Central banks say they are committed to reducing inflation. To that end, they are raising their policy rates. That misunderstands inflation, and means they are using the wrong tools to deal with the problem.
Inflation is a monetary phenomenon. Let me set it out plainly as Marx does in A Contribution To The Critique of Political Economy, and do so using the historical method he uses. First of all, we have products that have individual values, produced by primitive communes for their own consumption. Then some of their surplus products get exchanged with other tribes/communities, and as this trade leads to them being produced, specifically, to be traded, they become commodities rather than products. The individual values of products become aggregated into a single average market value for each type of commodity, as a result of competition between producers of these commodities. The market value of one type of commodity when compared to that of other types of commodity determines the exchange value of these commodities, one to another, i.e. 1 metre of linen equals 1 litre of wine.
Fairly quickly, single commodities whose value is well known, and which are traded regularly, come to be singled out in this process of exchange, and are used as a means of indirectly measuring the value of all other commodities. It becomes the money commodity, and the exchange values of all commodities, as measured against this single commodity, becomes their price. The classic example of such a commodity is gold, but many others have been used in the past.
So:
1 metre of linen = 10 hours labour
1 litre of wine = 10 hours labour
1 ounce of gold = 10 hours labour
1 metre of linen = 1 lite of wine = 1 ounce of gold
Gold is singled out as money commodity, so
1 metre of linen = 1 ounce of gold
1 litre of wine = 1 ounce of gold
As money, 1 ounce of gold has the name £1. So,
The price of 1 metre of linen = £1
The price of 1 litre of wine = £1
But, if the £1 is reduced to 1/2 ounce of gold = 5 hours labour:
The price of 1 metre of linen = £2
The price of 1 litre of wine = £2
If the £ is merely a paper note, with no connection to gold, its value is determined by the amount of social labour it represents, just the same, but this amount per note, depends on the quantity of them put into circulation. Money is the equivalent form of the value of all these other commodities., i.e. if total commodities is 1 metre of linen, and 1 litre of wine, whose total value is then 20 hours of labour, its money equivalent is also 20 hours of labour in the form of 2 ounces of gold. If the total value of commodities in an economy is then equal to 1 million hours of labour, its money equivalent must also be 1 million hours of labour, and so, if the value of an ounce of gold is 100 hours of labour, the money equivalent of all commodities is 10,000 ounces of gold.
In terms of the money required in circulation, to act as currency, this then depends on the velocity of circulation of each ounce of gold. If, on average, each performs 10 transaction in a year, 1,000 ounces of gold will be required in circulation. The amount of gold money in circulation is then a function of the value of commodities to be circulated. It increases if the total value of commodities rises, and vice versa. If the average value of commodities stays the same, but 10%, more of them are produced, i.e. the economy expands, then its value will be 1.1 million hours, and its money equivalent rises accordingly to 11,000 ounces of gold, 1,100 required as currency. If the total amount of commodities remains constant, but a fall in social productivity means that the value of each rises by 10%, then, again, the total value of these commodities rises to 1.1 million hours, and so an appropriate amount of money and currency is the necessary consequence. The opposite applies if the economy shrinks, or if the value of commodities falls due to rising social productivity.
Already, therefore, what is wrong with current policies to deal with inflation can be seen. If the economy shrinks, then the money equivalent of this economy shrinks, and less money is required in circulation. But, the policies being adopted by central banks are indeed to, if not shrink the economy, then to have it grow only slowly. That is their purpose in raising interest rates. They are intended to dissuade consumers from spending, and instead to save, and to dissuade firms from investing, and producing more. But, if that is successful, and the amount of money tokens in the economy – which, today, as notes, coins and credit takes the place of actual money – remains the same, then that means that there are too many of those money tokens in circulation, compared to the reduced total value of commodities. In response to a smaller economy, the amount of money is also reduced as its equivalent form, which means that the amount of notes, coins and credit, which acts in its place, should also be reduced. If not, each token becomes devalued, and the manifestation of that is not a reduction of inflation but an increase in inflation, because the measure of value has itself been depreciated. That is the road not to a reduction of inflation, but to stagflation.
In fact, given that there is already a huge excess of liquidity in the system, the way to deal with the inflation that results from it, is not to try to slow the economy, and to create a recession, but is to rapidly expand the economy, without expanding liquidity further alongside it. If we take a situation in which the amount of gold money in the economy, as set out above, should be 1,000 ounces of gold, each called £1, and is replaced by £1 notes, but where, instead 2,000 such notes have been put into circulation, then each £1 note can only be worth £0.50, because, in total, they can only be the equivalent of 1,000 ounces of gold. Because, each note continues to represent itself as £1, rather than £0.50, the only way this fall in its value can be manifest, is by the prices of commodities themselves doubling.
So, where, previously, the value of output was equal to 1 million hours of labour, or 10,000 ounces of gold, i.e. £10,000, now, each of these commodities would double in price, so that the total of prices rises to £20,000. That is inflation. To restore prices to their original level, the number of notes in circulation would need to be reduced to 1,000. But, that does not happen, because it would cause economic disruption, once prices have risen, or started to rise. However, if the amount of notes in circulation remained 2,000, but the quantity of commodities in circulation itself doubled, then this would also reduce prices to their original level. If previously, there were 1 million commodities, each with an average price of £0.01, giving a total of prices of £10,000, which rose to an average price of £0.02, and a total of prices of £20,000, as a result of the increase in liquidity, then, if the total output rises to 2 million commodities, then with a total of prices of £20,000, the average price per commodity falls back again to £0.01.
So, what central banks should be doing, is to correct the huge increase in liquidity they injected over the last 40 years, not raising interest rates, whose effect they anticipate as being to slow economic activity, which is not the same thing as reducing inflation. The reason they believe it is is that they think that inflation is caused by an imbalance of aggregate supply and demand, and in particular from rising wages, even though, currently, its obvious that wages are lagging way behind price rises, and have been doing for years. Its why they continually talk about needing a higher rate of unemployment.
What is required, is not measures such as rises in interest rates to slow the economy, but measures from governments to stimulate economic activity, so that the excess liquidity in the system is absorbed by it. But, they are not going to do that, in current conditions, because there are relative labour shortages causing wages to rise and begin to squeeze profits, as well as rising demand for capital causing actual market rates of interest to rise, which leads to asset prices falling.
Last week FOMC member Esther George, interviewed on Bloomberg, at Jackson Hole, repeated the mantra arguing that the inflation was a result of an imbalance of aggregate demand and supply that had to be corrected by higher rates. But, its nonsense. There can be a balance of aggregate demand and supply as easily at an index level of prices equal to 200, as there is at 100. All it requires is that the standard of prices, i.e. the Dollar, be devalued by 50%. If I put two equal weights on either side of a scale, them balancing is not at all affected by the fact that I measure their individual weights in kilos rather than pounds! That is exactly the position where the Dollar falls in value, and so it measures the elements of demand and supply merely in changed nominal amounts.
What George's argument amounts to is the old idea that arose in the debates between Lowndes and Locke, about the standard of prices being some fixed quantum of value. The same debate was held a century later between Thomas Attwood, and the Birmingham "Little Shilling" Men, against Robert Peel. The dogma that the standard of prices such as £, $ and so on is some kind of absolute fixed quantum of value, then believes that it is only the values of commodities that change. But, if we take say a £ as being equal to 1 ounce of gold, it is clear that the value of this £ can itself change for one of two reasons. Either the value of gold might change, because less labour is required for its production, or else the £ itself might come to contain less than 1 ounce of gold, or both. In either case, it represents less social labour-time, and when gold backed currencies are replaced by fiat currencies the value of each note is simply also a proxy for an amount of social labour-time that amount being diminished by the quantity of notes thrown into circulation.
In fact, both of these factors have been seen throughout history as devaluing the standard of prices, as the above debates illustrated. It is ludicrous to claim that the standard of prices remains constant, therefore, and that all the world changes around it. Moreover, as Marx describes, when these gold £'s come to be replaced by paper notes, what determines the value of these notes, is not any value of their material content, of which they have essentially none, but is solely the quantity of them thrown into circulation. In total, their value cannot be greater than the total of social labour-time they represent, divided by their own velocity of circulation. So, if there is a balance of aggregate demand and supply, with a price level indexed at 100, which rises to an index level of 200, because the standard of prices has been devalued by 50%, there should still be a balance of demand and supply, and any measures to change it, will itself result in an imbalance!
Its true that central banks have tentatively begun to also end their programmes of QE that pumped trillions of Dollars of liquidity into the global economy, and even to begin a process of Qualitative Tightening, by selling some of the bonds sitting on their balance sheets, but that is minor compared to the total excess liquidity that has been created, much of which still sits in the form of grotesquely inflated prices of assets of all kinds from shares, to bonds, to property, to works of art and on. Moreover, in conditions of global economic expansion, a large part of the liquidity comes from an expansion of commercial credit itself, so that, even as central banks sell bonds, liquidity continues to increase, including also from an increase in bank credit, and credit creation by other financial institutions.
If they wanted to reduce inflation, they would vastly speed up the process of selling all those bonds from their balance sheets, so as to reduce excess liquidity. But, they will not do that, because, as still growing economies lead to wages rising, central banks want to enable firms to recover those higher wages in higher prices, rather than suffer lower profits, and a tightening of liquidity would make that more difficult. Of course, if they did do that, and firms found that they could not raise prices further to protect their profits, but were driven to continue to invest, as the economy expanded, they would have to borrow more and that would cause interest rates to rise, which would slash asset prices. That is what central banks are trying to avoid, because the ruling class, today, holds all of its wealth in the form of such paper assets, and seeks to protect them over against the interest of real capital and the real economy.
Nor, in fact, will their minor adjustments of nominal interest rates make any significant difference for the reasons I have previously set out. With UK inflation set to hit 21%, interest rates of 3-4% are no deterrent to consumers using savings to spend now, to beat the rising prices, nor for firms to spend and borrow to spend on the same basis, and so as to be able to recoup the returns on their current investments at future, much higher nominal prices, and so much higher nominal profits. The only things such rates will deter is speculation in assets, including property, as the prices of those assets will be reduced by higher interest rates, which will also give anyone thinking of buying a house good reason to hold on to their money, so as to get much more with it, at some future date. That is the opposite of the conditions of the last 40 years.
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