Killing the cost-push inflation Hydra

Some myths never die. Just last month the Financial Review newspaper in Australia ran an opinion piece written by a senior portfolio manager at an investment management firm. The topic was inflation.

The author spent some time on cost push inflation, sometimes referred to as a wage price spiral, but it applies to all factors of production. At the risk of giving investment advice, here is my advice: do not let the firm that employs that portfolio manager manage any of your money.

There is no such thing as cost push inflation. That may sound weird to some but it is true. I know it was littered throughout economic text books for decades and it was a constant topic in newspapers during the last extended period of inflation in western economies. But then again, Keynesian economics was also littered through texts for decades, and it still, cuckoo-like, occupies the brains of the political establishment, public service and treasury officials to the exclusion of all other schools of thought. That is despite Keynesian economics also being mainly garbage. Cost push inflation is one of those bad ideas that are hard to kill off.

If you hear someone talking about cost push inflation as if it exists, politely challenge them. There is a very easy way to do so. Ask them to explain where the extra money comes from. If, as is claimed, rising wages set off a wage price spiral, rising wages increase production costs, so business increases prices which leads to more wage demands and so on then where is the extra money needed coming from?

Killing the Hydra may be easier

Prices, including wages, are relative. They are not absolute. For a given level of resources in the economy, if the price of a particular good or service increases, people adjust – maybe buy less, buy something else, substitute new technology inplace of labour etc. That is, there is no way that the whole existing structure of production and consumption can remain unchanged just at a generally higher price level. The mix must be adjusted, not shifted up. Only an increase in the money supply can support a general lift in prices without affecting price relativities. (In practice, relative adjustments do occur when the money supply is increased because it takes time.)

As an aside, the same principle applies to aggregate demand pull inflation. This principle explains why the Keynesian notion of unemployment being caused by a drop in aggregate demand is simply wrong.

So, why is it the case that in inflationary times, prices rise in general and wages rise in general, too? The answer is that wage earners see their real wages being eroded by inflation and to the extent that they can, will bargain up nominal wage rates. What caused the inflation? The increase in the money supply at a faster rate than overall wealth.

Inflation causes wage increases, not the reverse.

Back to the portfolio manager’s views, he listed a range of what he thought were inflationary causes. They were the usual mix of cost push, demand pull, supply side constraints etc. None of those cause inflation. They do cause the price relationships among goods and services to change, but they are not like an incoming tide that lifts all boats. That the topic of monetary policy and its central role of creating inflation was not mentioned by the portfolio manager is illuminating and should serve as a warning to clients.

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