Thursday, 8 July 2010

Why Spare Capacity Will Not Constrain Inflation

For the last year or so, the Bank of England has been forecasting that inflation would fall. It hasn't. In twenty-three out of twenty-nine months, inflation has been above its target rate. With the Retail Prices Index standing at 5.3%, inflation is already way above the bank's 2% limit. Even the fiddled Consumer prices Index, which excludes many things that people have to spend money on, such as housing and energy, is more than 50% above the limit. The Bank continues to argue that inflation will fall later in the year, due to the existence of spare capacity in the economy. It won't.

The most obvious argument against this position is that over the last year or so, during the recession, there was even more spare capacity, but prices have been rising. The other obvious example is the experience of the 1970's and 80's during which there was both persistent sluggish growth or recession, and high levels of inflation. The basis of the Bank's argument is what is known in Economic theory as “Say's Law” after the French economist Jean Baptiste Say. In fact, its a misnoma, because Sat actually took the idea from the English economist James Mill, who had developed it much earlier. Say's Law is much loved by Liberal economists, because what it says is is that in a free market economy, markets will automatically clear if left to their own devices. They will do so, it argues because every Supply, creates its own Demand. This is of course, nonsense, as the 1930's depression demonstrated. There is a basic truth to the idea, as Marx demonstrated, but the truth relates not to a Capitalist Market economy, but to an economy based upon barter.

Suppose, in a barter economy I have ten pairs of shoes that I take to market. Assume that a pair of shoes is equal in value to 20 lbs of potatoes, 1 yard of linen, 10 chickens, a gallon of milk or 10 bottles of wine. Because this is a barter economy, my supply of shoes can only be an effective Supply if I exchange it for these other products. My Supply of shoes is necessarily, at the same time, a demand for these other products, and similarly the Supply of these other products is a demand for my shoes. However, in a market economy instead of this exchange of one commodity for another, what occurs is an exchange of commodities for the one specific commodity that has been singled out to act as money. Now, I take my shoes to market and sell them in exchange for Money, which in turn could buy 200lbs of potatoes, 10 yards of linen, 100 chickens, 10 gallons of milk, or 100 bottles of wine. But, there is now, no reason why I will spend this money to buy these commodities. I may buy some or none of these other commodities. By introducing money as an intermediary in this process of exchange, I separate completely production from consumption, demand from supply.

The basis of Say's Law is that markets will clear, provided that prices are reduced low enough. But, for the above reason it is clear that this is not necessarily the case. Moreover, we know that in a situation of deflation, falling prices do not encourage consumers to spend more, but to do the opposite, to hold off purchases, in the ration al belief that by doing so they will be able to buy later at an even lower price. Rather than falling prices clearing the market, it leads to even bigger glut. And, of course, for some products it is simply the case that no matter how low the price is reduced, it is impossible to obtain a demand – unless you were to introduce negative prices i.e. pay people to take them off your hands. We all remember the Sinclair C5.

This would seem to contradict the argument I was making. It would seem to suggest that such excess Supply could indeed lead to falling prices. It is, of course, the case that where there is an excess of Supply of some commodity, then suppliers of that commodity will if all else fails, reduce its price, in order to cut their losses, and try to at least get something for it. Its this idea that leads orthodox economists to focus on this interaction of Supply and Demand to explain prices. But, there are two points to make here. Firstly, this interaction only explains the MOVEMENT of prices, not the actual prices themselves. Secondly, this effect is only a short term phenomena. Prices fall only because sellers want to get rid of their excess supply. But, the producers of those goods will not continue producing at the same level, if they see these falling prices, and consequent falling profits. Once production is reduced, the excess supply disappears, and prices rise once again. So spare capacity can simply be a sign that producers have decided that it is more profitable to produce at this lower level than to increase production, and have to sell at lower prices! The mistake that orthodox economics makes here is to believe that the consumer is sovereign, and that the purpose of production under capitalism is to satisfy consumer needs, rather than to maximise profits. In times of rising economic activity, and confidence, producers are encouraged to invest and to expand production in the expectation of increasing their profits. But, in periods like the present one, where economic activity is subdued, and there is considerable uncertainty – especially given the policies of the Government, which must reduce economic activity – producers will be cautious in investing or expanding production.

This is where the first part of this argument comes in. The implication of Say's Law, is that if economic activity is subdued, then businesses, will have reduced their demand for Labour, and other inputs. This will mean that there is then an excess of these inputs, particularly Labour, and so suppliers of these inputs will reduce their prices encouraging businesses to buy more of them. But, there is a clear logical contradiction here. If the suppliers of these inputs such as labour reduce the price of their commodity, then the level of monetary demand in the economy will fall even further. Seeing falling demand, then firms, rather than wanting to purchase more labour, materials etc. will cut back further. But, even were that not the case, as argued earlier, there is no reason why a falling price will lead to an increased demand. That will only be the case, if the commodity on offer can actually find a useful function. If firms already have sufficient labour to produce the level of output that is most profitable, then a lower price for labour power will not cause them to buy more of it. If their existing workers are prepared to work for less then the employer will say, thank you very much, and pocket the difference in higher profits. A business making suits, for example, cannot if the price of labour power falls, buy more labour power, and less cloth! It COULD but more labour power, and use it in place of machines, but rarely is that a profitable solution, which is why the history of Capitalist production has been the opposite, the replacement of labour-power with machines. Nor, having bought machines would a firm be likely to scrap them in order to employ more workers instead.

In short, even with high levels of unemployment, and consequent reduced levels of wages, firms will not employ more workers as a result, because firstly it is not a profitable course of action, and secondly their purchases of inputs will be based on what they see as being required to meet their planned level of output, which in a period of economic uncertainty is not likely to see expansion. So, the existence of spare capacity can have no role in reducing end prices under these conditions. It simply reflects that the economy is in a state of sub-optimal equilibrium, that is end supply is matching demand, but with unemployed resources. The question is what happens when rising costs are introduced into this situation? I have pointed out elsewhere that because we now purchase vast amounts of consumer goods from China, we are deeply affected by what happens there. In China prices are rising rapidly. In part, that is due to rising food and raw material prices, in turn due to rapidly rising Chinese demand for them. In part, it is due to the fact that Chinese workers have been getting 10% a year pay rises for the last decade, and are now demanding 50% pay rises. In part, it is because the economic strength, and rising income levels in China re being reflected in a stronger Chinese currency. All of the things increase sharply the prices of Chinese goods sold to Britain, and other western countries. If we want to continue consuming those goods we will have to pay the higher prices for them, because in large part we do not have the industries ourselves that could produce them, it would take time to re-establish them, and in any case although these prices will be much higher, they will still be much lower than the same goods made in Britain.

So consumer prices will rise sharply. In January when the Liberal-Tories VAT hike comes into effect, prices will jump even further. The fact, that huge amounts of money has been pumped into the economy over the last few years, means that there will be no shortage of means of exchange to finance these higher prices. Workers will need higher wages to compensate, and again that huge amount of liquidity sloshing around will enable employers to finance it, who will in turn raise their prices to compensate, again knowing that there is an ocean of money lying around to also finance those higher prices. The main losers will be workers in the Public Sector where the government will use its full might as a State capitalist employer to freeze wages, and pensioners and people on Benefits, whose incomes will fall significantly in real terms as prices soar. None of this will require that the spare capacity be used up, it just requires that the price labels on the existing level of activity be marked up – that is inflation. It will be coupled with a fall in the value of the pound accordingly, which may be hidden due to similar falls in other currencies against Asian currencies, and Gold.

Finally, as I stated the other day, it is likely that in order to finance continued levels of consumption those whose wages are frozen, and those workers who are unable to obtain sufficeint pay rises, or pay rises fast enough, will see a sharp reduction in disposable income, which will be reflected in a sharp reduction in demand for things such as houses, causing a crash in house prices. I noticed on the BBC's Money Watch – How To Beat The Recession programme, the financial analyst they had on, said that his firm was expecting a 30%, house price crash as a result of the downturn in economic activity. That is similar to the analysis that others have come up with in recent weeks. I calculate that to get back to long term averages, house prices would need to fall buy 50%. But, in such “reversions to the mean” it is rarely the case that prices move only the amount required. I suspect that prices could fall more in line with the 80% fall that occurred with Japanese property prices, and that has occurred in other asset classes when bubbles have burst, such as the 75% fall in the NASDAQ that happened in 2000. After all, prices fell by 40% in 1990, and at that time the financial situation was not as bad as it could be now, and prices had not at that time bubbled up by anything like the amount they have done in the last 10-15 years.

That I think is going to characterise the period ahead, collapsing asset prices, and rising consumer prices.

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