Bob Murphy on 1970s Inflation

Bob Murphy discusses the inflation of the 1970s here.

It is a perfect example of how Austrians are still mired in the false and misleading quantity theory of money, and all its mistaken assumptions.

He uses the following graph (which can be opened in a separate window) showing M2 money supply growth rates with the CPI inflation rates.

The key to understanding and interpreting this graph are the theories of

(1) endogenous money and
(2) mark-up pricing.

Furthermore, the supply shocks and wage-price spirals of the 1970s – the historically specific factors – cannot be ignored either.

First, let us dispose of the quantity theory of money and explain endogenous money theory.

There are two main versions of quantity theory, as follows:

(1) The Equation of Exchange: MV = PT,
where
M = quantity of money;
V = velocity of circulation;
P = general price level, and
T = total number of transactions.

(2) the Cambridge Cash Balance equation: M = k_d PY,
where
M = supply of money;
k_d = demand to hold money per unit of money income;
P = general price level, and
Y = volume of all transactions in the value of national income.

A number of assumptions have to be made for the quantity theory to explain changes in the price level, as follows:

(1) prices are flexible and respond to demand changes in either (1) both the short and long run, or (2) at least in the long run. Related to this is a tacit assumption that the economy is near equilibrium in the sense of full use of resources and high employment, where stocks and capacity utilization are not fundamental methods that firms use to deal with changes in the demand for their products.

(2) money supply is exogenous;

(3) under the equation of exchange, for an increase in M to lead to a proportional increase in P, both V and T must be assumed to be stable.

Under the Cambridge Cash Balance equation, M and P are causally related, if k_d and Y are constant (Thirlwall 1999).

(4) the direction of causation. The quantity theory assumes the direction of causation runs from money supply increase to price rises.

(5) in some extreme forms there is the assumption, following from (1), that money supply increases induce direct and proportional changes in the price level. (I will just note as an aside that Austrians already reject this, because they emphasise Cantillon effects, the idea that price level changes caused by increases in the quantity of money depend on the way new money is injected into the economy, and actually where it affects prices first.)

So how realistic are these assumptions?

The answer is not very realistic at all:

(1) most prices are mark-up prices and relatively inflexible with respect to demand changes in both the short and long run. Most capitalist economies are far from full use of resources, and even in booms businesses make use of stocks and capacity utilisation to manage demand changes, rather than changes in prices.

(2) money supply is largely endogenous;

(3) The velocity of money and demand for money are unstable, subject to shocks and move pro-cyclically (Leo 2005; Levy-Orlik 2012: 170);

(4) the direction of causation. Under an endogenous system the direction of causation is generally from credit demand (via business loans to finance labour and other factor inputs) to money supply increases (Robinson 1970; Davidson and Weintraub 1973).

Therefore the direction of causation generally runs:

credit demand → broad money supply increase → base money increase. (Moore 2003: 118).

This is true, as noted above, since the money supply is endogenous: most of the money supply is “broad money” or bank money, and that is increased by credit expansion in the form of bank loans.

(5) that money supply growth necessarily or generally induces direct and proportional changes in the price level is empirically false (De Grauwe and Polan 2005).

We can see here why broad money supply growth precedes inflation or real output changes.

The reason is that (1) money is largely endogenous and (2) growth in the broad money supply is generally caused by credit growth. Many businesses finance their wage and other factor input bills with credit from banks, so that before real output grows money supply will grow.

Cost-push inflation happens in the same way: when (1) workers or unions demand higher wages and businesses agree to these increases and/or (2) prices of other factor inputs rise, then businesses will need to obtain higher levels of credit from banks. Hence broad money supply growth rates rise, but this rise precedes price increases because businesses will generally raise mark-up prices to maintain profit margins at a later time, given that most firms engage in time-dependent reviews and changes of their prices at regular intervals.

The process of a wage–price spiral involves actually this type of phenomenon, but in a vicious circle.

This crucial point about the direction of causation in the relationship between money supply and output/prices is discussed by Joan Robinson:

“The correlations to be explained [sc. in the relationship between money supply and real output] could be set out in quantity theory terms if the equation were read right-handed. Thus we might suggest that a marked rise in the level of activity is likely to be preceded by an increase in the supply of money (if M is widely defined) or in the velocity of circulation (if M is narrowly defined) because a rise in the wage bill and in borrowing for working capital is likely to precede an increase in the value of output appearing in the statistics. Or that a fall in activity sharp enough to cause losses deprives the banks of credit-worthy borrowers and brings a contraction in their position. But the tradition of Chicago consists in reading the equation from left to right. Then the observed relations are interpreted without any hypothesis at all except post hoc ergo propter hoc.” (Robinson 1970: 510–511).

Secondly, we need to understand mark-up pricing.

Many businesses – and probably a majority in any given developed capitalist economy – set their prices mainly as a profit mark-up on total average unit costs (that is, fixed plus variable costs).

Prices tend to change when total average unit costs change or when the firm wants to change its profit mark-up, and therefore supply costs are the important factor causing price changes (the overwhelming empirical evidence proving that mark-up pricing is prevalent throughout the developed world is here).

Although demand-side inflation is a real and important phenomenon, it is not the only major cause of inflation. In fact, often demand-side inflation is a grossly overestimated cause of inflation and the really important cause is increases in mark-up prices by cost-push inflation: for mark-up prices are, generally speaking, not responsive to changes in demand (Kaldor 1976: 217).

In the post-WWII world when unions were much stronger, collective bargaining in wages prevalent, and cost of living clauses standard in wage contracts, a sufficiently large rise in wages or spike in energy or raw materials costs could set off wage–price spirals, as businesses maintained their profit margin by simply raising their mark-up prices.

Now we have sketched the two theories we need to understand inflation, in addition to demand-led inflation, we can turn to an actual explanation of the 1970s inflation from its origin in the late 1960s until 1975.

We can break down the inflation trends as follows:

(1) Phase 1: 1967–1971
The US saw a spike in inflation from October 1967 to February 1970. Then inflation turned around and, although high, inflation rates gradually fell right down to June 1972.

This was preceded by a spike in M2 growth rates from January 1967 to January 1968.

In the United States, unemployment had fallen to 3.8% in 1966 and 3.6% in 1968, historically low levels. Low unemployment led to some bidding up of wages in this period in the non-unionised sector. Unionised workers in turn also demanded higher wages. The inflation in the US, then, was driven by unusually higher wage demands (Kaldor 1976: 224), just as it was throughout other Western countries. As Nicholas Kaldor noted, around 1968–1969, similar types of wage rises occurred in Japan, France, Belgium and the Netherlands, and from 1969–1970 in Germany, Italy, Switzerland and the UK, which Kaldor attributed largely to trade union action (Kaldor 1976: 224).

But then the US recession from December 1969 to November 1970 struck, and there was a marked decrease in inflation and M2 growth rates.

From April 1970, acceleration in M2 growth rates began again and (as we would expect) preceded the recovery in real output that ended this recession.

But M2 growth rates soared to a high level from April 1970 to July 1971, as the expansion in the business cycle occurred and higher wage demands continued.

The momentous event that would set the stage for the inflation in the next phase was the end of the Bretton Woods system on August 15, 1971, when Nixon closed the gold window.

The end of Bretton Woods was momentous: inflationary expectations and instability on financial and commodity markets resulted, as well as a rise in commodity speculation as a hedge against inflation. This contributed to the cost-push inflation that was being felt in many countries after 1971.

Nevertheless, the end of Bretton Woods in August, 1971 did not suddenly unleash run-away inflation. As we see in the chart, US inflation rates continued to fall until June 1972.

(2) Phase 2: 1971–1974
The spike in US inflation began again in June 1972 and continued until December 1974.

What caused this? Three major factors did:

(1) an explosion in commodity prices from 1972;

(2) wage–price spirals, and

(3) the first oil shock.

Let us start with factor (1).

In the late 1960s, the US began dismantling its commodity buffer stock policies that had previously ensured price stability in the golden age of capitalism.

The prelude to stagflation was marked by a significant explosion in commodity prices that occurred in the second half of 1972. Part of the problem was the failure of the harvest in the old Soviet Union in 1972–1973 and the unexpectedly large purchases on world markets by the Soviet state (Kaldor 1976: 228). This could have been averted had the United States not dismantled its commodity buffer stock policies in the 1960s. As we have seen above, the end of Bretton Woods also induced commodity speculation and rises in commodity prices and raw materials costs.

This feed into further price rises, which in turn exacerbated wage–price spirals.

The final factor that explains the surge in inflation down to December 1974 was the first oil shock from October 1973, when various Middle Eastern producers of oil instituted an embargo that lasted until March 1974 (Kaldor 1976: 226). In most countries, the double digit inflation of the 1970s was caused by the oil shocks (both the first and second).

This explains why M2 growth rates, while high, actually fell gradually from January 1973 to June 1974 as a recession struck the US from November 1973 to March 1975. This inflation was a supply-side phenomenon.

The accelerating inflation rates from 1973 to 1974 occurred when the US economy was in recession and this anomaly puzzled many economists at that time.

The new portmanteau word “stagflation” (stagnation + inflation) was increasingly used to describe the phenomenon, which meant the simultaneous occurrence of stagnation or recession (with high unemployment) and accelerating inflation.

I have not bothered to continue this analysis down to 1980, but it could be easily done.

The very same factors as described above also explain the second bout of stagflation and the major cause was the Second oil shock.

Update
Philip Pilkington has a great post here on this very subject:

Philip Pilkington, “Animism and Monetarist Thinking: The Inflation in the US in the 1970s,” Fixing the Economists, August 6, 2013.

Further Links
“US Inflation Rates (1946–1987), Keynesianism and Stagflation,” March 24, 2013.

“Stagflation in the 1970s: A Post Keynesian Analysis,” June 24, 2011.

“Hans Albert on the Quantity Theory of Money,” March 2, 2014.

“Joan Robinson on the Quantity Theory of Money,” March 3, 2014.

“Endogenous Money: A Bibliography,” April 5, 2012.

“Endogenous Money 101,” April 20, 2013.

“Rochon and Rossi on the History of Endogenous Money,” May 4, 2013.

“Endogenous Money under the Gold Standard,” May 19, 2013.

“Some Empirical Evidence on Endogenous Money,” May 27, 2013.

“Empirical Evidence on Endogenous Money,” August 10, 2013.

“The Quantity Theory of Money is Wrong,” August 7, 2013.

BIBLIOGRAPHY
Davidson, Paul and Sidney Weintraub. 1973. “Money as Cause and Effect,” The Economic Journal 83.332: 1117–1132.

De Grauwe, P. and M. Polan. 2005. “Is Inflation Always and Everywhere a Monetary Phenomenon?,” Scandinavian Journal of Economics 107: 239–259.

Kaldor, N. 1976. “Inflation and Recession in the World Economy,” Economic Journal 86 (December): 703–714.

Leo, P. 2005. “Why does the Velocity of Money move Pro-cyclically?,” International Review of Applied Economics 19.1: 119–135.

Levy-Orlik, N. 2012. “Keynes’s Views in Financing Economic Growth: The Role of Capital Markets in the Process of Funding,” in Jesper Jespersen and Mogens Ove Madsen (eds.), Keynes’s General Theory for Today: Contemporary Perspectives. Edward Elgar, Cheltenham. 167–185.

Moore, B. 2003. “Endogenous Money,” in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics. Edward Elgar, Cheltenham. 117–121.

Robinson, Joan. 1970. “Quantity Theories Old and New: Comment,” Journal of Money, Credit and Banking 2.4: 504–512.

Thirlwall, A. P. 1999. “Monetarism,” in P. Anthony O’Hara (ed.), Encyclopedia of Political Economy: L–Z. Routledge, London and New York. 750–753.

US Inflation Rates (1946–1987), Keynesianism and Stagflation

It is sometimes claimed that the Keynesian golden age of capitalism (1946 to 1973) had an accelerating inflation rate. The story goes: all Keynesianism did was cause a never-ending, upward trend in inflation rates.

The myth was peddled by (of all people!) the British Labour politician James Callaghan (UK Prime Minister from 1976 to 1979) when in 1976 he declared that Keynesianism “only worked on each occasion ... by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step,” before he introduced at least a rhetorical commitment to a pre-Thatcherite form of monetarism in the UK.

But it is nonsense, certainly in the case of the US, as we can see in the graph below.




There were two outliers: the post-WWII inflation and the Korean War inflation. But, apart from these, the inflationary spike that did break out after 1968 was unusual and a deviation from the basic price stability of the golden age. That price stability was most notable for the late 1950s and most of the 1960s. In fact, actual deflation briefly occurred twice in the post-WWII era.

As Nicholas Kaldor long ago noted, during the golden age “for a long time the rate of inflation (as measured by consumer prices) remained moderate, and until the closing years of the 1960s it showed no clear tendency to acceleration” (Kaldor 1976: 214).

The reason for the inflationary crisis of the 1970s was four-fold:

(1) From 1968–1971 there were the beginnings of inflationary pressures, in both wages and prices in many industrialised nations. The fundamental cause was that around 1968–1969 in Japan, France, Belgium and the Netherlands and from 1969–1970 in Germany, Italy, Switzerland and the UK wage rises had occurred, which Kaldor attributes to strong action by unions (Kaldor 1976: 224). There is a perpetual struggle between capitalists and labour over distribution of income, and it just happened that around 1968 to 1970 labour won out in many countries causing a bout of cost-push inflation (via wage increases). But this would not have become a serious problem had it not been for factors (2), (3), and (4).

(2) the dismantling of commodity buffer stock policies that had previously ensured price stability. The prelude to stagflation was marked by a significant explosion in commodity prices that occurred in the second half of 1972. Part of the problem was the failure of the harvest in the old Soviet Union in 1972–1973 and the unexpectedly large purchases on world markets by the Soviet state. This could have been averted had the United States not dismantled its commodity buffer stock policies in the 1960s.

(3) The end of Bretton Woods (the post-WWII international monetary system) was momentous: inflationary expectations and instability on financial and commodity markets resulted, as well as a rise in commodity speculation as a hedge against inflation. This contributed to the cost-push inflation that was being felt in many countries after 1971.

(4) The final factor that caused the severe inflation of the 1970s was the first oil shock from October 1973, when various Middle Eastern producers of oil instituted an embargo that lasted until March 1974 (Kaldor 1976: 226). In most countries, the double digit inflation of the 1970s was caused by the oil shocks (both the first and second).

The unfortunate concatenation of these historically unprecedented shocks – that is, factors (1), (2), (3), and (4) – in toto was the cause of 1970s stagflation.

Kaldor stresses the importance of factor (2). During most of the golden age of capitalism (1945–1973), primary commodity buffer stocks had created stable prices. But this policy was changed in the 1960s when the US modified its buffer stock policies:

“… the duration and stability of the post-war economic boom owed a great deal to the policies of the United States and other governments in absorbing and carrying stocks of grain and other basic commodities both for price stabilisation and for strategic purposes. Many people are also convinced that if the United States had shown greater readiness to carry stocks of grain (instead of trying by all means throughout the 1960s to eliminate its huge surpluses by giving away wheat under PL 480 provisions and by reducing output through acreage restriction) the sharp rise of food prices following upon the large grain purchases by the U.S.S.R. [in 1972–1973], which unhinged the stability of the world price level far more than anything else, could have been avoided.” (Kaldor 1976: 228).

That was a major factor causing stagflation, along with wage–price spirals. The first oil shock was a final factor that exacerbated everything.


BIBLIOGRAPHY

Kaldor, N. 1976. “Inflation and Recession in the World Economy,” Economic Journal 86 (December): 703–714.

Stagflation in the 1970s: A Post Keynesian Analysis

The portmanteau word “stagflation” (stagnation + inflation) refers to the economic problems of the 1970s. We need a clear definition of stagflation, and there are in fact two senses in which it is used:

(1) the simultaneous occurrence of stagnation (low or no growth) and high inflation (the original definition of the term when it was coined by Ian Macleod, in a speech to the British House of Commons, in 1965);

(2) the simultaneous occurrence of rising unemployment rates and rising inflation.

It is sense (2) in which the word is normally used in economics, and it describes high unemployment and high inflation rates (even during recessions) occurring simultaneously. Thus the years from 1975-1977 in the US were not technically stagflation: these were years of an expansion in the business cycle with disinflation (falling inflation rates), rising employment, and rising real output growth.

The most serious periods of stagflation were in 1973–1974/1975 and 1979-1981 when many countries entered recessions and experienced rising unemployment and rising inflation. In most countries, these severe years of surging inflation and unemployment were the result of the first (1973-1974) and second oil shocks (1979-1980), and the double digit inflation rates in many countries (though not all) that provoked the sense of crisis in these years were caused by the high price of energy, a major factor input. But it is also true that from 1968–1970 many countries experienced an unusual rise in wages and prices, with further surges in prices from 1972-1973 before the first oil shock hit their economies. This requires an explanation.

There is no doubt that the era of stagflation was a theoretical and practical problem for neoclassical synthesis Keynesians, with their flawed Hicksian IS-LM models.

But Post Keynesians never had any difficulty explaining stagflation and offering effective cures for it. In particular, Geoff Harcourt explains in the video below (from 20.00 minutes onwards) how Keynes’s General Theory was easily capable of showing that rising unemployment can occur with rising inflation. Harcourt also talks about Lorie Tarshis and his textbook summary of Keynes’s General Theory for American universities in the 1940s, which was attacked by conservatives. Tarshis’s accurate summary of Keynes was rejected for Paul Samuelson’s neoclassical version of Keynesianism (the neoclassical synthesis), and if Tarshis’s book on Keynes had been used instead of Samuelson’s textbook, many of the theoretical problems of neoclassical synthesis Keynesianism would have been avoided.




One of the best analyses of stagflation is by Nicholas Kaldor:

“Inflation and Recession in the World Economy,” Economic Journal 86 (December, 1976): 703–714.

My analysis here is based on Kaldor and other Post Keynesian work.

When we buy many commodities we do not engage in some kind of haggling over price in each individual transaction, or compete with others to bid for a product as in an auction, nor do the prices of many commodities change even though demand has changed. For example, when you go to the supermarket, you do not see daily or weekly fluctuations in the price of milk or bread in accordance with demand for, and sales of, those commodities.

Real world capitalism has developed numerous markets where prices are not set, or explicable, by demand and supply curves. Instead, prices can be (1) administered by business institutions or (2) cooperation between businesses that produce commodities (the familiar concepts of monopoly, oligopoly and cartels). But modern corporations are often institutions that also administer prices, and prices can be stable or unchanged for significant periods of time. Nor do they not respond immediately to demand or sales fluctuations:

“In studies of price determination, business enterprises have stated that variations of their prices within practical limits, given the prices of their competitors, produced virtually no change in their sales and that variations in the market price, especially downward, produced little if any changes in market sales in the short term. Moreover, when the price change is significant enough to result in a significant change in sales, the impact on profits has been negative enough to persuade enterprises not to try the experiment again. Consequently administered prices are maintained for a variety of different outputs over time … The pricing administrators of business enterprises maintain pricing periods of three months to a year in which their administered prices remained unchanged; and then, at the end of the period, they decide on whether to alter them.” (Lee 2003: 288).

What disturbs this?

The price of commodities produced in an economy depends on the costs of factors of production, in particular the wage bill, and then the mark-up over the costs of factor inputs (Musella and Pressman 1999: 1100).

The factors of production are

(1) primary commodities or natural resources, including land, raw materials, water, and energy;
(2) labour, and
(3) capital goods.

Thus inflationary pressures can result from

(1) surges in the prices of primary commodities or energy, especially when the prices of these factor inputs are set on world markets or are influenced by supply shocks;

(2) workers pushing for wage rises, and

(3) business firms increasing their pricing mark-ups.

A vicious circle can result when (a) workers demand wage rises and then (b) firms increase their mark-ups, causing a circle of (a), (b) etc. The distinction must also be made between (1) demand-pull inflation, and (2) cost-push inflation, when the latter has a supply-side cause.

During the most of the Golden Age of Capitalism (1945–1973), primary commodity buffer stocks had ensured price stability. But this policy was changed in the 1960s when the US modified its buffer stock polices:

“… the duration and stability of the post-war economic boom owed a great deal to the policies of the United States and other governments in absorbing and carrying stocks of grain and other basic commodities both for price stabilisation and for strategic purposes. Many people are also convinced that if the United States had shown greater readiness to carry stocks of grain (instead of trying by all means throughout the 1960s to eliminate its huge surpluses by giving away wheat under PL 480 provisions and by reducing output through acreage restriction) the sharp rise of food prices following upon the large grain purchases by the U.S.S.R. [in 1972–1973], which unhinged the stability of the world price level far more than anything else, could have been avoided.” (Kaldor 1976: 228).

From 1968–1971 there were the beginnings of inflationary pressures, in both wages and prices in many industrialised nations. Around 1968–1969, this was reflected in wage rises in Japan, France, Belgium and the Netherlands, and from 1969–1970 in Germany, Italy, Switzerland and the UK, which Kaldor attributes to demands by unions for wage rises (Kaldor 1976: 224). There is of course an eternal struggle in modern capitalism between labour and capital over distribution of income, and sometimes this can get out of control. Post Keynesians recognise the need for some kind of control over wages in modern capitalism, when wage gains become excessive, and the method required is incomes policy of some type. This does not require hostility or opposition to trade unions, however, and Post Keynesian labour theory is, if anything, supportive of organised labour.

But the prelude to stagflation was also marked by a significant explosion in commodity prices that occurred in the second half of 1972. Part of the problem was the failure of the harvest in the old Soviet Union in 1972–1973 and the unexpectedly large purchases on world markets by the Soviet state. That was exacerbated by the uncertainty caused by the break up of the Bretton Woods system,
after Richard Nixon had ended the convertibility of the US dollar to gold on August 15, 1971, an event you can see Nixon announcing in the video below.



The end of Bretton Woods (the post-WWII international monetary system) was momentous: inflation expectations and instability on financial and commodity markets resulted, as well as a rise in commodity speculation as a hedge against inflation. This contributed to the cost-push inflation that was being felt in many countries after 1971. As Kaldor noted, this could have been averted had the United States not dismantled its commodity buffer stock in the 1960s.

The final factor that caused the severe inflation of the 1970s was the first oil shock from October 1973, when various Middle Eastern producers of oil instituted an embargo that lasted until March 1974 (Kaldor 1976: 226). In most countries, the double digit inflation of the 1970s was caused by the oil shocks. This fed into wage-price spirals in a number of countries.

A long-term solution to stagflation proposed by Kaldor was an international system of buffer stocks in major commodities. This could be used to raise commodity prices when they fell to too low a level by buying on the market (which would help incomes in developing nations and other producing nations), and to lower prices by selling into the market when prices were rising too high (Kaldor 1976: 228–229).

In short, Post Keynesian economics can easily understand and deal with stagflation. The wage-price spirals that broke out by the end of the 1960s in some industrialised nations could have been dealt with by incomes policy (national wage arbitration/wage-price controls), and the long-term solution was, and still is, an international system of commodity buffer stocks.


BIBLIOGRAPHY

Blaas, W. 1982. “Institutional Analysis of Stagflation,” Journal of Economic Issues 16.4: 955-975.

Cornwall, J. 1990. The Theory of Economic Breakdown: An Institutional-Analytical Approach, Blackwell, Cambridge, MA.

Cornwall, J. 1994. Economic Breakthrough & Recovery: Theory and Policy (rev. edn), M.E. Sharpe, Armonk, N.Y.

Eckstein, A. and D. Heien, 1978. “The 1973 Food Price Inflation,” American Journal of Agricultural Economics 60.2: 186–196.

Galbraith, J. K. 2008. The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too, Free Press, New York.

Hathaway, D. E. 1974. “Food Prices and Inflation,” Brookings Papers on Economic Activity Vol. 1974, No. 1: 63–116.

Kaldor, N. 1976. “Inflation and Recession in the World Economy,” Economic Journal 86 (December): 703–714.

King, J. E. 2002. A History of Post Keynesian Economics since 1936, Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.

Lee, F. S. 2003. “Pricing and Prices,” in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics, E. Elgar Pub., Cheltenham, UK and Northhampton, MA. 285–289.

Musella, M. and S. Pressman. 1999. “Stagflation,” in P. Anthony O’Hara (ed.), Encyclopedia of Political Economy: L–Z, Routledge, London and New York. 1099–1100.