Problem Of Price Increases: 'Cost Of Living' Versus 'Inflation'

Thursday, 21 April 2022, 10:10 am
Article: Keith Rankin

The new (though not unfamiliar to older New Zealanders) crisis of 2022 (and most likely beyond) has become, alternatively, a 'cost of living' or an 'inflation' crisis. The public discussion treats these two 'enemies of the people' as one and the same thing. But they are not. Indeed such conflation is quite dangerous; it leads us to assume – maybe even insist on – a policy response that comes with more costs than benefits. Anti-inflation policy costs may pile upon an already unwelcome reality of rising costs; costs which must be absorbed.

Cost of Living

Living has benefits and costs. No doubt about that. Costs are what constrain us from doing (or having) things that we want. Rising costs mean that we – or at least most of us – can have less of what we want. We have to bear rising costs. Doing magical things with the money supply cannot relieve us of real costs. For many of us, rising costs mean a likely sooner death than would otherwise have been expected. For a few, facing the direct costs of war or pandemic, rising costs may mean a very imminent death.

The appropriate policy response to rising costs is to properly identify their underlying problems, and then endeavour to remove or mitigate those problems. It is not appropriate to invoke a magical response to a real problem. Nor is it appropriate to fuel the 'cost of living flames' by deliberately or ignorantly adding new cost burdens to the already stricken. This category of response includes biased cost-benefit analyses, meaning that costly policy actions or inactions might take place. A biased analysis occurs when relevant information is systematically ignored, typically because it doesn't fit a prevailing political or scientific narrative.

Typically (but not always), in a cost of living crisis, there is a rise in the general level of prices. Such a rise is commonly called 'inflation'; indeed statisticians call such a rise 'the rate of inflation' regardless of the circumstances of the rising prices. (Policymakers sometimes favour replacing a cost of living crisis characterised by rising prices with a cost of living crisis in which the burdens are borne in other ways; the best known such 'other way' is through recession and unemployment.)

Inflation

'Inflation' actually means a process of rising prices – sometimes called a spiral – whereby the cause of the rising prices is not rising costs. It's confusing because, for some of us, our rising costs are having to pay someone else's rising prices. Nevertheless, at a societal level, prices may rise generally even when there is no costly event: no event such as a war, a pandemic, climate change, or increased administrative inefficiency.

Inflation may be caused by what economists call 'game-playing'. It may be caused by autonomous changes of sentiment, such as increased consumer or business 'confidence'. Or it may be caused by an economy shifting mode – eg from a war mode to a peace mode, or a pandemic mode to a 'normal' mode – meaning that there needs to be a significant adjustment of relative prices. For various reasons that don't need to be mentioned here, individual commodity prices are more 'sticky' downwards than upwards, meaning that – on average – a period of adjusting relative prices is also a period of rising average prices.

(In other words, inflation in some circumstances – such as the last-mentioned – may be a solution rather than a problem; in these cases we should simply let inflation play out, without an attempt to suppress rising average prices. Further, rising prices are beneficial when they alert us to an underlying real problem that may otherwise go undiscovered. And most economists do believe that low inflation is better than no inflation – hence the 'two percent' annual inflation policy targets that are widespread, including in New Zealand. Modest and predictable inflation is said to 'grease the wheels' of the capitalist economy, creating a disincentive for people to hoard money.)

In particular countries, inflation may be caused by a multiplicity of moneys, whereby the exchange price between one type of money and another may change; sometimes those changes are dramatic and lead to hyperinflation. In this kind of situation, the very high inflation in a few countries should be balanced by deflation (falling prices) in the many more other countries, meaning that deflation becomes the more common experience. (In the early 1920s, hyperinflation in some countries was offset by substantial deflation in others.) However, in practice, because this situation is a special case of relative price adjustment, when some countries are hyperinflating there is probably an average overall experience of rising prices. (If New Zealand's banks soon find it difficult to find profitable lending opportunities in New Zealand, then increased lending to foreign borrowers could lead to a sharp and ongoing depreciation of the New Zealand dollar, say next year.)

New Zealand's – indeed the world's – situation at present is a 'cost of living' crisis, not a crisis of inflation.

Game Playing: Helicopter Money, Demand-Pull, and Cost-Push

Game-playing usually exists where somebody (or some party) seeks an advantage at the expense of other (eg rival) parties. Though they might not know it. They may be unaware that their actions, if successful, necessarily impose disadvantages on others.

In a zero-sum game the benefits (advantages) to some parties exactly balance the costs (disadvantages) to others. In a negative-sum game – called a race to the bottom if taken to its logical conclusion – the advantages to the winners are less than the disadvantages to the losers. In a positive-sum game – which is what 'economic growth' is meant to be - the gains to the winners are more than the losses to the losers. (In this last case, the game is generally regarded as virtuous, because – at least in principle – the losers can be compensated by the winners.)

There are three main types of inflation games. The first is an odd one, highlighted by Milton Friedman and his 'monetarist' acolytes as the core inflation game; this is a game of gratuitous money creation. As is discussed in economics' textbooks, in economies that are largely problem-free, this game occurs if central banks (such as the Reserve Bank of New Zealand) decide to increase the money supply over and above the normal increases justified by economic growth. (This extra money is sometimes called 'helicopter money'.) This represents a kind of academic game, where the central bank does not really care who wins or who loses. As the game progresses, a process – an inflationary spiral – develops; a spiral of rising prices which under some conditions may accelerate (especially conditions characterised by rising 'inflation expectations'). This means that the measured rate of inflation – worldwide, or in a large economy such as the United States or China – keeps rising from year to year, indefinitely. The Friedmanites then made the intellectual leap, to claim that all actual inflations are like this artificially contrived textbook example. (The real game-player here was Milton Friedman himself.)

The other two types of games – prominent in economic textbooks in the mid-twentieth-century – are called 'demand-pull' and 'cost-push'.

'Demand-pull' inflation is when there is an explosion of confidence that creates an autonomous spending binge, meaning that we try to buy more than the economy – a normal economy such as the global economy in a 2019 world with functioning global supply chains – can produce, thereby bidding prices up. The story then continues with the world's central banks (futilely) 'accommodating' this spending by increasing the money supply. (The game begins because the 'confident' parties are trying to increase their consumption of world output at the expense of everyone else.)

'Cost-push' inflation occurs when a 'greedy' group of people with market power – the usual example is a group of unionised workers, though other examples may be a cartel of oil-producers or a disingenuous cabal of 'cost-plus' corporates – use that power to extract a bigger 'economic rent' for themselves. Once again the central banks accommodate, trying to ease the blow on the losers of this game-play. Essentially this conflates into the same process as demand-pull, because the winners of the game consume more from the global economic pie, meaning that the losers of the game consume less than they otherwise would.

(The more common cost-push situation is that the greedy game-players save – ie lend – rather than spend most of their 'ill-gotten' gains, so the world gets into more of a debt crisis than an inflation crisis. Or, if there are too few acceptable borrowers, the world moves into a recession whereby portions of the global economic pie go to waste. A particularly egregious – though not uncommon – case is when, under these circumstances, solvent governments refuse to borrow enough to avert recession; most governments are solvent, because they have legal powers to raise revenue that members of the general public do not have. The best known historical example of this case is the Great Depression of the 1930s.)

Orthodox Monetary Policy

A variation of the Friedmanite anti-inflation policy is really an example of suppressed cost-push inflation. This is the assumed central bank response to a 'cost of living crisis'; namely a raising of interest rates, raising the 'cost of money'. Few can explain why it is necessary to aggravate an existing cost of living crisis with additional costs; but all of us running business or with mortgages accept, too often uncritically, that this policy action will happen.

Last time this happened was in 2004-08. Not only did inflation peak in early 2008 – four years after the anti-inflation policy began in New Zealand – the inflation spiral largely caused by the policy only ended with a global financial crisis. New Zealand actually caught that crisis early, with the demise of significant numbers of finance companies.

Today's Problem: a Cost-of-Living crisis with external initial causes

Today we have a cost-of-living crisis with a labour-supply twist. Not an inflation crisis. A combination of disruption – through personal illness, the requirement for family members to isolate or to care for children experiencing a disrupted education, the 'great rethink' about work-life balance, and the disrupted flow of immigrant workers – has brought to a head an already existing (but hitherto unacknowledged) problem of 'supply-inelasticity'. The economy is taut; it has no 'slack'; slack is an important though unacknowledged benefit in our lives. Thus, unusually low levels of unemployment in countries that had become used to importing labour has been interpreted as a sign of 'demand-pull' inflation. Orthodox monetary policy has a role to play to address demand-pull inflation, though under textbook demand-pull circumstances interest rates should be rising without the help of the central bank.

The reality is that many countries' central banks are now aggravating a cost-of-living crisis – raising costs – while trying to suppress the inflationary consequences that are part-and-parcel of getting out of a cost-of-living crisis and returning to some kind of normalcy.

The most important way to respond to a cost-of-living crisis – in cases where the sources of the costs are largely outside of the control of market participants and a country's policymakers – is to mitigate the crisis by sharing the burden. The best way to do this – maybe the only way – is through a universal distribution of a significant share of the economic output available to a country's population, through a universal income. Normal market forces can be applied to distribute the remainder of gross domestic product.

Government spending on goods and services needs to prioritise people's needs, through the universal provision of social goods, and to deprioritise party political wishlists. Governments should always choose more borrowing over more taxes in all crises in which much of the constrained economic pie is either wasted or being spent by a few in ways (as in land speculation) that aggravate the crisis. In times of constrained supply, all land-holders should be accountable for the ways in which they use, misuse, or disuse this precious economic resource.

And bureaucrats – especially people involved in deciding who should be denied access to services, resources or opportunities – should be reflecting on whether they could raise the economic productivity of their country by moving into other occupations; in an important sense, these people do represent some slack in an otherwise taut economy. We have a labour misallocation problem. So many people in Aotearoa New Zealand get paid more than critical workers simply because they have a university degree, and not because having that degree makes their contributions more productive.

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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.

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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.

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