How to Approach the Problem of Inflation in Economics

Fixing the Economists Article of the Week

by Philip Pilkington

In my previous post I laid out why the Phillips Curve theory of inflation is wrong and why it was misguided to try to rebuild it. The key point I made in that regard was that inflation is a complex, multifaceted historical process and any attempt to reduce it to some abstract timeless law would always end in failure and confusion.

In this post I hope to address how the problem of inflation should be approached. In doing so I will draw on the excellent and under-read 1983 book by Wynne Godley and Francis Cripps Macroeconomics. This book led to the stock-flow consistent models that were put forward in Godley and Lavoie’s book Monetary Economics. I actually think that the 1983 book is a better guide for working economists (which is not to diminish the latter achievement). The models in it – if we can even call them models – are far more open-ended than those put forward in the Godley and Lavoie book.

In the book Godley and Cripps spend a lot of time on inflation and inflation accounting. The beginning of the chapter on inflation gives a good idea of the approach the authors take in the book which is an approach to macroeconomics that I would fully endorse. They write:

Our main concern is with logical accounting relationships which constrain what can happen without fully determining what will happen. (p. 169, Emphasis Original)

They do make some behavioral assumptions in the chapter but these are always highlighted as being rather arbitrary. The key is to understanding the mechanisms through which inflation is generated and what happens when these mechanisms are activated.

The authors focus mainly on wages, interest charges, profits and taxes and how these feed into inflation. It is important to note that these are rather different issues to those I dealt with in my last post. In my last post I tried to highlight some of the general types of inflation, of which I argued there were four. What Godley and Cripps are doing is highlighting the mechanism through which inflation feeds into the price system.

It is a fantastic approach and must be read in the original to be appreciated. It shows that the inflation process is one that is essentially distributional. When it occurs it manifests as various groups in society – governments, workers, capitalists and rentiers – vying to keep intact or even increase their purchasing power. Godley and Cripps summarise as such:

Each component of prices can be regarded as a claim on real income. We have portrayed inflation as a self-perpetuating process of adjustment which occurs when these real claims are mutually inconsistent. No single component – wages, interest, profits or taxes – can be regarded as causing the inconsistency by itself. (p. 215)

The authors use a framework that deploys the hypothesis of indexation. That is, the assumption various agents might bid up their share in line with rising prices. The extreme inflationary case then becomes one in which every component is fully indexed in which case inflation becomes infinite (hyperinflation), while the extreme non-inflationary case is the one in which there is no indexation and every component does not respond to a rise in prices at all. The authors write:

We have given no theory at all about what determines the various real claims. Instead we have concentrated on the process by which they are reconciled. If all components of prices were fully protected against this process (fully indexed) inflation would be totally unstable, accelerating rapidly and indefinitely whenever the real claims were inconsistent. The fact is that inflation is not so unstable from year to year despite substantial exogenous shocks from changes in tax rates, government incomes policies, interest rates and – in open economies – prices of imports and exports. The observed element of stability in inflation tells us that indexation is by no means complete and therefore that at least some real incomes are vulnerable to inflation. (p. 215).

This is a fascinating approach and one that I think should be promoted by every ‘real world’, reality-based economist. It sets up a framework through which we can actually study inflation in the real world. In doing so it sidesteps the need for some sort of silly General Theory of inflation that holds good across time and space. The authors note this explicitly when they write:

We very much doubt whether any purely economic theory can ‘explain’ the rate of inflation or indeed whether it is fruitful to seek any general explanation. (p. 215).

Heterodox economists arguing with orthodox economists like Tom Palley would do well listening to this pearl of wisdom. Because trying to build a ‘model’ that explains inflation is likely to lead up a dark alley and it will come back to haunt the builder when an inflation that it cannot explain takes place.

Now, if we can just get Godley and Cripps’ book reissued! I note that the paperback version is currently selling on Amazon used for over £68. In the future I might look into approaching some people to suggest a reissue. It would be very timely indeed.