly doubted by many economists. 
  • The co-relation of money supply and inflation increasing can just as easily be explained by the printing of money being necessary to follow the inflation rather than causing it. They don’t resolve the chicken and egg problem.  Regardless inflation is still a problem.

Points to note on who carries the burden of interest rate rises:

  • Because suppliers of goods and services simply pass interest costs onto customer in their prices; it is the demand side – the consumers- that carry the weight of the rises ( though not easy for small businesses to raise prices when selling something with high elasticity of demand). 
  • Suppliers may with higher interest costs: lay off staff, delay improvements, or investments, The negative impact for suppliers can be more an opportunity cost. But the burdens will again be carried by the demand side of the economy – less jobs etc. Though higher interest rates will hurt suppliers for any existing debt.