Neither oil price shocks nor higher wages cause rising consumer prices

Christopher Lingle , Luxembourg | Tue, 07/22/2008 10:14 AM | Opinion

With so much evidence of rising inflationary expectations, much attention is being paid to the higher oil prices the potential for higher wage settlements to push up consumer prices.

These fears reveal a common mistake of economic analysis that rising costs, either due to demands for higher wages or higher commodity prices, are the cause of rising consumer prices.

As it turns out, inflationary pressures have nothing to do with whether wage demands are held down or not or if there is a spike in oil prices or other input for production. A common misunderstanding of the nature and cause of inflation arises from a mistaken belief that prices are determined by costs.

Following this line of reasoning, increased operating costs by businesses will lead to higher prices. In such a world, consumers are unable to resist higher prices and would passively accept them in such a manner that no company would go bankrupt.

But in the real world, firms file bankruptcy when they are unable to pass rising costs on to consumers because the valuation of the goods they sell is inextricably linked to demand. And since consumer utility ultimately determines price, the direction of cause-and-effect is such that it prices that determine costs, rather than the reverse.

Given that the value of goods depends upon satisfying human wants, prices can rise only if consumers perceive a sufficient value relative to the price of a good or service. This means that when more is demanded, more will be produced so that changes in the demand for goods or services also influence the demand for the inputs used to produce them. And so the cost of inputs can rise when the demand for finished output rises.

The suggested relationship between inflation and wages implies that central banks must increase interest rates to counter the inflationary effects of wages increases. But this piece of conventional wisdom ignores some basic precepts about how markets work and how prices and wages are set.

In the first instance, there is an implication that the quantity of money is passive and adjusts itself to accommodate wage increases or rising commodity prices. However, the reverse is true in that money wages (and commodity prices) rise when there is an excessive expansion in credit or the money supply.

When wages are set through the forces of supply and demand, laborers tend to earn the full value of their marginal product reflected by the market price of the output they produce.

As such, the demand for labor reflects the marginal value of labor services over a given range of prices. If labor costs exceed the market-clearing price, unemployment will rise. This is because attempts to push up labor costs will stifle increases in productivity by inhibiting capital investment so that unemployment would rise.

Without an expanded money supply or fresh credit, an increase in wage rates or other costs in one sector will cause wage rates and costs in other sectors to fall. As capacity is shifted elsewhere, there will be a rise in unemployment in some sectors.

A general rise in wages (or prices) can only occur if central banks induce an inflationary expansion of money and credit.

Perpetuating the mistaken views about the relationship between inflation and increases in prices or costs interferes with setting appropriate monetary policy.

Since wide fluctuations in bond yields, higher mortgage rates and rising interest rate expectations, asset bubbles and devalued currencies are all caused by an inflated currency, one cannot cause the other.

As it is, economists unanimously agree that a general rise in prices causes resources to be misallocated and encourages speculative sprees that destroy wealth. It also harms those on fixed and low incomes and anyone whose income does not rise rapidly enough to offset the price rises.

But increasing money supply growth also inflicts damage on all wealth generators by allowing nothing (new credit) to be exchanged for something (real goods and services). This is because inflationary monetary policy causes real funding to be diverted away from wealth generators towards those with newly-created money or credit. And so the real problem of the misallocation of resources is due to these distortions rather than rising prices, per se.

Inflation previously referred to increasing the quantity of money and bank notes in circulation and the quantity of checkable bank deposits. Now it is used to depict of the inevitable consequences of inflation, principally the tendency of all prices and wage rates to rise.

Mis-specifying inflation as a general rise in prices allows whatever might be associated with price level increases to be deemed as inflationary. A problem with this logic is that it implies that neither central banks nor the fractional-reserve banking system are the basic source of inflation. Instead of central banks rightly being seen as being behind price instability, they begin to be portrayed as protectors against inflation brought about by other imaginary causes.

Inflation should not be considered to be a general rise in consumer prices nor should rising consumer prices be associated with higher production costs. Properly understood, inflation is a rise in money supply growth that leads to macroeconomic imbalances ranging from falling currency values to bubbles and rising consumer prices.

The writer is Research Scholar at the Centre for Civil Society in New Delhi and Visiting Professor of Economics at Universidad Francisco Marroquin in Guatemala.

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