Official forecasters use econometric models that assume that all markets simultaneously return to general equilibrium in the medium term. The cost-driven inflationary surges are transitory and mitigated by an equally transitory rise in unemployment. The financial markets have never upset the applecart. History and theory demonstrate that the imbalance revolves between the product, labor, financial and traded goods markets. Some are always out of step at some point. When one market corrects, it distorts the others. Forecasters need to explain what is happening in terms of the overall imbalance. Here is a crude attempt to do so. The key message is the question of the distribution of income and wealth.
Market equilibrium is illustrated graphically by curves. Movement and curve shifts are the essential ingredients, best explained by the Phillips curve of the labor market. This plots wages against unemployment. The more unemployment there is, the lower the wages. Fiscal and monetary policies cause movements along this curve. Tax cuts stimulate demand, reduce unemployment and raise wages, fueling demand-driven inflation. Shocks, such as oil price explosions, shift the Phillips curve with more inflation at all levels of unemployment. This is cost inflation. Reducing inflation to its equilibrium raises unemployment above its equilibrium and vice versa.
The Hicks-Hansen model shows how commodity markets and money markets balance out. Saving ex post always equals investment, and the rate of interest determines the level of gross domestic product at which they do so. This is called the IS curve. Interest rates are plotted on the vertical axis and GDP on the horizontal. The IS curve has a downward slope, with lower rates meaning more investment and more production. In product markets, interest rates stimulate production through savings and investment.
In financial markets, production determines interest rates for a fixed quantity of money. Production determines the transaction demand for money. Higher GDP leaves less money available for speculative and precautionary purposes, so interest rates rise. The preference curve for liquidity and money supply (LM) has an upward slope. Commodity and financial markets are in equilibrium where the curves intersect. Shifts in the curves alter output levels and equilibrium interest rates. The Hicks-Hansen model does not include inflation or the Phillips curve.
How does it help explain today’s stagflation?
After China opened up its economy and the Berlin Wall came down, the global economy benefited from cheap and abundant labor. Globalization has shifted the UK’s Phillips curve, meaning less inflation for any given demand pressure. Cheaper labor relative to capital meant less investment, leading to a shift in the IS curve and slower growth at a given rate of interest – the so-called savings glut. Slower growth, with an unchanged quantity of money, led to a downward movement of the LM curve. Lower interest rates were the consequence of slower growth, not the cause of faster growth.
The fiscal policy option to restore growth was to increase spending or cut taxes, which stimulated the economy through reduced inflation. The monetary option was to increase the money supply and further reduce interest rates, thereby causing financial market imbalances and a series of financial crises. The dotcom bubble burst in 2000. The financial crisis followed in 2008, threatening a new depression. The shift to zero interest rate policies and quantitative easing has exacerbated the financial imbalance, severely distorting asset prices relative to commodity prices. Not only was it then cheaper to employ more labor and less capital, but it was also safer and more profitable to buy existing assets rather than produce new ones.
The UK’s pre-2020 tax and spending policies have driven public sector deficits and debt to unacceptable levels, leading to corrections. Fiscal policy has dramatically increased income inequality, including by reducing progressive benefit spending and moving to less progressive expenditure taxes. Monetary policy and asset price inflation have dramatically increased wealth inequality. The bill for financial imbalance and the inequitable distribution of income and wealth is about to be presented through the resurgence of stagflation.
Covid-19 has been a severe supply-side shock, compounded by Russian President Vladimir Putin’s war in Ukraine. The Phillips curve has been shifted significantly. Cost inflation in the UK is now rampant, as the inequitable distribution of income and wealth means that few households are willing and able to lose income or continue to spend savings and credit. Moreover, most households have to pay more for any increase in spending through regressive taxes, made worse by the proposed income tax cuts.
The intensity of the wage-price spiral of the 2020s is potentially as strong as in the 1970s due to an inequitable distribution of income and wealth. The danger of depression is much greater because of the imbalance in the financial markets. Higher interest rates are inevitable due to the political obligations of the Bank of England. The recession and brutal strikes mean that indexing, especially of linked bonds, will deprive the public treasury of an inflation premium. A dramatic correction in asset prices in financial markets must follow, not an increase in real incomes.
The distribution of income and wealth is at the heart of the problem. They are totally neglected in official forecasts and policy planning. The Office for Budget Responsibility should be held to account for the distributional consequences of fiscal policy and the Chancellor of the Exchequer should work to reduce Gini coefficients.
Brian Reading was economic adviser to British Prime Minister Edward Heath and first economics editor of The Economist in 1972. He is a member of the advisory board of OMFIF.