The economics of inflation

Neither Marxist nor orthodox (bourgeois) economic theory has a good fix on price inflation, its causes and cures. This sketchy article will not remedy that lack, but it may help interpret debates and arguments on the issue.

In the Transitional Programme of 1938 Trotsky wrote: "Neither monetary inflation nor stabilisation can serve as slogans for the proletariat... Against a bounding rise in prices... one can fight only under the slogan of a sliding scale of wages. This means that collective agreements should assure an automatic rise in wages in relation to the increase in price of consumer goods".

He did not propose an alternative socialistic way of dulling inflation (which was actually quite low, by post-1945 standards, in the leading capitalist countries in the late 1930s). All known anti-inflation policies under capitalism would hurt workers probably as much as inflation, or maybe even more. Instead, Trotsky proposed workers find demands to defend their class interests against all contingencies.

He would have remembered Bolshevik Russia in 1917-22, when the workers' government, grappling with invading armies, civil war, and ruin from World War One, suffered rapid inflation. It could quell the inflation only in 1922, and then by a conventional capitalist-type method: a new currency linked to gold. The workers' government could and did organise better protection against inflation than a "sliding scale" - free distribution of basics - but only on a pauper scale. In Revolution Betrayed Trotsky saw the best expedient for future workers' governments, which could not abolish markets overnight and would need some reliable currency for even makeshift economic planning, as a currency based on gold reserves.

Marx was not much concerned with inflation. He knew, of course, about the rapid price rises in Britain during the Napoleonic Wars, when the guarantee of conversion of Bank of England notes into gold was paused between 1797 and 1821. In his day prices might jump up and down from one year to the next, but there was no embedded regime of inflation. Marx scorned the economists who argued in an economic crisis in 1857 against loosening the law linking the Bank of England's note issue rigidly to its gold reserves.

In Marx's day, there was already an "orthodox" theory of inflation, the "quantity theory". It said that the price level was determined by the quantity of the money-stock as compared to the level of output. Inflation was "too much money chasing too few goods".

Probably it was influenced by Europe's historical "Price Revolution", the general rise in prices in the 16th and 17th centuries. In Marx's view that came from a reduction in the labour-time value of gold and silver relative to that of other commodities, mainly thanks to the new production extracted by the Spanish empire from South America.

Marx rejected the "quantity theory". For most purposes, he assumed a money system based on a gold (or silver) standard. The "value of money", then, would gravitate around the labour-time required to produce gold relative to the labour-time required to produce other commodities.

The money stock (which already included bank notes and bank current accounts, as well as coin) would depend on the level of activity in the economy, as measured in money-prices, which would determine the amounts of cash required for current transactions and for "precautionary" stashing.

Whether with a gold standard or with a system using paper money without an anchor to gold, the money stock is not fixed at will by the central bank or the government. Most money is created not by minting coins, or by a central bank printing IOUs (bank notes), but by commercial banks.

When you deposit your £100 in your bank account, and the bank lends out £90 of that to someone else to put in their account, retaining only a fraction as reserves in its vaults, then the total stock of money (yours and the borrower's) increases from £100 to £190 through the action of the bank.

In World War One and World War Two, gold convertibility was suspended and inflation rose. It was limited in World War Two in Britain by a scheme largely worked out by John Maynard Keynes: heavy taxation of the well-off, part of wages becoming "deferred pay" to be recouped after the war, rationing to limit demand for some commodities, controls on profits and prices possible only because of the exceptional wartime willingness of capitalists to comply with the government, repression of high finance. The scheme worked to some degree, though at the cost of much black-marketing. Some elements of it might work for a workers' government, under which the major producers would be controlled democratically rather than by capitalists, and where the whizzing of money round financial markets, so frantic today, would be suppressed even more thoroughly than in the war economy. Even then it would have limits: prices, if they exist at all, and it is hard to imagine doing without them even in a socialist future when markets have been largely superseded, are important for registering and comparing costs, so manipulating them administratively on a large scale and over long periods can lead to serious misallocation.

After World War Two the gold standard was restored in a looser form. Exchange rates for major capitalist currencies were fixed relative to the US dollar (£1=$4.03, 119.1 francs=$1...). Currency exchanges were heavily controlled by governments. Central banks (only central banks) which held dollars could exchange them for gold at $35 an ounce.

That system "worked" too, but produced steady inflation even in the USA, and higher inflation elsewhere (except in West Germany, which practised rigid budget restraint). Currencies were, by government decisions, devalued against the dollar from time to time (£1 to $2.80, then $2.40). When the facility for central banks to exchange their dollars for gold at $35 an ounce was first used on a large scale, by France, the US, simultaneously troubled by large Vietnam war spending, ended the facility in 1971. By then the regular market price for gold was about $300 per ounce.

Why had steady peace-time inflation re-emerged, centuries after the old "Price Revolution"? The speed and intricacy of the circuits of capital was far outstripping the capacity of gold (heavy, difficult to move physically, restricted in quantity) to facilitate it, even with more elaborate provision for tokens to be used instead of physical gold most of the time. Money was becoming "fiat money", money valid because firms and households were confident that the government or central bank would make it a ticket for an approximate quantum of labour-time on the world-market. Or roughly so: there had never been full stability, and no-one expected or needed it.

Finance was heavily curbed in that period compared to its debauches from the early 1980s, but it was to the advantage of banks to increase the quantity of money created by their credit operations and of bosses to nudge up or at least maintain the mark-ups on their commodities. Bosses had to reckon that workers would be able in due course to catch up by winning wage rises, but that was all right as long as the bosses could maintain their mark-ups and credit.

Indeed, some "wage-price spiral" was advantageous: it produced steadily increasing demand for output. Lacking a rigid link to gold to restrain such a spiral, it happened, though in the 1950s and 60s at a moderate pace.

The ability of bosses to keep ahead was shown by what happened after the great French general strike of 1968, which won a 35% rise in the minimum wage. By investing and expanding use of capacity, bosses were able to keep their profit rates up, while inflation ran no higher than 5% or 6% a year until the oil crisis of 1973-4.

In the 1950s and 60s the process was mostly moderate. Economists sometimes wrote that price stability was desirable, but in practice moderate inflation served capitalists well. It eroded debt, and stimulated market demand and investment, creating an incentive to spend now, at current prices, rather than later, when prices would have risen.

By contrast, falling prices (deflation) are destructive for capitalism, because they encourage firms and households to hold on to their cash to seek a better deal at later, lower prices; and they make £1000 borrowed in the past a heavier burden to repay from today's diminished revenues than the borrower expected.

The main tool for orthodox economists on the issue then was the so-called Phillips curve. By increasing public spending and loosening credit the government could move along a curve showing trade-offs between inflation and unemployment, and thus keep unemployment low with some cost in the way of inflation.

In the 1970s inflation soared, and at the same time unemployment was higher. Right-wing economists pointed out, and truly, that once sizeable expectations of inflation were embedded in economic life and in current economic decisions, the Phillips curve would break down. Expansionary government policies, so they further argued, might accelerate inflation, but would never push unemployment below the "Nairu" (non-accelerating inflation rate), originally called the "natural rate", supposedly the level required to keep the labour market operating smoothly. That level was proclaimed to be maybe 5% or 6%, although unemployment had often been as low as 2% in the 1960s. To reduce the "Nairu", the right-wing economists argued for increased labour-market flexibility (making it easier for employers to sack workers; reducing welfare payments which would encourage workers to spend more time looking for better jobs rather than take the first one going, etc.)

In France Alain Lipietz, later a maverick Green politician, developed a Marxist theory of 1970s "stagflation". He said it was driven by ebbing of basic profitability, determined by labour-time relations (how much of the working day could be annexed to produce profits, how little had to be given over to producing the value-equivalent of wages).

"Expectations", as we've seen, had become a pivotal factor in orthodox theory. Inflation as a general regime, where everyone expects all or most prices to increase as a matter of routine, generates a whole different economic life from a system with only periodic increases in the prices of these or those commodities, caused for example by crop failures, which generate no expectation of generally-rising prices.

The main writer introducing "expectations" into economic theory had been J M Keynes, in the 1930s. Marx did not write about "expectations". Yet his central arguments about understanding capitalist production as an ever-mobile circuit, about "value in process", about the centrality of credit, and so on, implied that capitalist expectations were central determinants in the flow.

As Marx put it: "Use-values must therefore never be looked upon as the real aim of the capitalist; neither must the profit on any single transaction. The restless never-ending process of profit-making alone is what he aims at". Capitalist decisions in the present are governed by an "aim" based on expectations of a future process.

The average rate of profit, which according to Marx depends on relations of exploitation in the workplace, appears (and necessarily appears) as a fixed expectation. "Normal average profits themselves seem immanent in capital and independent of exploitation; abnormal exploitation, or even average exploitation under favourable, exceptional conditions, seems to determine only the deviations from average profit, not this profit itself".

Lipietz built on this thought to argue that bosses would seek to maintain profits by increasing mark-up. Governments and banking systems guided by capitalist interests would adapt credit and state-led determinants of demand to suit.

Since the labour-time value of labour power (the "living wage") could not be fundamentally driven down just by financial manipulation, but only by class struggle, wages would catch up; profits and investment would remain low; inflation would continue while unemployment remained high.

The British Marxist writer Bob Rowthorn emphasised another angle on this: in conditions of fiat money, heightened class conflict would increase inflation, as the state adapted to more intense battles by both bosses and workers to improve incomes in nominal (cash) terms, as their only way to seek improvements in real terms. Right-wingers were not entirely wrong to say that a "wage-price spiral" was driving inflation; only, for workers, a spiral of both wages and prices was better than a spiral of prices alone.

Some economists of the so-called "post-Keynesian" school have built on ideas like Lipietz's and Rowthorn's for their accounts.

Meanwhile right-wing economists had a new version of the quantity theory - "monetarism". To control inflation the money stock had to be increased at a constant rate, paralleling the longish-term trend of output growth. In the 1970s that meant a clampdown on credit, designed to slow down bank-created money: one of the historical arguments of the "monetarists" was that the Federal Reserve should have facilitated more expansion of the money stock to counter the Great Depression of the 1930s.

The theory was soon shipwrecked. Few denied that with fiat money, central policies increasing the money stock could, beyond a certain point, produce inflation. But even the most deft central bank would find it difficult to adapt the money stock exactly to targets. There were now several different measures of the money stock, ranging from notes and coins through to the sum total of all bank account balances. Which one to target?

As the Bank of England economist Charles Goodhart wryly commented, once a particular measure was targeted effectively, it would cease to be an effective lever for economic regulation.

Bourgeois economists also used a version of elements of Keynes's formula in World War Two: balance the government budget, so there's no extra money pumped into the system by government spending to allow for mark-ups to be validated. Now this was done not, as with Keynes, by heavily taxing the rich, rationing, etc., but by welfare cuts (also supposed to make the labour market more flexible).

In World War Two the official interest rate (Bank Rate) was kept low (2% - to allow the government to soak up private savings while paying low interest rates), but credit and investment were heavily government-controlled. In the 1980s, interest rates were pushed high to tighten credit in a more slippery system with much faster-moving and more extensive bank activity, and thus restrain money-creation. Finance was also a more globalised system. The leading countries scrapped exchange controls and fixed exchange rates, so that exchange rates (between the pound and the dollar, for example) "floated" freely, and foreign-exchange markets expanded. This gave the system an added shock-absorber and source of flexibility in anything like normal times, though an additional instability to be watched in crises.

The "Thatcherite" policies "worked" to reduce inflation - but only by way of bringing long periods of slump, union-bashing, high unemployment, and increased social inequality, which of course reduced market demand and pushed bosses to moderate prices and seek redress instead via cutting labour costs.

After that came the "Great Moderation", an era of relatively low inflation rates and interest rates (and often, though not everywhere or always, efforts at budget-balancing) until the 2008 crash.

The theory was that central banks, now given independence from government so that their chiefs could calculate without concern for political consequences, were sagely "targeting" a pre-set moderate inflation rate, usually 2%. With hindsight, the appearance of expert fine-tuning was an illusion.

Low overall inflation and interest rates also survived the 2008 crash, despite some price spikes and despite governments running big budget deficits and creating large amounts of "base money" (notes and coins) to offset the slump. Thus the belief that central banks had found reliable ways to "target inflation", which led them first to declare inflation in 2022 to be only a passing phase caused by temporary supply blockages, and now has them solemnly debating over 0.25% or 0.5% tweaks to interest rates as though those will quell inflation (on all historical experience, they won't).

In my investigations of the 2008 crash later written up in the book Crisis and Sequels I asked Costas Lapavitsas, a Marxist writer specialising in finance, whether governments' emergency policies would unleash inflation (as then looked possible or even likely).

They might, Costas replied, but probably not. The squalls of incipient inflation died away, and I didn't return to the question. It's a lesson in the importance, in economic investigation, of looking to understand what doesn't happen, as well as what (of course more impressively) does happen: the dogs that don't bark.

Why in fact was inflation so low for so long in the leading capitalist countries? And why was that low inflation so stable, upset relatively little even by the shock of 2008? Inflation was high in some capitalist countries, and even became hyperinflation (80 billion per cent, month-to-month) in Zimbabwe in 2008-9. But in relatively stable and prosperous capitalist countries it remained low, where it had been high in the 1970s and 80s.

One factor adduced is increased world-market competition - cheaper imports driving down prices. However, there had been a previous surge of world-market competition in the late 1960s, which plausibly had been a factor in increasing inflation (capitalists seeing diminished profits, so increasing mark-up where they could, and having that facilitated by anxious governments).

Low class struggle was a factor. Although market demand generally increased only modestly, less than in the 1960s or 70s, employers could maintain or increase profits by squeezing labour costs more easily than by pushing for increased mark-up.

A central factor, documented by the Marxist writer Michel Husson, though he did not discuss its relevance to inflation, is that in the leading capitalist countries investment remained low while profits rose. A larger part of surplus value went to the personal revenues of capitalists and their adjuncts (lawyers, bankers, managers, and so on), and a smaller part to fixed investment (new machinery and buildings).

There has been, as many orthodox economists put it, a "global savings glut".

Before Keynes, and in some "Economics 101" courses even now, rates of interest, or at least "the" (central-bank) rate of interest, were seen by bourgeois economics to be (as they appear to be) stable measures of inescapable facts of social psychology ("time preference", our supposed ingrained propensity to value £1000 now above £1000 in a year's time). "Profit of enterprise" (the profit a business person can pocket, if they finance their enterprise solely by borrowing and pay interest on the loan) is a chancy addition.

Marx debunked what he called the "abstinence theory" of capitalist gains (that the gains are a reward for investing in processes which take time, rather than consuming all wealth immediately), and argued that the fundamental social quantity is the rate of surplus-value, i.e. of profit plus interest plus rent plus taxes.

How much of that surplus-value appears as interest, and how much as profit, depends on the balance of forces between money-lending and producing capitalists.

The high interest rates of the 1980s, and the corresponding high revenues of banks and financiers then, appeared to fit neatly with an increased weight of finance within the capitalist class. But then from the 1990s high finance was able to continue high revenues, scooping up its cut through fees and so on, both from firms and from households, with relatively low interest rates.

For Keynes, interest rates were set by the processes of balancing savings and investments (i.e. fixed investments, investments which involve paying out cash with saleable results expected to come only later and over time). If lots of people want to save, but there is only a weak demand to borrow for fixed investment, then interest rates will be low.

That fits the picture of the "Great Moderation" era. The propensity to save had increased through rising social inequality (richer people save more than poor people), and through more people saving directly or through pension funds for longer retirements. Governments of the leading capitalist countries were able to sell bonds (IOUs carrying interest payments) at low interest rates because of a high propensity of those savers (and of the Chinese and other states, building up their foreign reserves) to seek safer long-term assets rather than go for buying shares which may boom but then may also slump.

Inflationary impulses were being soaked up by those savings, even though poorer people were reducing their savings (spending more on credit, and in the process further swelling the revenues of high finance).

Market demand grew relatively slowly, while the underlying workplace and labour-time determinants allowed for higher rates of profit; so employers felt less pressure from labour costs, less pressure to increase mark-up, and less confidence that they could sustain sales if they did increase mark-up.

If the low inflation of World War Two owed something to tight government controls over high finance, then maybe this low inflation, paradoxically, owed something to the increased autonomy and power of high finance, which absorbed revenues which would otherwise have augmented inflation.

Well-off people increased their savings during the Covid lockdowns, and have in 2022 been spending from those savings. That, with the supply blockages caused by lockdown dislocations, Brexit, and the Ukraine war, set off a round of price rises which now looks as if it may have grown over into a general regime of "embedded" inflation.

The capacity of governments to counteract by increasing taxes and cuts in public spending is reduced by several factors, including the fact that cuts already made in public spending to try to recoup from the emergency measures of 2008-9 have damaged public infrastructure to a degree where even by capitalist calculations it needs restoration. Even a capitalist government with no concern but to make its territory attractive to footloose global capital wants to offer that global capital efficient public services, a "reserve army of labour" kept in work-ready condition, etc.

And class struggle probably plays a role, as in the 1970s. It would be easier for governments to quell inflation if workers passively "soaked up" the price rises by way of accepting lower living standards. But history gives no grounds for confidence in bourgeois governments to tame embedded inflation in any short time scale and without great social cost, whatever concessions workers make.