Such a thorny subject. No matter how much politicians try and absolve themselves of responsibility, rising prices are always ultimately a direct result of Government policy or failure of Government to react correctly to circumstances. I intend, in this essay, to show that rising prices are not exclusively the result of excess demand, but can be systemic in their origin. I will also show that systemic problems can not be dealt with by increasing or decreasing money supply, and may even require ideological shifts to provide any lasting solutions.
Gordon Brown attempted to fully absolve Government from responsibility for inflationary impacts on the lives of people, by making it the responsibility of the so called ‘independent’ Bank of England, who can only be nominally independent as they are ultimately a subsidiary of Government. The Conservative Government, while claiming to be a Party of financial discipline, have pursued inflationary policies for the last decade, always on the basis of it is not us but ‘the markets’ that dictate prices. If inflation is bad we should ask ourselves why is it specific policy of both Labour and Conservatives to have a target of 2% inflation.
Fundamentally we know that the primary cause of inflation, or rising prices within an economy, is the printing of money. I will deal with Global effects separately, after first covering the local economy. Understanding prices increasing when money is printed was perhaps easier when we only had a coinage system, and printing money amounted to reducing the quantity of gold or silver in the coins. Traders would strive to receive the same quantity of gold for their goods and therefore increase the prices. With a paper money system where the money or currency is not backed by a physical asset, the reasons and mechanics are less obvious. Ultimately the bulk of printed money ends up in the hands of the population, and the average person will use that money to buy extra goods, or as the saying goes “money burns a hole in your pocket”. Thus we can deduce that, unless there is a corresponding increase in output or available goods, the printed money will be a stimulus to demand and prices will tend to increase until all that extra money has been absorbed.
Printing of money generally takes place when Government is failing to cover the costs of running government with taxation. While it is possible to deficit finance government expenditure, without having the effect of creating new money, this is rarely the case in the UK. For example if the Government debt issues are taken up by the population at large, or pension funds it amounts to a temporary use of existing idle money by government, if, on the other hand, the issues are taken up by the Banking sector, including Bank of England, and or foreigners we have a direct increase in the amount of money in circulation in the economy. Put simply we have printed money. Increasing Money Supply or more broadly speaking printing of money also takes place through the Banking sector which is evidenced by an increase in net borrowings (Bank credit – savings or idle balances) of the population. Why I also call this printing of money is that Banks are not required to actually have the money they lend you and purely rely on their own credit worthiness and agreements with the other banks within the banking sector. You will generally find that the total bank credit advanced exceeds the the savings or idle balances on their books.
To understand the inflationary impact of printing of money, we need first to understand why it is government policy to run the economy on a basis of having some inflation rather than purely stable prices.
Firstly inflation is generally kind to business, as it almost ensures increasing profits without necessarily having to improve productivity. If we consider the cost profile of a business and indeed the government, we generally see an element of fixed costs that are not directly impacted by inflation. This means that if the business increases prices by the rate of inflation while ensuring that wage increases are only marginally higher than inflation its profits will grow by more than inflation without producing or selling any more goods. In a stable price environment business will only increase profit by increasing output or productivity. This obviously applies at the macro level rather than the individual business (small businesses where the fixed cost element is relatively small, are not as sheltered as large businesses).
Secondly an inflationary environment acts as an inducement to the consumer to spend. In an environment of increasing prices delaying the purchase decision invariably costs more and the propensity to save (make money idle) is reduced. This is also beneficial to business, as by and large the population are willing buyers prepared to replace things before they wear out.
Finally an inflationary environment increases the government’s tax take without having to put up taxes.
From this it would seem that a policy of encouraging mild inflation is for the good of all. Certainly it is less harmful than deflation where the business sector, as a whole, is not guaranteed increasing profits and only those that are able to increase outputs or productivity are able to survive. However, we should be aware that is not the total picture and nor are the effects of inflation equal throughout the the economy.
While it is common to believe that rising prices are inflation, we should be aware that inflation is not the only reason for rising prices. I tend to define inflation as a situation that exists when aggregate demand exceeds supply. The inflation potential within an economy can be calculated by the simple formula (increase in overall debt) / (original debt) or (increase in money supply) / (original money supply). Part of this inflation potential will appear in increased consumer prices while another part will appear in housing and other asset prices, like stock exchange investments etc. To convert this inflation potential to an annual rate one needs to consider the overall effectiveness of the economy in moving the money created into the hands of the population, commonly called velocity of money. I will further discuss some of the peculiarities of the money flow within the economy later.
There are also other causes of rising prices unrelated to the purely monetary effect of printing money. These are systemic and relate to our cost equation within the economy. There are 6 elements of cost within an economy and the equation is as follows: Rent + Interest + Wages + (Profits + Tax) + imports = Price. Obviously any one of these six elements rising, without a corresponding increase in outputs, results in increased prices. What I am saying is that, although we believe that markets will regulate prices, they are still bound by an overarching cost equation. Before examining the elements of cost individually we should briefly consider the adequacy or otherwise of ‘markets’ as a regulator.
Markets, in spite of the free availability of information in this modern era, are never perfect and it is in their very nature to be anarchic with swings one way or another usually being overdone. Under these circumstances it does seem strange that we place total reliance on markets to regulate price, a little like appointing an anarchist to head an important function within an economy. In a state of perfect competition we know that prices will tend toward cost of production as defined earlier. Whenever prices are moving away from cost of production with any one of the elements of cost increasing beyond the level of increased output we are looking at a systemic issue, and it is a primary function of Government to address systemic factors within the economy. I am suggesting that we cannot place total reliance on markets and that there should be regulation of some form when markets, in any sector of the economy, are misbehaving.
We partially recognize that markets are an inadequate regulator in cases of monopolies and have a competition regulator, however his role is not fit for purpose as it is too closely bound to the consumer having choice. A monopoly is not in itself bad, and there are many cases where it is the only feasible way of providing certain goods or services, simply because of the scale of investment required to produce those goods or services. The bad thing is not their existence, but some of the practices and the pricing model they are able to adopt. Rather than this focus on ‘competition’ our focus should be on preventing monopolistic pricing and practices. In this way we would be tackling not only monopolies but the far more insidious oligopolies as well. Currently to tackle oligopolies the competition authority is required to prove collusion and it is not sufficient to show that pricing policies are the same. If our competition authority were able to examine pricing models of companies that were generating excessive profits, in other words, way in excess of a reasonable profit given the scale of investment and level of risk. We would then add some tangible teeth to the competitions authority and instead of levying fines against companies that are laughable they would reclassify their tax status so that our tax system can be set to counter excessive profits. Adopting something like this would also capture those cases where excessive profits are generated, as a result of the excessively long (21 years) patent protection we grant.
While what I have just said might fly in the face of popular ‘free market’ beliefs,consider that, no lesser authority than Adam Smith the founder of free market ideology was clear that ‘licensed companies’ [monopolies] were an evil that should not be allowed to exist. Because of the distortions they cause. To illustrate this with a simplistic example, a monopoly, charges say £1000 for something that cost it only £1 to make, but the item, is a must have product, so we now find that the individual has £1000 less of his available income to spend on other things, so all other businesses have been deprived of potential income. If you think that far fetched. I suffer from age related Wet Macular Degeneration, the only treatments that slows it down (prevents near total blindness) are two drugs either of which needs to be injected into the eyeball at about 6 week intervals. The leading one costs £1000 per dose, the second costs £ 800 per dose. The company with the leading drug also has a patent on a second drug used in certain cancer treatments, that has been shown to be almost as effective, and costs less than £15 a dose. In the UK, because the company, holding the patent, has never submitted test data or applied for it’s use as an eye treatment, it has not been approved for the NHS to use for this purpose (it does get used elsewhere in the world). Some might think it clever business no9t to submit the data for approval by NICE and thus preserve the profitability of their front line product, but is it not just another example of monopolistic practises?
If our taxation and regulation systems were designed better to prevent excessive profits a lot of the heat in the current energy cost crisis would have been removed. We are approximately 80/85% oil independent so by adopting the type of measures I am talking about, it would have been within Government’s gift to mitigate against at least the fuel cost rises. Norway achieves this by running a Sovereign Wealth fund that takes the bulk of the excess profits from the oil and gas industries in times of high market prices while subsidizing those industries in times of low market prices. Fundamentally this is little different from what I have suggested above, for the record Norway’s Sovereign Wealth Fund now owns approximately 1.5% of the total stocks on all the world’s stock exchanges.
Having covered the need to prevent the anarchic side of market prices through regulation we can now look at the cost equation. We need always be aware of what is happening in the country’s cost equation as this is the first indicator of systemic problems within an economy. The issues I will raise here have been self evident in the UK economy for at least the past decade, if not the last three. Systemic problems that exist are issues that the Government should tackle. Here most of the issues can be blamed on failure by both Labour and Conservative governments.
If for a moment we exclude imports from the cost equation it becomes easy to see that rising prices are attributable to one or other of the factors of production increasing beyond the level of increased outputs. Where I say profits I mean profits after tax or the amount that can ultimately be distributed to shareholders or the population. So let us consider each of these factors of production and try and picture their overall effect. As I include profits in my equation we should see that Price is synonymous with Cost. Stated simply: Price = Rent + Interest + Wages + Profits = Cost As you can see for Price or Cost to rise one of the four factors of production must also rise.
Rent: There are two aspects, one affecting business and the other directly affecting the consumer. In the 1700’s, Adam Smith in explaining why the Colonies (USA) outperformed the UK, laid most of the blame on Landlords who he said squeezed all the profit out of the property so that the lessee had little left over for investment, and when the lessee had improved the property and made it more profitable, the the Landlord would duly increase the rent being charged. To a large degree we see the same today. Few commercial properties are let out without a percentage of turnover being added to the rent. This applies particularly to smaller businesses. Larger businesses will tend to own their properties which increases the fixed cost part of their own cost equation, giving them a competitive advantage. The housing market is also subject to higher than inflation increases in Rent, mainly because the largest part of inflation in the UK, over the last three decades, tended to be in house prices, and Landlord seek to charge a rent that gives x% return on the perceived value of the property. While rents charged in the housing market do not impact on the country’s cost equation we should be aware that they are part of the inflationary impact. If the overall earnings in this sector are growing at a rate that is faster than the increase in output it implies that markets are failing in their regulatory function. Governments should be tackling this as a systemic issue and therefore subject to controls either through taxation or direct regulation.
Interest: Nominally this is controlled by the Bank of England, however much of the lending to the consumer falls outside of the controls exerted by the BOE and rates of 30% and higher are fairly common in credit card lending. Interest coupled with credit policy is the main tool of the BOE in controlling inflation. How this actually works is that in increasing the base rate of interest people find that mainly the mortgage payments increase meaning that they have less money in their pockets to spend and is therefore a dampener on demand. As a concept this only works in conjunction with tighter credit policy and a balanced budget. If credit policy is loosened there will be no, or little positive effect on rising inflation, the same applies if government is failing to balance it’s budget. This is easy to understand if the government is pumping £100 billion into the economy while the increased interest rates only withdraw £20 billion or less from the economy, there will be money available to fund increased demand and the inflation spiral will continue. When we see the interest earnings of Banks and other peripheral Financial Service companies growing at a rate greater than the increase in output we are once again dealing with a systemic issue that needs to be addressed.
Wages: Much as we believe they should be ever increasing, it is not a sustainable proposition. Where wages (I am talking about aggregate wages including bonuses) are rising at a rate higher than the increase in outputs, plus whatever moderate inflation is considered acceptable, we are dealing with a systemic issue. We should understand that once we have full employment, defined as more than 95% of the available work force, markets can no longer play a self regulatory role, and as businesses seek to expand their output by increasing their workforce, they will start having to outbid their competitors in order to induce someone to change jobs. While we were part of the EU this was not an issue as freedom of movement ensured that we were easily able to draw additional labour from areas of the EU where there was less full employment. We already see vast shortages of labour in various sectors of the market, including not only specialist skill sets, but lower or more generally skilled workers as well, I have no doubt that we are already have serious systemic issues in the labour market, which will bring about rising wages and pricing pressures within the economy.
Profits: I have reflected after tax profits with tax as a separate category of the cost equation as both these numbers are important in themselves, the one reflecting the amount that will ultimately affect aggregate demand and the other the efficiency or otherwise of government. As with all the preceding items if profits are rising at a rate greater than the increase in outputs we have a systemic issue indicating that the markets have failed in their regulatory role.
Tax: A word we all hate, yet it is only a way of distributing the cost of running government and providing the services we all desire. The first thing we should understand, and here I talk as a conservative with a small ‘c’, it is the primary function of the government to collect taxes equal to at least the cost of running the government from day to day. Unlike Gordon Brown who used to say ‘I will balance the books over the business cycle’, only it seems he was the only one who knew when the so called cycle was going to end, as he took more and more things off balance sheet. A large part of the NHS funding crisis revolves around his public private partnerships and continued by the Conservatives. Or like the Conservative Party who tell me that lower taxes will result in greater tax collections! What happened once in a particular set of circumstances where the ‘business cycle’ was at a particularly low point is unlikely to repeat itself. There is no new North Sea oil or London Big Bang to kick us into a new cycle. If they truly believe this garbage why isn’t their tax rate 1% because in terms of their theory we would then be, rolling in the dough, instead of, grovelling in the mire!
While in the short term, at most two or three years, it is acceptable for government to fail to balance it’s books. Generally however, in this case, we would expect the Government to raise the required shortfall without printing money. As I pointed out earlier, if the government borrows from the public and pension funds it will not be increasing the money supply within the economy, because it is using existing idle money within the economy.
Assuming that the government accepts that it balances the books, then this number has significance, otherwise you must accept that you are going to pay the shortfall twice, once through inflation and once when the government eventually increases tax to repay the debt it has incurred. Failure of the government to balance the books over the short term is a systemic problem that will come back to bite. Businesses are usually wise enough to know that a low tax rate while the government’s books are not balanced can only be short term. We have now spent some 12 years with the lowest corporate tax rate amongst the G7, but business has failed to invest, I wonder why!
Before moving on to Imports and the Global economy let us look at the local economy and attempt to summarize the various effects.
The need for Fiscal discipline (balanced budgets) was a cornerstone of Margaret Thatcher’s policies and in this there was a fundamental difference from those of Ronald Regan. She continually compared the the economy with the household budget, once you have spent your income you must do without. Borrowing was only acceptable for investment that would bring future income. Possibly the most clear enunciation of this principle comes from Dickens’ Mr Micawber: ‘Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.’
A deficit in the budget, in the long term, will always lead to misery as it has the effect of increasing the quantity of money available within the economy. As we have shown increased supply of money always leads to rising prices without increasing output. John Milton Keynes in his General Theory argued that printing of money would not result in inflation, but added the caveat ‘unless we believe that increasing prices are inflation’, so even the biggest champion of deficit financing believed that it would result in increasing prices. While it is possible in the short term to operate a deficit without increasing the amount of money circulating if the Government borrowed from the population’s savings, mainly Pension Funds but also idle balances, this can only be a short term solution as the savings will run out.
Inflation will take place when the quantity of money available to the public (consumer) exceeds the supply of goods. The public will seek to make that money productive by either bidding up the price of goods they desire/need or converting into assets ( housing or stock market shares). In both cases we see that prices start rising because demand exceeds supply. Whether it is the price of consumer goods rising or asset prices rising they are both simply inflation even though we call asset prices rising ‘a bubble’ rather than inflation. The solution to this is fairly simple, reduce the amount of money available to the public and the pressure on prices will subside. This is often easier said than done, mainly because a large part of the money available to the public comes by way of credit or borrowings. The tools available to achieve a reduction in the quantity of money available are both fiscal and monetary but neither can work in isolation.
If we increase interest rates it should reduce the willingness of the public to borrow and perhaps increase their willingness to save (make money idle). There will also be a reduction in the amount of money available to the consumer as a result of increased interest bills and mortgage payments. However, from the Thatcher era, we know this is not adequate, as if the inflationary expectations are higher than the interest rate borrowings will continue to increase. Interest rates need to be increased beyond the level of inflation and be accompanied by a tighter credit environment. In any event without fiscal measures to ensure the government is not pumping additional money into the economy through a deficit financed budget the interest rate increases and credit restrictions are going to need to be fairly draconian.
From my earlier discussion on the cost equation, you should have gathered that not all price increases are demand led. Past economists have tended to distinguish between the two forms of pricing rises as demand pull inflation and cost push inflation. Today we tend to brand all rising prices as inflation. I prefer looking on the two as entirely different phenomena, where the cost side of the equation is at fault the problem is systemic, while if the demand side is at fault the problem is monetary or true inflation. Monetary inflation can be dealt with through monetary and fiscal policy as outlined above, while a cost led inflation is indicative of something wrong in the system and can only truly be cured by fixing what is wrong.
Systemic problems, or shall we say supply side problems, are far harder to deal with as they indicate something that is actually unsustainable.
Let me try and illustrate. We currently have what is generally considered full employment with a large number of unfilled vacancies in the economy. No matter how much we say technology will come to the rescue it can only be in the long term. We are therefore confronted with a situation where wage rates will start rising faster than outputs because of the competition amongst employers for employees. Without addressing the core problem ‘shortage of workers with required skill sets’ the only way this can correct is by contracting the size of the economy or increasing the number of immigrants allowed into the country. The reason is fairly clear, by leaving the EU, we gave up the regulatory role that freedom of movement provides in the EU preventing excessive wage increases.
Obviously we can also train people, but, this requires time possibly as much as a generation. Our business sector has grown up with a fairly small need to train people, as by and large we have had free access to a fairly large pool of trained workers. A change requires what amounts to a cultural shift both in business and in our education policies.
I am also certain that an examination of the Rental sector, will also reveal that an excessive proportion of the income being generated by the economy is going into this sector. Excessive profits will always create distortions within the economy that tend to create unsustainable situations. For example if any sector of the economy starts making excessive profits we would expect other entrepreneurs to enter the market and drive down prices by competition. This is not possible in the Rental sector as the amount of land is absolute and the possibility of competition very limited. In this case we should be able to see that ‘the market’ cannot provide a regulatory role and should be looking at either our taxation system or some form of direct regulation.
Finally where the price increases are the result of systemic problems, prices will not come down without, business insolvencies, driving down both the level of employment and demand for premises. Whereas in the case of demand led inflation monetary and fiscal measures should result in an actual reduction in prices because of reduced demand. We will discuss this again once we have completed the International aspects of our cost equation and the forces driving them.
We can now look at imports and international trade and the role they play in our cost equation or prices.
Imports: Adam Smith was fairly clear that we should be buying goods from places which have a competitive advantage in producing them. Our imports represent around 35% of our GDP and as such make up a significant proportion of our cost equation. While imports are not subject to the pricing pressures of the local market they are subject to the vagaries of the foreign exchange market as well as inflation within the supplying country. If our rate of inflation or price increase is higher than that of other countries then our relative competitiveness will be decreasing and this will be evidenced in an increasing deficit in our ‘current account’ (difference between total exports and total imports), and will represent the amount that needs to be paid out of reserves. Once again if a current account deficit is persistent we are looking at a systemic problem within the economy.
A further issue affecting the cost of Imports is of course the exchange rate. Since 1970 odd, this has been increasingly out of our control and largely in the hands of ‘the market’, unfortunately the most anarchic of all markets. Over the long run ‘the market’ should, however, find the correct exchange rate. The correct exchange rate is one that virtually eliminates any current account deficit or stops the country from either getting richer or poorer out of it’s international trade. ‘The market’ will be making a judgement on the sustainability of the economy rather than the wealth of the nation. This means that sound bites from the PM, Chancellor or Governor of the BOE, will not always be taken at face value. To understand the reasons better, we need to understand that the current account deficit never gets paid until we part with assets. Very briefly, when we ‘pay’ for an import we are simply giving the foreign country a promissory note to pay, and it is for the exporting country’s Central Bank to choose when he asks for settlement which can only be completed by the transfer of assets or goods.
You might have noted that I have said that the correct exchange rate is one where where there is neither a surplus nor a deficit in our current account over the longer term, which may well fly in the face of popular belief that we must always profit from what we do. This is true of developed countries as opposed to developing countries although, a case could be made for an element of wealth transfer from the developed world to the developing world, at this stage I prefer a position where we are neither getting richer nor poorer at the cost of other nations. It might surprise you to know that ever since Kenneth Clarke’s chancellorship we have actually been getting poorer! Not that we would believe that from the sound bites we hear from politicians, nor indeed our own experience aren’t we continually getting wealthier? The value of our house is getting higher the supermarket shelves are full, sorry supermarket shelves no longer full and unfortunately the value of our house is only a perceived value and could as easily fall by 20 or 30% in the blink of an eyelid.
Imports should, in theory, over the long term enable us to expand supply well beyond the ability of our country to produce goods and we should not see a demand led inflation driving up the prices in our local market. This said, we must also realize that our ability to import in the long term is dependent on our ability to pay, once again we must look at that current account deficit. For the last 25 years we have not closed the gap, which actually slightly widens each year. This must ultimately result in a reduction in the our exchange rate, which will have the effect of increasing the cost of imports.
Outside of exchange rates our imports are also subject to the risk of inflation in the supplying country. Here I would point to China who have a stated economic policy targeting to equalize standards of living with the USA by the mid 2030’s this naturally implies substantial wage growth in the Chinese economy which will impact on the goods imported from China.
Discussion about exchange rates can never be complete without looking at the impact on exports. In the first instance our largest exports are in fact oil and certain bulk chemicals where the markets are established in US Dollars which means that apart from exports appearing to rise because we are getting more pounds per unit of sale we don’t become any more competitive, and physical exports are not actually rising. I have never fully understood our oil exports as we in fact import more oil than we export and suspect that it might be a form of counter trade with the Arab Emirates and Saudi to support our arms trade. I would expect that the devaluation that has taken place would have made some of our exporters more competitive and that, in time, we should see an increase in our export numbers. At moment there is scant evidence to show that we have gained in the export market since the fall in the Pound’s exchange rate. This is fairly normal as business will seldom invest to expand production and output unless it has confidence in the future.
The other big impact on cost equation is the rising oil price, and, we are complicit in allowing the biggest oligopoly (OPEC) to get away with manipulating supply in order to keep prices high. We and particularly the USA choose to simply follow OPEC’s lead and allow them to effectively set the price of oil. It is within our gift to operate our local markets differently and was within our gift to retaliate against unfair manipulation of the oil price. We could right now possibly mitigate against the oil price by lifting sanctions on both Iran and Venezuela. Our sanctions against these two countries have both strengthened the position of OPEC and driven them firmly into the Russian Camp. We could try and sort out the mess we made of Libya and get their production levels back to those that existed under Gaddafi. We need to realize that these were political choices we made through our Governments.
We should be able to conclude from this that there are severe issues with our cost equation, and that the rising prices are systemic rather than inflation where demand outstrips supply because of excessive money supply. We do however know that since 2008 we have been printing money at a rate that is almost without precedent in our economic history, excluding perhaps the Napoleonic wars and their aftermath. The inflation that occurred then was cured by two measures firstly the introduction of a ‘temporary’ Income Tax and secondly on the advice of Ricardo (the greatest free-marketeer of all time) the re-adoption of a Gold Standard in 1823. I am not suggesting a return to the Gold Standard, but would like to point out that an asset based monetary system imposes a discipline and limits the ability of Governments to gerrymander money supply. The effects of these two measures were both to bring inflation under control and to bring about 80 years of sustained wealth creation in the UK, underpinning the Victorian era.
So what happened with all the money we printed in the last two decades? We have only seen moderate price rises until recently. Fundamentally the ‘quantitative easing’ (printing money) program resulted in the money ending in the hands of the banks, pension funds and people of high wealth. The Banks under pressure to earn from all this unproductive cash chose to lend largely for property purchases, the least risky form of lending, which coupled with the low interest rate resulted in the prices of existing houses rising rapidly (a property price bubble). Pension funds forced to use this cash increased the proportions of investment in stock exchange and property making them a little less liquid and possibly exposing them to a future shock. People of high wealth denied interest income also chose to move the money into the stock exchange and property, while the ‘dribbling down’ hardly increased. Without a large portion of this money landing in the hands of ordinary people there was little overall increase in demand for consumer goods hence the relatively moderate inflation we have seen. The frightening thing is there are two ‘bubbles’ that are likely to burst at some point.
The current situation, without Government acting to address the systemic problems fiscally, cannot be addressed by the BOE. Driving up interest rates is likely to burst the property price bubble if not the the stock exchange price bubble as well. The impact of either of these events will be far greater than the current energy price crisis.