We won’t fix inflation while economists stay in denial about causes

Led on by crusading Reserve Bank governors, the nation’s economists are determined to protect us from the scourge of inflation, no matter the cost in jobs lost.

But there’s a black hole in their thinking about the causes of inflation, only some of which must be stamped on. Others can be ignored. Meanwhile, here’s another sermon demanding the government act to raise productivity.

In your naivety, you may think that inflation is caused by businesses putting up their prices. But economists know that’s not the problem. Businesses raise their prices only in response to ‘‘market forces’’. When demand for their products exceeds the supply, businesses seize the chance to raise their prices.
In your ignorance, you may think they do this out of greed, a desire to increase ‘‘shareholder value’’ at the expense of their customers. But that’s the wrong way to look at it.

In raising their prices, businesses aren’t being opportunistic, they’re doing what comes naturally, playing their allotted role in allowing the ‘‘price mechanism’’ to bring demand and supply back into balance.

As balance is restored, the price will fall back, pretty much to where it was before. What? You hadn’t noticed? Funny that, neither had I.

No, what causes prices to keep rising at a rapid rate is when the greedy workers and their unions force businesses to increase their wages in line with the rise in the cost of living. Can’t the fools see that this merely perpetuates the rapid rise in prices?

So, what we need to get inflation down quickly is for workers to take it on the chin. They can have a bit of a pay rise – say, 2.5 per cent – but nothing more, especially when there’s been no increase in the productivity of their labour.

This will cut the workers’ real incomes and lower their standard of living, of course, but that can’t be helped. It’s the only way we can make them stop spending as much, so businesses won’t be able to get away with continuing to raise their prices by more than 2.5 per cent.

But cutting real wages probably won’t be enough to stop businesses raising their prices so high, so we’ll need to raise interest rates and really put the squeeze on workers with big mortgages. Sorry, nothing else we could do.

Another worry is our return to full employment. If the demand for labour exceeds its supply, that would allow the suppliers of labour (workers) to raise their prices (wages) and that would never do.
Indeed, our history-based calculations say the unemployment rate has already fallen below the level that causes wage and price inflation to take off. It hasn’t yet, but it will.

But not to worry. As incoming Reserve Bank governor Michele Bullock explained in a speech extolling full employment, the Reserve estimates it should be necessary to raise the rate of unemployment by only 1 percentage point to 4.5 per cent to get inflation back down to where we want it.

What! Cried the punters in stunned amazement. To get inflation down, you will put about 140,000 workers out of work? How could you be so inhuman?

What stunned and amazed the nation’s economists is that anyone should be surprised or offended by this. Don’t they know that’s the way we always do it? And 140,000 would be getting off lightly.

Just so. When, as now, the Reserve Bank and the government accidentally overstimulate the economy, allowing businesses to increase their prices by more than they need to, what we always do to stop businesses raising their prices is bash up their customers until the fall-off in households’ spending – caused partly by people losing their jobs – makes it impossible for businesses to keep increasing their prices.

Problem solved. Standard practice is to stop businesses’ opportunism (‘‘rent-seeking’’ as economists say) by bashing up their workers and customers until the businesses desist.

But what never happens is that the level of prices falls back to about where it was before the econocrats stuffed up – as the economists’ price mechanism theory promises it will.

Why doesn’t the theory work? Because what’s required to make it work is intense competition between many small firms. When one firm decides to raise its prices and fatten its profit margin, the others undercut it and it either pulls its head in or it goes out backwards.

In the real world, industries are increasingly dominated by just a few huge firms – firms that have become so mainly by taking over their smaller competitors. This is true in all the rich economies, but none more so than ours. Economists know ‘‘oligopolies’’ form because it’s easier for a few big firms to gain a degree of control over the prices they charge (whereas the price mechanism theory assumes they’re too small to have any control).

The few big players compete on marketing and advertising, and using minor product differentiation, but never on price. When prices rise, they rise together – and they rarely come back down.

Economists know all this – it’s knowledge gained and taught by economists – but it’s classed as ‘‘microeconomics’’, whereas the econocrats seeking to manage the economy and keep inflation low specialise in ‘‘macroeconomics’’. And they never join the dots – though that’s changing in other countries.
This year the European Central Bank, the IMF and the OECD have delved into the national accounts and determined that rising profit margins explain a high proportion of the recent inflation surge.

But when the Australia Institute replicated this analysis for Australia, both Treasury and the Reserve Bank used dodgy graphs and dubious arguments to dismiss its work as ‘‘flawed’’.

Entrenched inflation emerged as a problem in the 1970s. After much debate, the world’s economists decided the problem was caused by powerful unions, whose expectations of continuing high inflation caused a ‘‘wage-price spiral’’, which could be broken only by using high interest rates to put the economy into recession.

This is the thinking we’ve had full strength from the Reserve for the past year or more. Since the 1970s, however, multiple developments have weakened union bargaining power, while decades of takeovers have increased our big businesses’ pricing power – without the econocrats noticing.

And despite their sermons about the need for governments to increase national productivity, it’s never occurred to them that the primary driver of productivity improvement is intense competition between businesses.

The calls by successive heads of the ACCC for stronger powers to block mergers that would ‘‘substantially lessen competition’’ have gained no support from the Reserve, Treasury or economists generally. But we won’t fix inflation until we have stronger laws defending competition.

This article by Ross Gittins was 1st published in the Sydney Morning Herald