"The Keynes Solution" (8) by Paul Davidson - Keynes's New Thinking - Inflation (3)

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Continued from here.

"Classicals" versus (Post-)Keynesians

Davidson offers an intriguing juxtaposition of two rivalrous policy schools addressing incomes inflation: classical and Post-Keynesian. I find particularly striking his claim that 

• the classical approach simply and brutally sacrifices employment and economic buoyancy to keep inflation within a certain range, whereas 

• the (Post-)Keynesians, admitting that a policy that guarantees full employment will be facing recurrent inflation threats, whose containment they seek to attain by moral suasion, by appeal to the good sense of the involved parties or by an tax-based incomes policy that punishes employers who give in to wage demands that outstrip productivity increases.

Crux of Incomes Inflation

Let me remind us of the crux of incomes inflation:

Wage contracts typically specify a certain money wage per unit of time. This labor cost plus a profit margin or markup to cover material costs, overhead, and profit on the investment become the basis for managerial decisions as to the prices that must be received to make the undertaking of production profitable.

If money wages rise relative to labor productivity, the labor costs of producing output increase. Consequently firms must raise their sales price if they are to maintain profitability and viability. [...]

Clearly, to prevent incomes inflation, there must be some constraint on the rate of increase of money incomes relative to productivity.

Davidson, p. 73

The Politics of Incomes Inflation

For a blogger concerned with all aspects of freedom, it is interesting to note that it was for political reasons that

... rising money wage rates in most developed nations were a major factor in producing incomes inflation ... As the economist John Kenneth Galbraith noted: " The market with its maturing of industrial society and its associated political institutions ... loses radically its authority as a regulatory force ... [and] partly it is an expression of our democratic ethos."

Ibid. pp. 73-74

Is this not a case of freedom having unintended consequences? 

After the devastating experiences of the great depression, the emerging ethos of the common man in democratic nations held that people should have more control of their economic destiny. The great Depression had taught everyone that individuals cannot have control over their economic lives if they leave the determination of their income completely to the tyranny of the free market. Consequently, after World War II, in societies with any democratic tendencies, people not only demanded economic security from the capitalist system but also demanded that they play a controlling role in determining their economic destiny. The result was an institutional power struggle for higher incomes among unions, political coalitions, economic cartels, and monopolistic industries that led to an incomes inflation.

p. 74

Political freedom empowers new strata of society to make demands on the regulation of the economic sphere. Reacting to these demands, full-employment policy becomes a prime objective of politics. In attaining this objective, however, the beneficiaries of the full-employment policy are liable to exploit their new found security:

As long as the government guarantees that it will pursue a full-employment policy, all self-interested workers, unions, and business managers have little to fear that their demand for higher prices and money income will result in lost sales and unemployment. As long as the government accepts responsibility for creating sufficient aggregate effective demand to maintain the economy close to a full-employment level of output, there will be no market incentive to stop this recurring struggle over the distribution of income that results in incomes inflation.

Ibid., p. 74

Guaranteed full-employment amounts to the disappearance of Marx's "industrial reserve army" consisting of idle workers willing to offer their labour at prices lower than those demanded by inflation-pushing wage claims. 

"The Classicals" - Punishment by Monetary Policy

The classical approach avoids the problem of incomes inflation by barring government from assuming an intervening role, such as required by a full-employment policy, and leaving matters to the free market. Put more harshly: 

The classical solution to incomes inflation is to depress the economy.

Ibid. p. 75

After all not entirely without interventionist means, the classical solution is based on using monetary policy as a tool for punishing an economy that is venturing too far along the path of inflation.

[T]he nation's central bank can raise interest rates and thereby choke off borrowing and spending in the private sector.The result of this tight money policy will be that the profit opportunities will decline and employers will have to fire workers. With increasing unemployment, market demand for the products of industry will decline, and business firms will be every  wary of raising wages and/or prices. ... [In other words], the central bank will deliberately create a recessionary environment, threatening people's jobs, in order to force people to reduce their inflationary income demands.

Ibid. p. 76

In Davidson's view, classical anti-inflation policy is quite simply destructive.

In this way spreading fear and playing havoc with the economy, Davidson suggests that 

civil society is the first casualty of this war.

Ibid. p. 78

Davidsonian Incomes Policy

Davidson thinks he has a better approach to offer: taxed-based incomes policy (TIP), an idea that he has taken up from his professorial mentor Sidney Weintraub. 

TIP required the use of of the corporate income tax structure to penalize the largest domestic firms in the economy if they agreed to wage rate increases in excess of some national productivity improvement standard. Thus, the tax system would be used to penalize those firms that agreed to inflationary wage demands.

I cannot examine this proposal in any detail at this point. However, it does strike me as rather ambivalent - on the one hand, there is no doubt in my mind that we have to try to work out some rational compromise among the involved parties so as to limit inflation, not least because there will never be a truly laissez faire outcome in the matter. People do work the political and legal channels to twist the system in accordance with their interests. The demand for laissez faire is (though it may be appropriate) invariably an exercise in declaring certain forms of inaction as desirable while conveniently omitting to cast light on other forms of intervention that go on or whose results are in effect all the while.

On the other hand, I seem to sense enormous risks of detrimental manipulation in trying to put TIP into action. The issue of determining a national productivity improvement standards of itself seems to invite incompetence and abuse.

To be continued.