Inflation (1)

All over the world, inflation is emerging as a serious economic problem. Some economic commentators are suggesting that we are seeing a return of the problem of stagflation that plagued the world during the 1970s and early 1980s. Fortunately, or perhaps unfortunately, I am old enough to remember the 1970s well, and the inflation we are seeing now is quite different from the problem that occurred back then.

The inflation during the 1970s was initially triggered by an oil shock (OPEC raised the price of oil from $5 dollars to $12 dollars a barrel), but it quickly became an institutional contest in which businesses and employees ratcheted up wages and prices. Businesses would put up prices because their costs were going up. Employees would demand an increase in wages to cover the rising cost of living (Unions were stronger in that season and would often strike to get the wage increases their members needed to maintain their standard of living).

This behaviour created a vicious cycle. Businesses would put up their prices. Unions would demand an increase in wages to compensate them for the rising cost of living. Businesses would put up their prices to cover the increased wages and other rising costs. Salary and wage earners would demand an increase in pay to compensate for the rising prices. The increases tended to get bigger and bigger and it seemed like this inflation could not be stopped. Of course, it was facilitated by lax monetary policy as politicians increased the money supply to help themselves get re-elected.

Most people did okay during this season, as they would get an increase in wages to compensate them for the increasing cost of living. I can remember a year when nearly everyone in New Zealand got a 15 percent wage increase. It seemed good, but we were no better off due to the rising prices of consumer goods.

Governments tended to adjust pensions and welfare benefits in line with the rising inflation. Interest rates were low during this period, so people who owned a house did really well because the rapid inflation of prices (including house prices) quickly wiped away the value of their mortgages. Of course, some people in vulnerable positions were not able to push their wages up, and they suffered declining real incomes. Some businesses were not able to push prices up quick enough to cover the rise in their costs and they folded.

The immediate cause of the inflation coming to an end was the appointment of Paul Volcker as Chair of the US Federal Reserve in 1979, a post he held for twelve years. Volcker squeezed the money supply by massively pushing up interest rates. This squeeze permeated around the world putting a dampener on interest rates everywhere. Tight monetary policy caused a serious recession, but it choked inflation out of the world economy. I can remember a period in the mid-1980s when interest rates on house mortgages reached 21 percent.

The more important cause of the long-term death of inflation was the increased globalisation of trade that began during the 1990s. Tariffs and import duties were removed all over the world, which allowed a massive increase in international trade. Increased trade increases the efficiency of production because it allows production to be shifted to the businesses and countries that can do it most efficiently. This increased inefficiency reduces the costs of production which led to declining price of consumer goods.

Most of the people of the world benefited from the expansion of world trade. The people of China and South East Asia benefitted when industrial production was moved to their countries to take advantage of cheaper labour. Although they were paid less than the people they replaced, it was a big increase in income for them, and they gained access to a huge range of consumergoods. Of course, people in high wage economies suffered when they lost their well-paid work in industries that moved production to Asia. But even they benefited from the massive increase in the supply of cheap consumer goods from China. It was the massive increase in international trade and the shift of industrial production to China that really killed the price inflation that plagued the 1970s and 1980s.

Inflation is appearing again, but the situation is totally different now. I will explain how in my next post.