Economist Brian Easton says reductions in effective productivity, largely as a result of events overseas, require reductions in real incomes. Ignore that and you cannot defeat inflation

This is a re-post of an article originally published on pundit.co.nz. It is here with permission.

What would you think of a doctor who treated only the symptoms and never tried to identify the causes? A quack? Skilled quacks will have accounts about causes for which there is not much scientific evidence, convincing to the naive because they connect with their prejudices. Other evidence of quackery is confidence which far exceeds expertise, and that – surprise, surprise – the treatment is beneficial to the quack, typically more beneficial than to the patient.

The same thing is happening in the discussion on recent sharp price rises. They are being treated as the problem rather than a symptom of the problem. Bit like a high body temperature; certainly it may be necessary to bring it down with ice packs, but your doctor will look for what is causing it. Often it is difficult to tell, and he or she proceeds cautiously. The quack knows what the problem is before you enter the room.

So what is the story behind the recent sharp rises in prices? (I am not yet calling it ‘inflation’ which, once upon a time, meant sustained increases in prices. What has been going on has not lasted long enough for us to be certain we have inflation, rather than a price spike. If we follow the quacks’ snake oils, the price rises may become ongoing.)

We know the largest source of the consumer price rises comes from overseas both directly into the tradeable products and from feeding into the costs of producing the non-tradable products. (I have tried to estimate the feed-through from tradable price rises into non-tradable prices. I got a surprisingly high correlation, but I don’t trust it for various econometric reasons. Even so, it seems that over half of the current price rises come from offshore including from the feed-through.)

Bang goes a number of quack explanations such that the rises are due to expanding government spending (although, as I explain below, attention to government spending may contribute to the treatment). There are some minor domestic influences; for instance, the hydro-lakes are low (climate change?), which is pushing up the price of electricity. We are having domestic supply-chain difficulties, as witnessed by the empty supermarket shelves, which discourage price competition. I observe significant prices rising in the local eateries and wonder how much of that is due to lockdown recovery (but, this is the sort of anecdote that quacks thrive on).

However, it is clear that the main source of the local price rises is offshore. As I explained last week, they are a consequence of the Covid pandemic and the invasion of the Ukraine.

We can summarise these as effective productivity reductions. The supply-chain disruptions obviously reduce productivity; a ship hanging around outside a port adds to costs without adding to output; that is a reduction in its productivity.

The other big impact is the effect of a rise in import prices due to various factors including the breakdown of international supply chains, the world recovery from the depressed Covid economy and the Ukraine invasion. Each requires an intricate analysis but ultimately the resulting higher prices mean that we have to export more to pay for our imports – equivalent to a reduction in the export sector’s productivity, its ability to earn useful foreign exchange. (There is an offset insofar as export prices rise.)

I studied this phenomenon in some detail in regard to the wool price collapse in 1966 which led to two decades of high inflation (much higher than the international rate). There were all sorts of quack diagnoses; one of the worst was by the Rogernomes. I wrote the story up in my 1996 book, In Stormy Seas.

The resolution involved cutting the real wages of the public sector (the 1989 Public Finance Act) and of workers (the 1991 Employments Contract Act) and the Richardson-Shipley benefit cuts of 1991. Someone had to take the real income reductions.

Inflation is a mechanism for reducing them. It does this in at least two ways. Those on fixed incomes have their purchasing power reduced and there is a lag for those whose incomes keep up with inflation which reduces their purchasing power in the interim.

That is as true today as it was after 1966. Pretending that reducing incomes is unnecessary will prolong the inflation – the painful market solution to the problem.

What about policy solutions?

One promoted option is to cut government spending. The quacks don’t explain what spending they propose to cut, so let me guess. Perhaps they mean to cut public-sector wages and benefit levels, provide less free public health and increase education charges (add whatever you like) – like the Rogernomes did. Each one reduces real incomes, so in that sense while extra government spending is not a major cause of the inflation, cutting the spending has some anti-inflationary merits, especially if you are well-off (you will hardly be affected) or of a particular ideological persuasion.

Those in alternative situations or political positions might argue for higher income taxes, using some of the revenue to compensate the poor and average. I have not seen anyone proposing this as an anti-inflation measure. The opposite is advocated, which is to cut income taxes to compensate individuals for their real income losses. Two points. First, the proposals most benefit those higher in the income rankings. In any case the current proposals would, at best, offer only partial compensation. Second, the effect of any tax cuts is to increase real incomes, adding to the fiscal pressures discussed in the previous paragraph. You cannot escape the required real income reduction.

Muldoon tried to escape the dilemma by borrowing, which shifts the income reductions onto future generations (and also onto those who directly or indirectly held government debt because he controlled interest rates). I have always admired the Rogernome’s heroic addressing of the Muldoon debt-overhang (although I would not have done it quite the same way).

Another Muldoon strategy was price (and wage) controls; he was desperate. The aim of such anti-inflationary price controls is to sustain consumer purchasing powers by shifting the income reduction onto the profit takers. I leave others to make the value judgements inherent in the policy but make the point that the controls are clumsy and that businesses find their ways around them. Remember the continual revision of restaurant menus during the Muldoon price freeze? (Inflation or not, there is a strong case for increasing competition to reduce market power in favour of consumers.)

There will be other proposed anti-inflationary measures – quacks are irrepressible. Ask who they are proposing to take the real income cut.

Many will say it is up to the Reserve Bank. But to what extent is this round of inflation a monetary phenomenon? The inflation is precipitated offshore. Perhaps the RBNZ should finance a putsch against Putin.

In the Muldoon era the Reserve Bank was passive, facilitating the underlying inflation caused by the real income drop. A tightening of the monetary stance would have reinforced the recessionary tendencies on the 1970s and early 1980s. Is that what is proposed this time – another recession? That would cut real incomes but there would also be reduction in production, in effect compounding the productivity loss across the economy as whole. It is not a solution to the real income reductions.

Higher interest rates would cut the real incomes of borrowers, but they would increase the income of those who are savers. The two effects may not exactly balance out, but in the current context interest rate policy is distributive rather than dealing with this sort of inflation. (I expect domestic interest rate rises as world interest rates rise. As they do, they are an additional offshore pressure for real income reductions here, given our high overseas borrowing.)

There was the usual commentariat flurry when the Governor of the Reserve Bank told the IMF that ‘we are going to have to be very clear with our fiscal authorities around what we are doing and how they could assist around more targeted effective fiscal policies.’ Thirty years ago I publicly argued with the RBNZ that monetary and fiscal policy had to work together; there was very little public support for my position. Now it is orthodox among bankers, although there are quacks remaining in the neoliberal dark ages.

The Governor was making the same point as this column. This round of world price rises – even inflation – is not a simple monetary or aggregate demand phenomenon. So it cannot be addressed simply by central banks. It involves an economy-wide response of which fiscal policy is a major contributor.

*Brian Easton, an independent scholar, is an economist, social statistician, public policy analyst and historian. He was the Listener economic columnist from 1978 to 2014. This is a re-post of an article originally published on pundit.co.nz. It is here with permission.