Economist Brian Easton says too many commentators on current price pressures have not understood that this time it is very different from the 1970s. Their prescriptions may accelerate inflation

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

The New Zealand economy is experiencing an external price shock arising from the Covid pandemic and the Ukrainian invasion compounded by related supply chain difficulties. It is true that the shocks have impacted on an economy which is booming and which is drowning in liquidity. But the external shocks have triggered the price hikes. I explained the story in greater detail here.

This is a rather different analysis from much which is commonly in the public domain but it is more consistent with the facts. And it is not subject to Keynes’ accusation that it is based on ‘defunct economists’ or as, he might today have written, Econ101, with its models of a closed economy, a single commodity and elementary money. While the commentariat seems to be harking back to the Great Inflation of the 1970s, they seem unaware that there were external price shocks in the early 1920s and early 1950s which did not trigger major inflation.

Today’s economy is very different from the 1970s one. Then there were rigid relativities between most wages. For example, one year first up for the annual wage round was the electricians’ union. Everyone was very nervous because its workers were migrating big-time to better wages in Australia. That meant the award would have to settle high in order to retain workers, and as the sparkies were first up, their award would set the rate for the awards that followed. Yet they settled at a reasonable 15 percent increase for the year, not very far from the rate of consumer inflation plus productivity increases. The other unions followed on with settlements near the 15 percent increase too. However those involved with the electricians’ award mentioned – it was said oh-so casually – that they would have to come back to tidy up some matters of tool and other allowances. When they did after the wage round finished the additions made the actual electricians’ settlement near 22 percent so an excessive across-the-board wage increase was avoided.

The wage-relativity rigidities could not have been maintained without other features of the economy, such as border protection which prevented imports flooding in if local wages rose too fast. That protection has gone, while today’s union structure is very different and unable to impose nationwide awards in the market sector. These days wage paths are not as feisty as they were once.

Monetary arrangements were very different then too. The Muldoon Government set interest rates well below the rate of consumer inflation, so that there could be little effective monetary control. Today the Reserve Bank sets the base interest rate (the OCR – official cash rate) and the market settles the margins for risk above it. The Bank will increase the OCR as much as it thinks is necessary. (And yes, it acknowledges there is too much liquidity in the economy and is trying to reduce it, which is one of the purposes of high interest rates.)

Another difference is with inflationary expectations. At the end of the 1970s, everyone expected consumer prices to continue rising at ‘double digit’ rates – more than 10 percent per annum. That is not the standard view – not yet. However, the commentariat, still fighting the 1970s inflation, are encouraging people to adopt high inflationary expectations, so that those professing to be concerned about inflation are pouring oil on its nascent embers.

(My impression is that some are so keen to damage the current government that they will tell any story that will worsen things, even if it means that when they get into power they will face severe inflationary difficulties. Why try to damage the government? It is doing enough to damage itself.)

Nicola Willis, National’s spokesperson on finance, has demanded income tax cuts. There has been little pressure on her to explain the details. If they do not make offsetting spending cuts, then the borrowing will stoke inflationary pressures. Presumably, interest rates will rise markedly.

(One cannot help noticing the parallel with Liz Truss, candidate for British Prime Minister, who is also promising tax cuts. Again her spending plans are unclear. She says her tax cuts would reduce inflation. Asked to justify this statement, she could only cite Patrick Minford, a notable member of the Economists for Brexit group, not particularly respected for the accuracy of his forecasts. Minford has stated that ‘interest rates have to go up, and it’s a good thing. A normal level is more like 5%-7% [p.a.], and I don’t think it will be any bad thing if we got back to that level.’ Currently the British level is about 1.75% p.a..)

The ACT party is offering even more inflationary stimulus. They propose income tax cuts, which will need major expenditure cuts, but they don’t say where and on whom. They want to liberalise immigration restrictions, perhaps without realising that because immigrants initially increase demand more than they add to supply, that would initially be inflationary. (ACT wants to abandon all tariffs. Yes, it would slightly reduce the price level, but it would leave us even more naked going into trade negotiations.)

Rather than addressing inflation the Opposition parties and the commentariat promote their standard policy tropes which they would apply in every circumstance.

Is the government doing any better? Here is my assessment of what we might be able to do; I leave you to judge how well the government is following that course.

The current price rise is more like that of the early 1920s and early1950s: a sharp external shock which, if managed properly, will not boom into high rates of inflation although it will lift the price track a little.

Proper management requires avoiding raising inflationary expectations. That requires a ruthless realism. Yes, prices are going to be a little higher because of the external shock but that is not the same thing as ongoing inflation. Yes, some people are going to be worse off as the consequence of the shocks.

Observe that to some extent the overseas price shocks are unwinding and that our prices should follow. (Perhaps every member of the commentariat should have a copy of the Hitchhiker’s Guide to the Galaxy with its ‘Don’t Panic’ in large friendly letters on the cover.)

Expect the Reserve Bank to play its part in managing expectations even if it cannot reverse the external price shock. That means that interest rates are going to rise – international rates are rising too. The Bank needs to give priority to reducing the excess liquidity in the economy – higher interest rates help.

The fiscal stance – the direct responsibility of the Minister of Finance – needs to be restrained. The economy is booming and does not need any additional stimulus, as argued in relation to the Opposition proposals. Wherever it can, the government should reduce the supply chain jams; there may not be a lot it can do in the near future.

The government needs to more actively manage expectations. For instance, real household consumption and real wages are both higher today than when the Labour Government was elected, even if the commentariat does not mention this in their ideological panic. (Of course, both could be higher.)

If the public is seduced into fighting the last inflation war, they will one day regret the out-of-date measures used to fight this one.

*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.