"The Keynes Solution" (7) by Paul Davidson - Keynes's New Thinking - Inflation (2)

Image credit. Continued from here.

Continued from here.

In the preceding sequel, we have seen that inappropriate theoretical assumptions (money neutrality) may tempt economists to misjudge economic policies (governmental deficit spending) as necessarily inflationary, when under certain conditions (unemployment and idle capacity) they are, in fact, apt to give rise to non-inflationary economic growth. The Bottom line: government debt is not per se inflationary. Efforts at putting limits on government debt should not be triggered by some magic threshold number (e.g. 60% of GDP), as in the Maastricht Treaty; instead they ought to be informed by an assessment of the specific condition that an economy happens to be in. Depending on which phase of an economic cycle the economy is traversing, the same policy choice may or may not be inflationary, may or may not be conducive to economic activity.

Having said that, of course, manifest inflation is a serious problem and we are well advised to remain vigilant to the threat of it, at all times.

But what is inflation? According to Davidson:

Inflation occurs whenever there is a significant increase in the money prices of most goods and services that residents of a nation purchase.

Davidson, pp. 67-68

Peculiarly, in many basic discussions of inflation (or deflation, for that matter) the detrimental effects which give us reason to fear, study, and fight it are simply taken for granted. Davidson does not spell them out either. So, let me add: inflation is a problem to the extent that it debases the economic position of people. It does this by creating a painful mismatch between income/wealth and expenses/liabilities, with the latter increasing disproportionately compared to the former. The cost of living goes up, whereas one's salary does not. That is inflation.

Now, what is the cause of inflation?

Commodity Inflation and Income Inflation

In answering this question, Davidson adduces Keynes distinction between commodity inflation and income inflation. 

Commodity Inflation

Roughly speaking,

commodity price inflation occurs whenever there is a sudden and unforeseen change in demand or available supply [for key commodities] ...

Ibid. p. 69

A regime change in populous countries like China and India, opening them up to world markets, may lead to a global demand shock and rising prices in commodities crucial to the average consumer in other countries. Large-scale damage by frost just before harvest is liable to engender a supply shock, a sudden diminution of supply in the face of customary demand. Or think of the artificial curtailment of oil supplies by OPEC in the 1970s.

In some cases of threatening commodity price inflation, Davidson recommends governmental buffer stocks to absorb or cushion price swings. Though, this is not a topic for the present post.

Income Inflation

I suppose, ultimately, all inflation is "incomes inflation."

[I]ncomes inflation occurs when the money costs of production increases because owners of the inputs to the production process [wage and salary earners, material suppliers, lenders, and / or profit recipients] receive higher money incomes that are not offset by productivity increases. [...] Thus, for example, if the money wage rate increases while worker productivity is unchanged, the labor costs of each unit of output rises. This rise in the unit cost of production requires business firms to raise prices accordingly in order to produce and still make a profit.

Ibid. p. 72

This raises a tricky issue. How to contain incomes inflation:

If the government is to constrain the rate of incomes inflation of domestically producible goods and services, it must somehow constrain the rise in the money income of inputs in the production process to improvements in productivity.

Ibid., p. 72

A tall order.

In the next sequel, I shall take a look with Paul Davidson at the two different approaches - the classic and the Keynesian - to containing incomes inflation.

Continued here.