Rising 'Cost Of Living' And Inflation

Wednesday, 16 March 2022, 4:45 pm
Article: Keith Rankin

The big new story in the news cycle – in New Zealand but not only in New Zealand – is the rising 'cost of living', which is usually conflated with 'inflation'. These topics – together and separately – are, like Covid19, devolved to 'social science' (macroeconomist in this case) 'experts'; within the policy-making apparatus and within the newsroom.

In fact, these topics – 'cost of living' and inflation, as policy topics – have never been dealt with scientifically; monetary and fiscal policies routinely applied are as unmodern as was bloodletting as a commonly prescribed cure in the pre-modern era of medical 'science'; as in the era when, routinely, medical interventions on balanced caused more cost than benefit.

Just as we do not yet have anything like a consensus about the causes of and recovery from the Great Depression of the 1930s, we have nothing like a scientific consensus about the causes of and recovery from the Great Inflation of the 1970s. It's mainly because most 'experts' take a textual (akin to religious) approach to these questions, and not a scientific approach.

Cost of Living

It is widely understood that a rise in the cost of living and inflation are the same thing, and that they are caused by wicked people 'price-gouging' or (as economists might say) 'rent-taking'. Or that some foolish or wicked bankers have created too much money, allowing the greedy to gain at the expense of the regular 'mums and dads'. (We may note that Jacinda Ardern spoke of a 'wicked perfect storm', before waving a policy wand in the form of waiving some petrol taxes. On Radio NZ [14 March], economist Eric Crampton, more scientific in his approach than most, tried to explain that these measures were little more than wand-waving, but he didn't say what the host of The Panel wanted to hear.)

The cost of living is a 'real' concept, whereas inflation is a 'nominal' (or 'monetary') concept.

The present rise in the cost of living arises from a number of real factors which cannot simply be waved away or waived. The most important of these real costs are the pandemic (and related restrictions imposed upon businesses and households), the war in Ukraine (and the related impact on world petrol, wheat and other prices), and climate change (causing droughts and floods).

Because these are real rather than monetary contributors to rising prices, ethical policy measures must be about finding fair ways to allocate the cost burden (such as universal benefits and higher taxes), and about creating more incentives to modify and reduce unsustainable economic demands. Examples of such behaviour-modification incentives would be incentives to travel less, and incentives to travel relatively more by public transport (a policy tick here) and through more sustainable transport modes (such as bicycles).

What is unethical is for one group of people to try to shift the entire burden onto other groups of people; eg people in other countries. We need to realise that all people in the world should bear some of the cost burden of the Ukraine war, while also understanding that the combatant countries will disproportionately bear that burden.

Inflation

This is essentially a nominal concept, often thought to be entirely a monetary concept. Thus, in principle, inflation can be suppressed or exported by monetary means. Inflation is more nuanced, however; and can be regarded, in part, as a real but secondary cost. Another example of a real but secondary cost is pain, which is a physiological symptom of some other cost (trauma), and may indeed be a part of a solution or cure to that trauma. Thus, a fever may be both an indication of infection (a real cost) and a part of the curative process. A pain in the arm after a vaccination is an indication that the vaccine is effectively working to prevent disease.

Pain is also a useful analogy to inflation, in that pain has many causes, and therefore many remedies. Choosing the correct remedy depends on a good scientific diagnosis of the cause of any particular pain. A rising cost of living is an economic pain, and inflation is part of the process of working through that pain.

A good example of a real cost is that of a huge boulder falling from a mountain into a lake below, causing a lot of direct damage to the lake and its ecosystem. (In macroeconomics, this would be called an 'adverse supply shock'; like a war or a pandemic.)

In addition to the direct damage is the secondary 'ripple effect'. As such the ripples (waves) represent both additional costs and energy diffusion benefits. The ripples may sink boats and/or flood the lakeshore. Nevertheless, we cannot easily imagine how it would serve any purpose to suppress those ripples; the ripples are a necessary part of how the lake-system returns to a new equilibrium. If we are patient, the ripples will eventually subside; albeit with some permanent ripple-damage to the lakeshore.

The only practical way to suppress the ripples – the ripples being the secondary effect of the initial adverse supply shock – is to generate counter-ripples. The problem is that the cost of generating counter-ripples may be greater than the cost of the ripples; and even if that cost is not greater, the cost-burden of the anti-ripple policy may be more inequitable than the cost-burden of the ripples. Even worse, anti-ripple policies in practice often aggravate the ripples before dispelling them.

We should also note that, following the ripple analogy, neoliberal monetary economists believe that, if unchecked, the ripples will never stop and may indeed accelerate over time. Hence, such economists believe that the 'ripple-problem' is much worse than it really is.

Using Deflation Policies to Fight Inflation

Again, we must start by reminding ourselves that inflation is typically a necessary part of the adjustment to a new reality, following a 'cost of living' shock; or indeed following a 'perfect storm' of cost-of-living shocks. So, the best policies are patience (keeping calm and carrying on), combined with other abovementioned incentives and income distribution measures that facilitate the adjustment process.

What policymakers normally do, instead, is to pursue deflationary policies as counter-inflationary policies. In particular, these are likely to be monetary policies – we expect the central bank (Reserve Bank) to raise interest rates as a one-size-fits-all panacea. In addition, there may be 'fiscal policies' – most likely reductions in government spending and reductions in social security payments; maybe, also, tax increases. (Together, these are known as 'contractionary macroeconomic policies'.) These policies are attempts to reduce aggregate spending to match reductions in aggregate output. They work – inasmuch as they do work – by creating a recession in the 'medium term'; by intentionally creating a cure worse than the disease. In the 'short term' these policies aggravate the 'cost of living' problem. Increasing interest rates (and increasing taxes) add to, rather than detract from, the cost burden.

The Rationale for Contractionary Policies

The first part of the rationale is that inflation is understood be macroeconomists as a problem of too much spending or too much money. That is, inflation arising from a real cost of living shock (let alone a 'wicked perfect storm') is considered to be an atypical form of inflation. Regardless of this, the conventional contractionary policy – like paracetamol as a cure for pain, or bloodletting as a cure for disease – is embarked upon as a 'one size fits all' or 'one curative elixir solves all' remedy.

The rationale is that, even if there is not too much money, then, nevertheless, reducing the quantity of money will still counter the problem.

While the argument for contractionary fiscal policy is similar to that for contractionary monetary policy, I will comment in coming paragraphs mainly about contractionary monetary policy. We should note, however, that the fiscal policy argument is one for a direct cut in total spending, and is an argument for reduced 'demand for money'. And it’s a neoliberal argument, in that it assumes that, when money is scarce, it is better spent in the private sector than in the public sector.

We should also note that, while the monetary policy argument is essentially a closed economy argument – ie a global rather than a national argument – governments are by definition agents of national polities rather than a global polity. (We may also note that big countries like USA and China more closely approximate a 'closed economy' than do little countries such as New Zealand.) Nevertheless the most pressing argument – as a political argument rather than a moral argument – is an open economy argument about countries' exchange rates.

Argument One (the classical argument):

Higher interest rates discourage spending, and reduced spending leads to a recession. In a recession it is very difficult for businesses to raise prices, even if their costs rise. This is a closed-economy 'global argument'; that rising global interest rates lead to global disinflation (reduced inflation rates) despite rising interest costs. Like 'mask-wearing' during covid times, the argument is that the benefit (disinflation) is greater than the higher interest costs faced by businesses and households.

The practical problem – especially in circumstances, like today, following a 'supply-side' 'perfect storm' – is that you get the worst of both worlds: inflation and recession. In pre-modern times, bloodletting would usually weaken rather than strengthen a sick person.

Argument Two (the open-economy argument):

Following one country's central bank raising interest rates, 'investor' money will flow into that country from other countries. The exchange rate for that country appreciates, and the exchange rates for the other countries depreciate. When a country's currency appreciates, prices in that country fall, or at least rise more slowly. Raising interest rates in one country exports inflation to other countries.

This is by its very nature an immoral policy. It is immoral to export a problem, knowingly.

And it's self-defeating. Such interest-rate-raising monetary policies generate a 'race to the bottom' (indeed a wicked race to the bottom) because they oblige other countries to counter them with similar interest-raising policies. Otherwise, these other countries find themselves importing inflation in addition to the inflation they already have. (This is Turkey's problem at present; it tried to reduce rather than raise interest rates, leading to a run on its currency.)

A variation of this argument applies to a world with fixed currency exchange rates. This is the argument as it applied in the years before World War 1, and in the late 1920s and early 1930s (the period of the classic gold standard). A 'surplus' country with rising gold reserves should cut its interest rates (to reverse that monetary inflow) while a 'deficit' country with falling gold reserves should raise interest rates (to reverse its monetary outflow). These were 'the rules'. The latter (deficit) countries had no choice but to follow the rules; but the rules were in effect discretionary for the surplus countries. The result was global deflation; and recession or worse.

Argument Two; corollary (the pure monetary argument):

In the gold standard times it was understood that the global price level was regulated by the global gold supply. While the data generally did not conform with this proposition, it seemed too good a story to abandon. In many times – eg the seventeenth and nineteenth centuries – the extra gold was generally hoarded or banked rather than spent. So extra gold had no impact on inflation, and often was coincident with deflation.

Nevertheless, the argument was adapted to national currencies, especially at times – like today – of flexible ('floating') exchange rates. And the argument seemed to work, some of the time. If one country kept interest rates low and allowed its money supply to increase, then there would be a resulting and matching fall in its exchange rate. The rate of inflation would match the rate of currency depreciation. This sort of thing used to happen a lot in South America. It did not happen in Switzerland and Denmark, where negative interest rate policies have been in place since 2014. Most importantly, this exchange rate argument is about particular inflations in particular countries, and is not an argument that connects world inflation to falling interest rates or rising money supplies.

The Rational Expectations Argument (essentially a closed economy argument):

This is the argument that was pushed during the 'monetarist' decade; the 1980s.

The argument is based on the idea that if everyone believes that a policy will work, then the policy will work. So, if you – as a central banker – believe that other people (including other central bankers) believe that any policy (eg raising interest rates; or making a sacrifice to the gods) will lead to a desired outcome, then it will lead to that desired outcome. This is really, in essence, the same type of argument that justified human sacrifices by priestly authorities in ancient 'civilisations'; such as the Aztecs of Mexico.

It has become a mantra in the world of central banking and neoliberal economics, that whenever inflation threatens, then central banks should raise interest rates; it works because enough people believe it will work. And a credible central bank will maintain that 'tight money' stance, no matter what economic pain ensures; because a central bank's rigidity is what gives that central bank its credibility. When a central bank is being staunch, then workers will demand smaller wage increases because they believe inflation will be low. And businesses will avoid raising prices, because they believe that their competitors – themselves believing that inflation will be low – will not raise their prices.

Summary

'Inflation' and a 'rising cost of living' are not the same thing. But both lead to authoritative impulses to raise interest rates and to restrain government spending. In reality, the application of deflation to counter inflation leads to both inflation and deflation in the short term, and to recessions (or worse) in the medium to long term.

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Keith Rankin (keith at rankin dot nz), trained as an economic historian, is a retired lecturer in Economics and Statistics. He lives in Auckland, New Zealand.

Recent stories about 'Cost of Living' and 'Inflation' in New Zealand:

Inflation Nation: Why the cost of living is rising and what we can do about it, NZ Herald, 13 March 2022

Liam Dann: Inflation is now Jacinda Ardern's biggest problem, NZ Herald, 13 March 2022

'A wicked, perfect storm': Govt slashes petrol taxes to tackle soaring prices, Otago Daily Times, 14 March 2022

Inflation Nation: Building supplies, housing, rents - pick the odd one out, NZ Herald, 16 March 2022

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Keith Rankin

Political Economist, Scoop Columnist

Keith Rankin taught economics at Unitec in Mt Albert since 1999. An economic historian by training, his research has included an analysis of labour supply in the Great Depression of the 1930s, and has included estimates of New Zealand's GNP going back to the 1850s.

Keith believes that many of the economic issues that beguile us cannot be understood by relying on the orthodox interpretations of our social science disciplines. Keith favours a critical approach that emphasises new perspectives rather than simply opposing those practices and policies that we don't like.

Keith retired in 2020 and lives with his family in Glen Eden, Auckland.

Contact Keith Rankin

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