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This is the second part of my discussion of the causes of inflation in modern capitalist economies, based on an unpublished paper by Guglielmo Carchedi and me.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

Michael Roberts. Edmund Phelps: free markets and inflation expectations

Edmund Phelps: free markets and inflation expectations

by Michael Roberts

American Edmund Phelps recently died at the age of 92. Phelps was a classic free market mainstream economist from the monetarist school and winner of the 2006 Nobel Memorial Prize in Economic Sciences (the Riksbank prize in reality).

Edmund Phelps

Phelps researched and taught at Yale University until 1966. He then moved to the University of Pennsylvania, where he wrote the papers that made him famous. He was founding director of the Center for Capitalism and Society at Columbia University, from 2001 to its closure in 2024. In 2013, he published the book, Mass Flourishing, a statement of his belief that “modern values” — a shared desire to create, explore and meet challenges — are the wellsprings of economic dynamism, but were being lost because the innovative ‘competitive free markets’ were being suppressed by ‘corporatism’ and the dead hand of the state.

In the 1960s, along with arch monetarist Milton Friedman, Phelps strongly opposed the Keynesian view that central banks and government should try to manage employment and inflation. He claimed that this approach could only end in an inflationary upsurge.  Phelps argued that central banks can control long-run inflation, but have little control over long-run average output growth at the same time. When two objectives become incompatible as they did in the stagflation of the 1970s, Phelps insisted the best policy for the monetary authorities would be to bring ‘inflation expectations’ down, even if it meant raising interest rates at the expense — at least temporarily — of jobs. The stagflation of the 1970s and early 1980s in the major economies discredited Keynesian macro management and appeared to vindicate Phelps.  Phelps became a leading theorist of the neoliberal period that followed, supporting ‘balanced’ government budgets, privatisation and low inflation.

Phelps argued that capitalist economies cannot reduce the unemployment rate by accepting high inflation, something that economists had, until then, assumed to be the case, based on the Phillips curve. That was because if public spending increased, all the ‘economic agents’ (ie households and businesses) would ‘expect’ to see higher inflation, then demand higher wages (workers) and higher prices (bosses). Inflationary expectations would nip in the bud any desired economic growth and the associated fall in unemployment.

Phelps was right that Keynesian macro management that aimed to deliver full employment without inflation was impossible – but not for the reasons he cited, which was too much government spending.  I and others have shown that the failure of Keynesian policies was primarily due to the falling profitability of capital in the 1970s.  At first, central banks lowered interest rate in the hope that this would boost the economy.  That policy was reversed in the early 1980s by US Fed chair Volcker.  But what really broke inflation of the 1970s was the major slump of 1980-82, that saw US manufacturing decimated and unemployment rising sharply.

In recent years, Phelps’ expectations theory has been increasingly adopted by central banks and mainstream economists as monetarist and Keynesian theories of inflation have been found wanting in the Great Recession of 2008-9 and in the pandemic slump of 2020. During the post-pandemic spike in inflation in 2022, the economic advisers to the Biden White House put it like this:“Over the longer-term, a key determinant of lasting price pressures is inflation expectations.”

But Phelps’ theory does not explain why inflation began in the first place.  The theory removes any objective analysis of price formation. Once inflation is rising for other objective reasons (in the case of 2022, clearly due to global supply shortages), expectations may come into play.  But all the empirical evidence shows that only if inflation has been running high for months, do ‘economic agents’ factor this into their future outlooks. In this sense, expectations are largely adaptive—i.e. backward-looking rather than purely forward-looking.  They do not drive inflation, but instead follow it.In analysing Phelps’ theory of inflation, economist Jeremy Rudd points out that: “at best, only circumstantial evidence of a causal relationship in which expectations determine the long-run properties of inflation; it could equally well reflect a situation where respondents to these surveys are making reasonably plausible inflation forecasts in response to observed changes in actual inflation.”  He concluded, “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.”

Phelps continued to argue that inflation was caused by excessive government spending and ‘expectations’ of rising inflation. But the global financial crash of 2007-8 and the ensuing Great Recession of 2008-9 put paid to that theory. Inflation in the ‘real economy’ remained low in the early 2000s and government budget deficits were small, but still there was the biggest slump since the 1930s. As Phelps admitted: “Economists also failed to see the inherent dangers. The majority of my colleagues were simply not capable of believing that the market could fail. After all, they spent the past thirty or forty years preaching that whatever price the market sets must be right.”  However, that critique applied to Phelps himself.  

Phelps stood firm against those who wished to revive Keynesian policies in the wake of the great slump.  Monetarist theory had failed, because it was not prices in the shops that had got out of hand, but financial asset prices, which eventually collapsed and triggered the crash. But let’s not return to Keynes, said Phelps. “The thoughts of some have turned to Keynes. His insights into uncertainty and speculation were deep. Yet his employment theory was problematic and the “Keynesian” policy solutions are questionable at best… At the end of his life, Keynes wrote of “modernist stuff, gone wrong and turned sour and silly”. He told his friend Friedrich Hayek he intended to re-examine his theory in his next book. He would have moved on. The admiration we all have for Keynes’s fabulous contributions should not sway us from moving on.”

Nevertheless, the global financial crash did bring a change in Phelps’ thinking.  After 2009, like many other mainstream economists caught napping, he recognised that “some parts of the market are not sufficiently regulated”.  Governments would have to monitor bank lending to make sure that it was used for productive investment rather than for speculation in financial assets and property. I’m afraid Phelps’ hopes on achieving that have been sorely dashed since 2009 with continued credit-fuelled speculation in the stock market, bank runs and the rise of cryptocurrencies.

Throughout, Phelps continued to advocate free market capitalism with fervour: “policy must aim to build a business sector of high dynamism and broad inclusion. The research task is to identify the institutions that are pathways to dynamism and the institutions that are obstructions.”  For Phelps, socialism was only one threat to business dynamism, the other was corporatism—”a system where established businesses and entrenched special interests collude with governments to stifle bold, uncertain innovation in favour of stability and protectionism”. 

Phelps continued to advocate the ‘deregulation’ of labour markets ie ending any labour job rights with no say from employees. As he put it: “The less frequently employees have to look for new positions in which they need to exercise their full potential, the more the innovative strength of companies declines. Models such as the co-determination that is practised in Germany can be particularly harmful. For example, if a decision to move a plant from one town to another was submitted to the employees, they would always vote no, even though it might be in the best long-term interests of the company and society.”

In his last years, Phelps severely criticized Trump’s economic policies for trying to control the economy and tell companies what to do. This was “like economic policy at a time of fascism.” He called for free trade internationally, prudent fiscal measures and the maintenance of the independence of the Federal Reserve from government interference – a true free market neoliberal to the end.

Michael Roberts: Inflation and the central banks

 

Inflation and the central banks

by Michael Roberts

The era of disinflation is over.  By disinflation, I mean a rise in overall prices of goods and services, but at a slowing rate.  Deflation means an actual fall in prices.  That has not been the case for many decades, not really since the end of money as a physical commodity, namely gold and the arrival of what are called fiat currencies, ie money as coined, or ‘printed’, or digitally created by national states to replace gold.  Only in rare occasions have states so restricted the supply of fiat money that it has caused deflation and really only happened when there was already a slump in capitalist production.

For the last 70 years or more, governments have controlled the issuance of currency and so the direct relationship between production of value in an economy and its representation by the supply and turnover of money has become separated.  Inflation of prices has become the norm, but the pace of that inflation is now the issue.

In our (forthcoming) paper on inflation, Guglielmo Carchedi and I identified two separate periods of US price inflation in the post-1945 period to now. The first was from 1948-81 and the second was from 1981-2019. In the first period, the rate of inflation rose, constituting an inflationary period. In the second period, the rate of inflation fell, constituting a disinflationary period.

Between 1948 and 1981, the average annual rate of inflation was 4.3%; from 1981 to 2019 it slowed to 3.0%.

If we look at the annual average rate by decade, we can see the change even more clearly.

From the 1980s onwards, the US (and other major economies) entered a period of progressive disinflation, culminating in the Long Depression of the 2010s , a decade with an average rate of just 1.8% (and a rise of just 0.1% in 2015).  But now in the 2020s, starting with the post-COVID pandemic inflationary spike in 2022, the major economies appear to have entered a new period of inflation ie. a rising rate of price change. 

In various posts, I have argued, contrary to the mainstream theories that inflation is supply, not demand driven.  What determines the rate of inflation in a modern capitalist economy with fiat currencies, is the rate of growth in the production of value relative to the rate of growth in the supply of money. The latter excludes the supply of money that is hoarded in banks or used for speculation in financial assets (fictitious capital, to use Marx’s term).  The supply of money rose sharply in the 2010s as central banks tried to keep interest rates low and provide liquidity for the financial sector after the Global Financial Crash.  This monetary injection was called ‘quantitative easing’. Mainstream monetarist theory argued that this would lead to a big rise in inflation.  No such thing happened – on the contrary, price inflation slowed almost to zero, because a large portion of central bank monetary injection never left the banking system.

As unemployment fell to lows not seen since the 1960s, Keynesian monetary theory also argued that high government spending (large budget deficits) and ’tight’ labour markets would create ‘demand-led’ inflation.  However, the empirical evidence for this theory – the famous Phillips curve that supposedly revealed the inverse trade-off between falling unemployment and rising inflation rates – was missing.  The Phillips curve was flat.  Low unemployment did not lead to high inflation. That’s because the differential between the rate of growth in money supply created by the banking system into the economy and the growth in value production had narrowed. 

The post-COVID inflation spike was clearly supply-driven as the closing down of production and trade that produced the pandemic slump of 2020 was accompanied by a lingering breakdown of global supply chains and the squeezing up of prices in energy and key commodities by multi-national companies. A new Fed paper confirms that “underlying inflation dynamics have shifted since COVID.” The share of the consumption basket experiencing inflation above 3 percent remains well above the 2014–2019 average in the major economies, more than doubling in the euro area and the UK.  The Fed still wants to blame this on ‘excessive wage increases’, but this is not born out by the evidence.  Real hourly earnings roughly doubled between 1940 and 1970, but have barely risen since 1980.

Central banks have been at sixes and sevens in trying to control inflation.  In the 2010s, they lowered interest rates to zero and raised money supply to new heights, but inflation slowed. Then in the post-pandemic period they hiked interest rates and introduced ‘quantitative tightening’ of the money supply. But that failed to stop inflation heading above 10% a year, a rate not seen since the supply-driven oil crisis of the 1970s. The story then was that 1970s US inflation subsided because the US Federal Reserve under Paul Volcker hiked its policy interest rate to an unprecedented high. The reality was that Inflation only dropped because the US economy went into a major slump in 1980-2 that decimated its manufacturing industry. The Fed’s high interest policy just added to that investment and production collapse. Stagflation turned into slumpflation.  Indeed, the annual inflation rate stayed above the average of the 1960s until at least the 1990s.

Now with the Iran conflict and the reduction in oil and other commodity exports, inflation is back on the agenda.  Global supply chain pressure was building even before the Iran conflict. 

Supply disruptions in metals, grains, and livestock markets can generate macroeconomic effects comparable to oil shocks. When adverse supply disturbances hit these non-oil commodities, inflation rises persistently while industrial production falls, closely resembling the stagflationary dynamics typically associated with oil price spikes. 

The signs of a return to inflation are already there in the rise in inflation rates so far in 2026.  The latest March CPI data for the US show that another inflation spike is underway.  Consumer price inflation rose to 3.3% in March, a near 1% pt leap from February.  And there will be a further rise ahead towards 4% or more this year as the lasting impact of the energy and trade blockage feeds through.

Trump’s tariff tantrums are only adding to the inflationary pressure. Based on 2025–2026 data, the US Federal Reserve reckons that tariffs have resulted in a “near-complete pass-through to consumer prices, contributing roughly 0.8 percentage points to core PCE inflation and explaining the excess inflation in core goods.”  

Goods inflation was +0.84%, a huge month-over-month increase (10.6% annualized) and the largest since Jan 2022.

And the Euro area is experiencing a similar spike.

Again, the major central banks are in confusion. Federal Reserve policymakers sparred during the central bank’s March meeting over how to respond if the Iran war triggers a prolonged period of high energy prices. Minutes of the March meeting showed “most” members of the Federal Open Market Committee fretted that a lengthy war could warrant cutting rates to support the jobs market, while “many” suggested it might require raising them to counter higher prices.

Before the war, the ECB had been expected to keep rates steady in 2026. However, the war-driven surge in energy prices revived inflation concerns. ECB governing council member Olaf Sleijpen warned that sustained energy disruptions could still feed into broader price pressures. “Persistently high oil prices will ultimately feed through to the prices of other products, and thus also to wage formation, which could amplify inflationary effects,” he said. “In that case, the ECB will naturally intervene to keep inflation around 2% in the medium term”. 

Divisions within the Bank of England have emerged. Andrew Bailey, the bank’s governor, indicated that he expects depressed UK demand and labour markets to make “second round” effects from surging energy and food prices less dangerous than in 2021-22, reducing the risk of another wage-price spiral. But other Monetary Policy Committee members including chief economist Huw Pill and deputy governor Clare Lombardelli sounded less sanguine.

This confusion could be resolved if central banks recognised that monetary policy has little influence over price inflation, which depends first and foremost on the pace of value creation. If economies’ output slows and the monetary authorities react by increasing money supply and lower the ‘price’ of money (interest rates), then inflation will accelerate. If money supply growth stays close to value growth, inflation subsides.

Having seen monetarism and Keynesian monetary policies fail, central banks economists have diverted to a psychological theory of ‘consumer expectations’ of inflation, namely that inflation rises because consumers expect it and act accordingly by buying more to beat price rises. But as Federal Reserve economist Rudd concluded in 2021: “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.” But central banks are not going to admit this because it would remove their perceived role in the macro-management of the capitalist economy and reduce it to just acting as a ‘lender of last resort’ for the banking system. 

In its latest World Economic Outlook, the IMF reckons that economic growth will not slow much if the Iran conflct is shortlived. But it sees global inflation rising significantly.  Moreover, this time the ‘supply shock’ won’t be easy to contain. IMF: “the 2022 surge reflected an unusually steep aggregate supply curve, with strong demand running into supply bottlenecks, allowing central banks to achieve disinflation with limited output losses. Evidence now suggests a return to a flatter supply curve, making disinflation more costly.” Nevertheless, the IMF advocates that central banks must be prepared to hike interest rates because “if medium- or long-term inflation expectations drift up as prices and wages pick up, restoring price stability must take precedence over near-term growth, with a swift tightening.”

The Iran war and ensuing oil and commodity price rises are clearly a supply-side problem.  Falling supply will raise prices but it will also lower growth, as it will cut into the wages and savings of households and raise costs for companies. High energy prices are a regressive tax,falling heavily on middle- and lower-income consumers. Weaker non-energy consumption and rising costs beget pressure on corporate margins which beget lay-offs, and the job market cracks. US fourth-quarter real GDP growth was just 0.5% (quarter-over-quarter annualised) and the consumer sentiment index just hit an all-time low.

The major economies are not in ‘slumpflation’ yet.  In the US, corporate profit margins remain at record highs. And corporate earnings for the first quarter of 2026 are expected to be very strong. Trump’s planned fiscal handouts to US companies are substantial with tax incentives for businesses investing in machinery and factory equipment. And a weaker dollar in the latter half of 2025 will help boost dollar earnings from foreign investment revenues.

But the bulk of these earnings gains are concentrated in the US silicon valley tech giants. The rest of the corporate sector is struggling.  Profits for the whole of the non-financial corporate sector fell in 2025.

And the impact of the Middle East conflict on profits has yet to be fully felt.