Michael Roberts: Part three – a value theory of inflation

Part three – a value theory of inflation

 

In this post, I return to my review of the theories of the causes of inflation in modern economies.  In the first part, I discussed the mainstream theories; in the second part, I discussed heterodox and other Marxist theories. In this third part, I present a value theory of inflation developed by Guglielmo Carchedi and myself.

Part One is here, Part two here

by Michael Roberts

In our view, any explanation of inflation in modern capitalist economies must start with Marx’s value theory. In all the conventional, heterodox and even most Marxist-claimed theories, the role of value creation is missing. This creates a black hole in any analysis of inflation. For Marx, value is the expenditure of human labour power in the abstract, and is measured in labour time, i.e. the time worked by labour for capital. This is the time actually worked for the production of commodities. Not all abstract labour is productive of value: some labour is unproductive (basically commercial, financial and labour in armaments and real estate). Unproductive labour merely redistributes value. Productive labour is that which creates new value and surplus value. So, in our value theory of inflation, value is measured by the hours worked in the productive sectors.

The realisation of value requires the exchange of the different commodities and thus money acts as a medium of exchange. Money makes exchange possible and so represents value. If money represents value, then changes in money are determined by changes in value. This is a key difference between the monetarist and the value theory of inflation, as I explained in part one. The monetary authorities only react to value changes either by increasing or decreasing the supply of money or raising or reducing interest rates on holding cash or borrowing; but this does not change value.

In mainstream economics, inflation is defined as the change in the prices of commodities on the market.  Instead, in our value theory of inflation, inflation is the difference between changes in money in circulation and changes in value production. This difference will become important in considering the impact on workers’ wages. 

We define and measure value as the hours of productive labour worked in any period. We define and measure money supply as money in circulation. Not all money supply in a capitalist economy circulates for the purposes of purchases of goods and services. Some portion will be hoarded i.e held in reserve by capitalists. Another portion will be used to purchase financial assets (bonds, stocks etc) and real estate (land, buildings). This money will not circulate to purchase goods and services and so will not affect any change in the prices of goods and services consumed by workers.

So in our measure of money supply we adjust money supply (deposits in banks) by the size of bank money reserves held at the central bank and by the velocity of money in any period. The velocity of money is a measure of the turnover in the money supply. If the velocity is greater than one, it means that the money supply has been used more than once in any period and so adds to total money in circulation. If the velocity of money is below one, it signals that the holders of money are hoarding more of the supply rather than putting it into market for goods and services. Accounting for these adjustments, we obtain a measure of ‘money in circulation’ for any period.

We can measure the size of hoarding and financial speculation by the difference in the rate of change in money supply and the rate of change when adjusted for hoarding and speculation in financial assets. In the second half of the 20th century, there was little difference in the rate of change in money supply (bank deposits etc, or M2 in US financial statistics) and the adjusted money in circulation in the US. Indeed, M2 adjusted for hoarding and speculation generally rose faster than M2.  That’s because the velocity of money was usually greater than one and hoarding and financial speculation was minimal. However, after 2000 and especially after 2008 and through the 2010s, the gap between money supply growth and the growth of money in circulation rose sharply. This was the period of so-called ‘quantitative easing’ adopted by the US Federal Reserve. Much of the Fed’s monetary injections mostly ended up being hoarded or used for speculation in financial assets rather than for the purchases of goods and services. US CPI inflation fell to virtually zero during this period, while financial asset prices soared.

Source: FRED, author’s calculations

To obtain the value rate of inflation, we measure the difference in the change in adjusted money supply against the change in hours worked in the productive sectors of an economy. If there is no difference, there will be no inflation. Inflation emerges when the percentage change in money in circulation is greater than the change in value created. Deflation emerges when the rate of change in money circulation falls below the rate of value growth. Inflation rises when the difference widens between the rate of change of money in circulation and the rate of change in hours worked, and when the difference narrows, inflation falls (disinflation).

What determines these two factors and which of the two is the determining and determined factor? Let us begin with productive hours worked, our measure of value created. Over the whole period analysed (1949-2022), hours worked increased in the productive sectors of the US economy. That’s because the increase in the number of workers employed rose more than sufficently to compensate for any fall in hours worked per employee, except when workers were laid off in recessions (1957-8, 1974-5, 1980-2, 1991, 2001, 2008-9 and 2020). Then overall hours worked fell.

Source: FRED, authors’ calculations.

In Marxist theory, investment growth leads to an increase in the ratio of constant capital (means of production) relative to labour employed ie a rise in the ‘organic composition of capital’. The reciprocal of a rising organic composition is a decrease in value created per unit of capital invested, in other words, a fall in the rate of profit on capital invested. Over the whole period 1949-2022, there is a positive correlation between the fall in the rate of profit on capital and slowing growth in hours worked relative to capital invested.

Source: FRED, author’s calculations

The annual ‘value rate of inflation’ is the difference between the annual change in the adjusted money supply and the annual change in productive hours worked. Over the whole period 1949-2022, adjusted money supply growth averaged 6.6% a year and growth in hours worked in the productive sectors averaged 1.4% a year. So the value rate of inflation averaged 5.2% a year (6.6%-1.4%).

Source: FRED, author’s calculations

Over the whole period, the rate of money supply growth falls, while the change in hours worked rises (slowly). So the value rate of inflation falls over the whole period – in effect, there was disinflation (a falling inflation rate). Disinflation has been the long-term trend since the end of WWII until the end of the 2010s.

Source: FRED, authors’ calculations

But we can discern two sub-periods within 1949-2022. The first is from 1949-81 and the second is from 1982-2019. In the first period, the annual value rate of inflation rises, constituting an inflationary period. In the second period, the annual value rate of inflation falls, constituting a disinflationary period. The value rate accelerates in the first period because the adjusted money supply grows faster than hours worked (see Figure above). This was particularly the case in the 1970s, when hours worked stagnated or fell (see the hours Figure above). The value rate of inflation rose sharply in the 1970s while the hours worked grew very slowly and indeed fell sharply in the 1974-5 and 1980-2 recessions.  Thus the economy suffered what has been called ‘stagflation’.

The reaction of the monetary authorities to slowing value growth was to increase the money supply in order to boost economic activity, leading to an acceleration in the growth of the money in circulation. But this did not lead to faster growth in hours worked. As a result, the value rate of inflation was rising by more than 10% a year at the end of the 1970s (see Figure above). So the US monetary authorities, now under then Fed chair Paul Volcker, sharply changed tack and tightened monetary policy. The growth rate of money in circulation was more than halved by the end of the 1980s. Inflation (accelerating price rises) was replaced by disinflation (slowing price rises). Indeed, after the end of the Great Recession through the 2010s, inflation virtually disappeared (see Figure above).

Changes in value depend on the objective factors of a rising employed workforce (more hours) and a falling rate of profit (less growth in hours). But changes in money in circulation depend on the subjective reaction of the monetary authorities and the financial sector to these objective changes in the economy. The US Federal Reserve will ease its monetary policy if it considers the economy is weakening and will tighten its monetary policy if it considers inflation is accelerating. 

In our view, it is the change in value creation, which is the objective factor in prices, that determines the subjective reaction of the monetary authorities. The monetary authorities believe that they can hold back the deterioration of the economy by increasing money supply in the wrong belief that more money can end any decline in investment and GDP growth. So the authorities increase the quantity of money faster than the quantity of value created. Thus with active monetary policy, inflation becomes a permanent feature of modern economies, although the rate of price inflation will vary, first because of changes in the growth of new value (hours worked) and second, because of the relative size of the reaction of the monetary authorities in varying the growth in the money in circulation.

Is there empirical support for the view that changes in value (hours worked) is the main driver of the value rate of inflation? First, there is a relatively high correlation between the rate of profit on capital and the change in hours worked (0.66). Second, there is a relatively high correlation between the change in hours worked and changes in money in circulation (0.60). Correlation does not prove causation. But these high correlations do indicate the ‘possibility’ of a causal relation. And there are strong theoretical reasons to assume that changes in value cause changes in money circulation rather than vice versa.

And we can add a statistical test of causation. A Granger causation test of the direction of causation between changes in value (hours worked) and changes in money in circulation finds that the ‘null hypothesis’ does not hold for changes in value leading to changes in money circulating, implying a causal connection, while it does hold for changes in money in cirdulation causing changes in value, implying no causal connection. This tends to confirm empirically the proposition that value growth is the objective driver of inflation and monetary injections are the subjective reaction of the authorities.[1]

To summarise, only our model of inflation is based on Marx’s value theory. We construct a value rate of inflation, as measured by the difference between the percentage change in money in circulation in the whole economy and the percentage change in value, namely the hours which have been expended for the production of commodities. Changes in value are the outcome of the interplay between two opposing forces: a rise in hours due to the expanded reproduction of capital (more workers, longer working day or year) and a fall in the growth of hours worked due to the increase in the organic composition of capital and the fall in the rate of profit.  

So the value theory of inflation incorporates both the role of profitability and growth in investment as emphasised in part two of this series of posts by Mavroudeas et al, but also the role of money as raised by Shaikh in part two. Combined, we arrive at our theory. In modern economies, money is managed by the monetary system (central banks, commercial banks), with a measure of relative autonomy. The monetary authorities manipulate the money supply according to their assessment of the economic situation. This is the subjective element, which together with the objective element (the growth in value) determines inflation.

And here is the interesting implication. Both the official consumer price and GDP deflator indexes of inflation are highly correlated with our value rate of inflation. But the average annual value rate of inflation from 1949-2019 is much higher at 5.2% a year compared to 3.4% (CPI) and 3.1% (GDP def). 

This suggests that workers’ real wages when measured in value terms (ie in hours worked to obtain commodities) have risen much less than when measured against official price inflation. We shall consider this issue in more detail in part four, which will also deal with why inflation spiked after the end of the pandemic slump in 2020 and whether inflation is now here to stay after the period of disinflation from 1982-2019.

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[1] The results of the Granger causation test are available on request.

 

Theories of inflation part two – heterodox and Marxist

This is the second part of my discussion of the causes of inflation in modern capitalist economies, based on an unpublished paper by Guglielmo Carchedi and me. Part 1 is here.

by Michael Roberts

There are various heterodox views on the causes of inflation. Generally, they argue against the mainstream focus on monetarism, excess demand and inflation expectations as discussed in part one. The heterodox views can be divided into two. First, there are those who suggest the focus should be on the sectoral structure of the economy, namely how supply constraints lead to price surges in certain sectors of the economy and then, through input-output linkages and changes in firms’ pricing behavior, spread to the whole economy. And second, there are theories based on the view that inflation is caused by class conflict ie workers’ demands for higher wages and the response of capitalists.

In the sectoral view, some turn to corporate price ‘mark-ups’ as an explanation of inflation i.e. inflation is caused by monopolies and their power to impose market prices above ‘free competition’ prices. Monopolies can raise their profit mark-ups and sale prices if costs rise, including labour costs.  Stephanie Kelton, the well known ‘modern monetary theorist’, explains that “companies with enough market power can also unilaterally raise prices in a quest for greater and greater profits.” 

Marx would disagree. Yes, the market price of commodities sold can and will deviate from the production price, the price at which all capitals produce commodiities at the same average rate of profit (a rate that is always moving). If the price of production that is based on the average rate of profit in the economy falls, then all individual prices revolving around that should fall as well. But there is a degree of freedom within which some firms might lower their price less than the average or even increase it. However, this ‘monopoly’ ability to do this always has limits. Competition will tend to rule, even with oligopolies. So the market ‘monopoly’ price cannot deviate for long from the price of production.

In the recent inflationary spike after the pandemic slump, the sectoral theory has taken a different form. In this view, inflation is due to supply constraints in key economic sectors, which is then amplified by firms raising markups due to their market power. Supply bottlenecks which spread through sectors in the economy initiate the inflationary process, but then markups by companies can go above the average, so putting additional pressure on prices. Isabella Weber and Even Wasner argue that rising prices in certain “systemically significant upstream sectors” provide an impulse for further price hikes. To protect profit margins from rising costs, downstream sectors propagate, or in cases of temporary monopolies due to bottlenecks, amplify price pressures. 

The evidence for profit-led sectoral driven inflation has some basis in the recent post-pandemic inflation spiral, but can it be considered as a general explanation of inflation in capitalist economies?  Inflation has existed long term in the major economies even when there have been no increased mark-ups by companies or when there are no spikes in raw material prices. Sure, prices in oligopolistic markets are likely to be higher than in more competitive markets, but higher inflation can occur both with fairly competitive or oligopolistic market structures. In the late 19th century, the so-called Gilded Age Era was characterized by the rise of cartels, but with deflation in prices; and the 1990s, often seen as a second Gilded Age with increasing market concentration, experienced a so-called Great Moderation in price inflation ie disinflation (as shown in part one). Indeed, in the last big inflationary spiral of the 1970s, profits actually fell. According to Sylos-Labini, writing then:“the decline of the share of profits in several capitalist countries can be attributed primarily to the persistent increase of direct costs in labor, raw materials, and energy.” I shall return to the discussion about so-called ‘sellers inflation’, profit mark-ups and sector-driven inflation in part four when I analyse the post-pandemic inflationary spike to date.

The second heterodox explanation for inflation is that it is due to class conflict. This heterodox theory rejects Keynesian theory that attributes inflation to wage-cost pushes resulting from excess demand and worker bargaining power. Instead, this theory reckons that wages rise in response to price rises, as Marx argued. But what about the cause of the original spurt in inflation? This will be due to supply disruptions or mark-up power by monopolies – so back to the first heterodox theory. But inflation will continue, depending on whether workers have sufficient labour power to respond, leading to further attempts by companies to compensate by hiking prices further.Thus inflation depends on the balance of class power between workers and capitalists.  But this theory provides no explanation of the initial inflation of overall prices, except the contingent factor of a supply disruption or ‘shock’. And it falls back on the initial trigger for any price surge being due to increased markups or supply constraints as in the sectoral argument above.

There are some overtly Marxist theories of inflation. One ‘Marxist’ explanation of inflation is merely the monopoly mark-up price theory as described above. Baran and Sweezy (1966) explained the cause of inflation as follows: “Keynesian theory assumed free competition; under oligopoly, increased demand leads to rises in prices … and ultimately (as a result of the rising cost of living) to higher wages rather than an expansion of output. The result is general inflation.” Similarly, Kotz (1982) argued that monopolies can set market prices that exceed prices of production. But monopolies since the end of WWII have existed both during the inflationary period (1949-1979) and even increased market power in the disinflationary period (1980-2021). So generalised inflation must be explained aside from monopolies. Indeed, if monopolies have the power to increase uncontrollably their market prices, why do they choose to do so only in very certain circumstances? Specifically, they have chosen to raise their prices significantly only twice in recent economic history (in the late 1970s and in 2021), namely when profitability was low.

Paul Mattick Snr argued that “inflation is an expression of inadequate profits that must be offset by price and money policies … If prices rise faster than wages, then what could not be extracted from the workers in production is taken from them in the circulation process.” (1977, Chapter 3). This is evident. If prices rise faster than wages, there is a pro-capital redistribution at the cost of wages. And if prices grow less than wages, there is a pro-labour redistribution at the cost of profits. But neither explains any cause of the initialrise in the general price level.

Ernest Mandel (1987) attempted a Marxist explanation that involves money: if “paper money circulation has doubled without a significant increase in the total labour time spent in the economy, then the price level will tend to double too.” But why does money in circulation not just match the change in the value of commodities as measured in total labour time? Mandel is close to identifying the relevant factors in inflation, but without an analysis of how they combine.

Harman (1979) correctly identified that the profitability of capital was a key cause of inflation. But Harman adopted a subjective analysis: “in a boom, capitalists feel confident that their goods would sell, even if they increased their prices. … Once the recession sets in, capitalists have to respond … \[by\] contracting markets \[and\] have to slash prices.” This presents the capitalist reaction to a boom and price inflation, but does not explain the cause of inflationary or alternatively disinflationary periods. For example, it cannot explain the persistence of disinflation from the 1980s to 2019. There is no explanation of how movements in profitability are relevant and no recognition of the impact of the monetary authorities.

Choonara (2021) also underscores the role of profitability as the core cause of rising prices: “inflation depends on the interrelation between value creation through the expenditure of labour power, the creation of money (primarily through the credit system), and the relationship between capital accumulation and profit rates.” This is closest to our ‘value theory of inflation’ that I shall deal with in a later post.

The two most thorough Marxist explanations of the causes of inflation are by Anwar Shaikh and more recently, by Greek Marxist economists Stavros Mavroudeas and Athanasios Chatzirafailidis.

Shaikh does not like to call his theory Marxist, preferring ‘classical’. He argues that “modern inflation is the balance between a demand-pull generated by new purchasing power and a supply-response depending on profitability and the degree of growth utilization.” The combination of these two provides “a general theory in which inflation responds positively to new purchasing power because the portion of the latter which is not absorbed by current supply spills over into price increases; and negatively to net profitability, since this raises real output growth; and positively to the growth-utilization rate insofar as the latter inhibits real output growth.”

Where does this ‘new purchasing power’ that represents demand come from?  It comes from new domestic credit from private and central banks, ie in effect an increase of money in circulation.  The supply capacity to meet this increase in demand depends on the profitability of capital, which is the ‘motivation’ for investment.  If the stock of capital rises, it will provide an increase in capacity to produce and allow more ‘growth utilisation’, ie more real output.  If the stock of capital falls, the capacity to produce is lowered. In other words, Shaikh is saying that inflation is caused by aggregate demand exceeding supply capacity. If the profitability of capital rises, then capitalists will increase supply and inflation will be avoided. If the profitability of capital falls, then supply capacity will fall and inflation will emerge.

So inflation is driven up by increased demand (new purchasing power) and by low supply capacity, the latter being caused by falling profitability.  Inflation slows or disappears if new purchasing power is satisfied by rising supply and that will tend to happen when profitability rises. Thus in the period when US profitability fell (1964-82), the increase in supply capacity slowed and inflation accelerated.  In the period 1982-2007, when profitability rose, supply capacity rose and inflation decelerated. Shaikh provides empirical evidence to support this theory, while at the same time, refuting the Keynesian Phillips curve. I have reproduced his graph 15.10 from his magnum opus, Capitalism, p711 and recalculated it.

The graph shows a high correlation (0.63) between rising inflation and the using up of capacity (in other words, a slowing increase in supply) and vice versa. The correlation is very high in the inflationary (accelerating inflation) sub-period 1948-1981 (0.83) and still relatively strong in the disinflationary (slowing inflation) period from 1982-2010 (0.59).

Stavros Mavroudeas and Athanasios Chatzirafailidis define inflation as the phenomenon “in which the total sum of market prices significantly exceeds the total sum of prices of production for an appreciable period in the economy.” A strong and persistent inflationary phenomenon (namely the rise in total market prices above the total prices of production) arises when the capitalists’ demand for more means of production significantly exceeds investment for a considerable period.  

Why would demand exceed investment for periods?  Mavroudeas and Chatzirafailidis fall back on Marx’s reproduction schema as in Volume 2 of Capital.  For them, inflation is due to the systematic over-accumulation of capital and specifically due to an incessant demand for more means of production. Investing in more means of production relative to labour drives up the organic composition of capital, which in turn eventually leads to a fall in profitability which slows investment and delivers weaker output growth. So demand outstrips supply and market prices rise above prices of production and inflation ensues.

Both theories have the merit of placing the role of profitability of capital at the centre of the causes of inflation. Unlike Shaikh, Mavroudeas and Chatzirafailidis emphasise that the supply side in Marxist terms depends on the growth in the value of commodities: “inflation should not simply be perceived as a process in which the market prices of commodities are vaguely rising above an arbitrary “normal” price level. On the contrary, they should have the values of commodities as their “anchors.”  

But in my view, both theories do not provide a complete Marxist theory of inflation.  While Shaikh says that aggregate demand is driven by credit growth or money in circulation, which in my view is correct, he offers no explanation why that demand should accelerate or decelerate. What he does not explain is why demand does not also sink along with a fall in supply capacity and thus avoid inflation. After all, that is what happens in a slump. Also his emphasis on capacity utilisation rather than on the rate of growth in value for the supply side of the inflation equation suggests a Keynesian excess demand theory rather than Marxist value theory.. 

In contrast, Mavroudeas and Chatzirafailidis put the value of commodities firmly as the anchor for prices of production around which market prices fluctuate. But they have no role for money. For them, inflation of prices in a capitalist economy is purely a real, not a monetary phenomenon. They start with the assumption that money is a commodity (gold), which rules out the role of money in inflation. This is unrealistic in modern economies where money can be created by central banks and governments (fiat money) that is not tied to the value of the gold commodity. In modern economies, money growth can diverge from growth in the value of commodities and so affect market prices.  Without money in the story, we cannot explain why demand should outstrip supply and cause inflation.

In part three, I shall present what Carchedi and I call a ‘value theory of inflation’, which incorporates the role of the profitability of capital, changes in the value of commodities and the role of money.  Bringing all these together offers a more comprehensive theory.

Theories of inflation: part one – the mainstream

by Michael Roberts

Guglielmo Carchedi and I have been working on a theory of inflation for several years.  We completed a detailed paper some time ago which was accepted for publication by a Marxist journal.  However, publication takes forever, so I thought I would provide a shortened version of our work on my blog.

For the blog, I have divided the paper into various parts: 1) mainstream theories of inflation; 2) heterodox and other Marxist theories; 3) our theory, called a ‘value theory of inflation’; and finally 4) a discussion of the application of our theory to the recent spike in inflation since the paper was completed.

Let me start with part one: mainstream theories.  

What causes inflation has been a puzzle for mainstream economics. As Walter Munchau in the Financial Times put it in 2020: “central bankers do not really understand how inflation works. There are lots of theories and approaches, theoretical and statistical, but none that has been able to explain persistently what is going on in the real world.” Charles Goodhart of the London School of Economics was harsher in 2021: “The world at the moment is in a really a rather extraordinary state because we have no general theory of inflation.”  Why is this? It’s because conventional or mainstream theories of inflation have failed to provide any robust explanation of why there are changes in the prices of goods and services in modern economies. 

The mainstream view of inflation can be divided into three groups: 1) the monetarist theory; 2) the Keynesian ‘excess demand’/cost-push theories; and 3) central bank expectations theory.

The monetarist theory of inflation holds that inflation is purely a monetary phenomenon, i.e. that inflation is determined by changing money quantities relative to the changes in the quantity of output. Leading monetarist Milton Friedman argued that “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.“

The monetarist perspective is based on a mathematical identity 𝑀𝑉 = 𝑃𝑌, where 𝑀 represents the money supply, 𝑉 is the velocity of money (which measures how frequently money is transacted within the economy), 𝑃 is the general price level, and 𝑌 is the real output of the economy. MV adds up to money in circulation and PY adds up to the nominal amount of income in an economy. Monetarism argues that the left hand side of the equation drives the right-hand side. So, assuming that the velocity of money (V) remains constant, then if M rises faster than Y, there will be an inflation of prices. Thus, changes in M drive changes in P. 

But this equation is an identity; the causal direction cannot be assumed. Marx’s position was the opposite of the monetarist direction. For Marx, money is not value, but the representation of value. So it is changes in the value/price of commodities that determines the volume of money in circulation. “If the velocity of circulation is given, then the quantity of the means of circulation is simply determined by the prices of commodities. Prices are thus high or low, not because more or less money is in circulation, but there is more or less money in circulation because prices are high or low.” 

Changes in P (prices of production) determine changes in MV (money in circulation).And prices change as a result of value changes (Y), as measured in the amount of labour time used to produce all the commodities. If the value of commodities rises/falls (ie more or less labour is necessary for their production), more/less money is needed for their circulation. This is because money is the representation of value, not value itself, which comes from the expenditure of human labour, not from money.

Who is right, Friedman or Marx?  Do changes in MV lead to changes in PY, or vice versa? Is there a close correlation between changes in money supply (M) and changes in prices (P)? Figure 1 shows annual percentage changes in US money supply (M2) and inflation as measured by the ‘implicit’ GDP price deflator). The correlation between the two seems relatively close up to the 1990s.  But from then on, US money supply growth accelerated as a trend while the price deflator decelerated. There was even a negative correlation. Over the whole period from 1960, the correlation between money supply and prices was low (0.21).

Figure 1. Source: FRED, authors’ calculations

A key factor in the weak correlation between changes in money supply and changes in prices is that money supply and money in circulation are not the same. Money hoarding and use of money to make purchases of financial assets can make a considerable difference to the relationship between money supply and prices. Indeed, as Figure 1 shows, the rising gap between money supply growth and GDP deflator from the mid-1990s onwards suggests a diversion of money out of productive assets into financial assets. 

Thus Friedman’s monetarist theory does not hold to explain US inflation in the post-war period.  In a later post, I shall show how it is changes in prices of production (or the value of commodities) that drives ‘money in circulation’ – the opposite of monetarism.

The second mainstream theory is Keynesian. This is dominant among mainstream explanations. A classic example of the ‘cost-push version of this theory was recently offered by Jason Fulman, former US White House economic advisor: “When wages go up that leads prices to go up. If airline fuel or food ingredients go up in price, then airlines or restaurants raise their prices. Similarly, if wages for flight attendants or servers go up then they also raise prices. This follows from basic micro and common sense.” (Fulman, 2022). The causes of inflation, apparently, are rising raw material costs and attempts by workers to get higher wages. This forces companies to raise prices to maintain profits.  This is the cost-push inflation theory.

Marx answered this theory way back in 1865. When debating with the trade unionist Weston who argued that wage rises would cause inflation, Marx argued that rising wages are the “reaction of labour against the previous action of capital” and that “wage rises generally happen in the track of previous price rises.” (Marx, 1865).  Moreover, it escapes Fulman that the effects on prices of wage increases or of materials could be countered by less profits. Given a certain quantity of value, if wages rise/fall, profits fall/rise, prices can remain unchanged.  Fulman’s argument assumes that profitability must be maintained ‘at all costs’.

An IMF study in 2022 addressed this question by applying a cross-economy database of past episodes among advanced economies going back to the 1960s. It found that “wage-price spirals, at least defined as a sustained acceleration of prices and wages, are hard to find in the recent historical record. Of the 79 episodes identified with accelerating prices and wages going back to the 1960s, only a minority of them saw further acceleration after eight quarters. Moreover, sustained wage-price acceleration is even harder to find when looking at episodes similar to today, where real wages have significantly fallen. In those cases, nominal wages tended to catch-up to inflation to partially recover real wage losses, and growth rates tended to stabilize at a higher level than before the initial acceleration happened. Wage growth rates were eventually consistent with inflation and labor market tightness observed. This mechanism did not appear to lead to persistent acceleration dynamics that can be characterized as a wage-price spiral.” In inflationary episodes, wages just try to catch up with prices. But even then, wage increases do not cause ‘wage-price spirals’ – this echoes Marx’s view in 1865.

A variation of the Keynesian view is the ‘demand-pull’ theory of inflation, namely that inflationary pressure results from a positive ‘output gap’ – where actual GDP exceeds ‘potential GDP’, defined as output at the limits of productive capacity including full employment. So inflation results from ‘excessive demand’ in an economy (ie above the supply capacity limit). This ‘excessive demand’ could be due to an expansionary government fiscal policy or due to fast rising wages given full employment, compounded by a fall in ‘potential GDP’, possibly from supply chain constraints and energy shocks. 

What is the evidence for this ‘excessive demand’ theory? Keynesians refer to the ‘trade-off’ between changes in wages and prices and/or changes in unemployment and prices.The former would have a positive correlation and the latter an inverse correlation. In graphic form, this trade-off would take the form of curve, as was first argued by AW Phillips with his so-called Phillips curve in 1958. The evidence for the post-war US economy is that, far from being a curve (ie a trade-off), the Phillips relation is broadly flat.  Here is our own calculation for the US.

Figure 2. Source: FRED, author’s calculations

Other empirical studies also show the Phillips curve to be broadly flat – in other words, there is no inverse correlation between wages or prices and unemployment. President Daly of the Federal Reserve Board of San Francisco, concluded that “the relationship between unemployment and inflation has become very difficult to spot.”. BIS economist Borio agrees: “the response of inflation to a measure of labour market slack has tended to decline and become statistically indistinguishable from zero.” And more recently, he concluded that “inflation has proved unexpectedly unresponsive to economic slack – the Phillips curve is very flat.” (Borio 2021). The former Fed Chairman Jay Powell also acknowledged the problem: “There was a time where there was a tight connection between unemployment and inflation. That time is long gone.” (Powell 2021). This uncomfortable conclusion was also reached earlier by two prominent mainstream economists. Solow (2018) remarked that “the slope of the Phillips curve itself has been getting flatter, ever since the 1980s, and is now quite small.” And Gordon (2018) echoed this: “The slope of the short-run inflation—unemployment relationship has flattened.”

So why do economists and central bankers continue to peddle a theory that has little empirical support? Gavyn Davies, a Keynesian and former chief economist at Goldman Sachs, explained: “without the Phillips Curve, the whole complicated paraphernalia that underpins central bank policy suddenly looks very shaky. For this reason, the Phillips Curve will not be abandoned lightly by policy makers” (Davies 2017). ). But the theory is not made less shaky by denying the empirical evidence against the theory.

The third mainstream theory of inflation is even weaker. It is promoted by central banks and international agencies. It is the expectations theory of inflation. Here inflation is caused by the psychology of the economic agents. If prices rise, then consumers expectations for price rises also increase, leading to accelerating inflation. As the IMF puts it: “It is possible that changes in current and expected inflation are both driven by changes in expectations about the future state of the economy. For example, if firms and households expect that the economy will be in a recession in the near future and inflation will be lower than today, they will start cutting their consumption and investment expenditures now, putting downward pressure on inflation today.”

But the consumer or household expectations of a rise in inflation does not provide a theory for why prices are rising in the first place. Federal Reserve economist Rudd points out that “unsurprisingly, what little evidence we have suggests that firms pay little attention to forecasts of aggregate economic conditions, including inflation.”  Yes, if inflation over the long term falls, then ‘unsurprisingly’, households and firms will expect inflation to fall. So “there is a suggestive low-frequency correlation between an estimate of inflation’s long-run stochastic trend and survey measures of long-run expected inflation.” In the graph below, as inflation slows, so expectations or forecasts of slowing inflation also follow. But expectations follow inflation rates, not vice versa.

Rudd concludes: “economists and economic policymakers believe that households’ and firms’ expectations of future inflation are a key determinant of actual inflation. A review of the relevant theoretical and empirical literature suggests that this belief rests on extremely shaky foundations, and a case can be made that adhering to it uncritically could easily lead to serious policy errors.” Central banks should note.

So we have three mainstream theories of inflation: monetarism; Keynesian cost-push and ‘excess demand’; and expectations, none of which is convincing or borne out by the empirical evidence.  No wonder the mainstream has ‘no general theory of inflation’.

In the next part, I shall discuss heterodox and other Marxist theories of the cause of inflation.