On the trail of inflation and the fears of the same …

Today I’ve been following a document trail concerning the French government decision to adopt the so-called Barre Plan in 1976. This is part of the research on doing for my next book on why the Left abandoned progressive economic strategies and became what we now think of as austerity-lite merchants. I am hoping the manuscript will be finished by April 2016 and the book will emerge a bit later in the year. while the approach that will be taking is emerging, the strategy is to pinpoint key events in history where significant economic policy changes occurred and to analyse the rationale that was used to defend those policy shifts and to assess whether the circumstances that applied at those points in time provide any guidance to current day challenges. One of the big events that lead to deep uncertainty among Social Democratic politicians and their advisers, which arguably, was a key driver in the shift of these parties to the Right, was the Stagflation of the 1970s. The phenomenon of the simultaneous coincidence of accelerating inflation and rising unemployment had not previously been witnessed in the period following the Second World War. It needs a careful analysis because much of the popular understanding of this period and the claims that it demonstrated a failure of Keynesian policy approaches are incorrect and provide no basis for rejecting fiscal intervention to maintain full employment.

Like all research, this project follows a line of thinking, where the line gets thicker and longer the more deeply one ventures into the literature and the data.

My current book – Eurozone Dystopia: Groupthink and Denial on a Grand Scale (published May 2015), started out to be a planned manuscript of 200 odd pages but as the research process unfolded it became necessary to tie wider threads together than originally thought pertinent, which increased the size of the final output to 500 odd pages.

That’s why research is fun. Frustration but fun.

While today’s blog is not intended to be a definitive statement on what is a very complex period of history it does offer some of the elements in my current line of thought on this topic.

Let’s start with Raymond Barre, who was a French academic and later became prime minister of France (1976 to 1981). Prior to entering politics he was the vice president of the Commission of the European Communities (1967 to 1972) in addition to his academic role.

His role on the Commission was exemplified by his contribution to the Werner Committee process on economic integration, which reported in 1970.

After the Treaty of Rome 1957, which established the European Economic Community (EEC), there was regular discussion about the need for closer economic cooperation between the Member States.

In February 1969, the so-called Barre Report reaffirmed the European preference for fixed exchange rates and a move to a common monetary policy.

The Europeans were concerned about developments in world currency markets and the depletion of US gold reserves, in the context of the commitment by the US government under Bretton Woods to guarantee US dollar convertibility into gold.

During the 1960s, a large quantity of gold reserves shifted from the US to Europe as a result of persistent US balance of payments deficits.

There was a great reluctance to let go of the fixed exchange rate Bretton Woods system, which had organised international finance since its inception in 1945.

It was obvious that the system was doomed to failure.

The use of the US dollar as a reserve currency exposed the instability of the Bretton Woods system. The economist Robert Triffin warned in the early 1960s that the system required the US to run balance of payments deficits so that other nations, who used the US dollar as the dominant currency in international transactions, were able to acquire them.

In the 1960s, nations started to worry about the value of their growing US dollar reserve holdings and whether the US would continue to maintain gold convertibility. These fears led nations to increasingly exercise their right to convert their US dollar holdings into gold, which significantly reduced the stock of US held gold reserves.

The so-called Triffin paradox was that the Bretton Woods system required the expansion of US dollars into world markets, which also undermined confidence in the dollar’s value and led to increased demands for convertibility back into gold. The loss of gold reserves further reinforced the view that the US dollar was overvalued and, eventually, the system would come unstuck.

The way out of the dilemma was for the US to raise its interest rates and attract the dollars back into investments in US denominated financial assets. But this would push the US economy into recession, which was politically unpalatable. It was also incompatible with other aspects of US government policy, including its War on Poverty and its relentless, anti-Communist militarism (the development of NATO and the prosecution of the Vietnam War).

So already, in the late 1960s, Raymond Barre along with the then French Minister of Economy and Finance (later President) Valéry Giscard d’Estaing were shifting away from the traditional French Republican tradition, which eschewed handing over national sovereignty to European level decision making units, towards a line of thinking that was much more compatible with that of the Germans – a emphasis on inflation and monetary integration.

When Giscard d’Estaing defeated François Mitterrand in the 1974 presidential election, it became clear that he would impose his belief in free markets as the solution to international imbalances onto French national policy.

When Giscard d’Estaing appointed Raymond Barre as Chirac’s successor on August 23, 1976, he proclaimed “M. Barre est sans doute le meilleur économiste français, en tout cas un des tout premiers” (Mr Barre is without doubt best economist in France at least one of the best!). Barre was also appointed as Minister of Economy and Finance, a position he held until 1978.

The pair promoted a powerful anti Gaullist position with respect to domestic economic policy, reflecting their neo-liberal views, and moved the French perspective on ‘Europe’ closer towards the German ‘economists’ viewpoint.

In his speech to the French parliament upon taking up his role, Raymond Barre devoted a substantial portion to outlying his policy priority – “la lutte contre l’inflation” (the fight against inflation).

He argued:

la récession mondiale de 1975 a montré brutalement ce que coûtent la recherche systématique d’une croissance à tout prix et le renoncement aux équilibres fondamentaux.

That is, “the 1975 global recession demonstrated what happens when policy seeks growth at all costs and renounces the need for fundamental balances”.

He argued that restoring balance required “d’établir l’équilibre budgétaire et de modérer la croissance de la masse monétaire” (“balanced budgets and the moderation of money supply growth”).

He said the priority was to act on prices:

… d’abord par leur gel temporaire, puis par la réduction de la taxe sur la valeur ajoutée et une hausse limitée des tarifs publics …

That is, “first via a temporary freeze and then reducing VAT and limiting the increase in public tariffs”.

He claimed that it was a priority to maintain an environment where French export competitiveness was enhanete to allow the nation to compete more vigourously with Germany in trade.

He said:

L’esprit d’entreprise, c’est précisément celui qui conduit à l’émancipation et non pas à l’assistance. Il est indispensable à notre pays. C’est lui qui doit, notamment, permettre le renforcement de la capacité de notre économie à offrir des emplois stables et nombreux, mais il est clair que l’esprit d’entreprise ne peut se déployer si la liberté de décision des chefs d’entreprise est par trop limitée et si les résultats financiers des entreprises sont insuffisants.

Il nous faut réviser à ce sujet, et je le dis en toute objectivité, une conception du profit qui prévaut trop fréquemment dans notre pays. Celui-ci ne saurait être le produit de rentes de situation, de privilèges ou de subventions de l’Etat, mais le fruit des efforts de productivité et d’innovation. Utilement réemployé, il est la condition pour que les entreprises développent leur contribution au progrès économique et social.

So free enterprise liberates and is essential for the progress of the Nation. He also articulated the view that French policy regulations restricted entrepreneurship and restrained corporate earnings.

He wanted this to change and to create a policy structure where profits were driven by productivity rather than economic rents, privileges, or state subsidies.

But, it is clear that he led the charge on inflation-first policy innovations, which were characterised by cutting public spending in order to reduce the fiscal deficit, promoting exports and suppressing imports, and ensuring the French currency became stronger against the German mark.

He said that “the fight against inflation is now a prerequisite for national ambitions”.

The ‘Barre Plan’, introduced in 1976 and consolidated in 1977, involved a combination of tax increases on fuel, tobacco and alcohol, wage freezes to fight inflation, fiscal austerity, attacks on trade unions and industrial restructuring, particularly in the steel industry.

His approach exemplified what we now consider to be the neo-liberal way whereby government focused on maintaining a strong currency by suppressing domestic costs.

The focus shifted from regarding the fiscal balance as a reflection of the pursuit of functional ends, such as a strong domestic economy with low unemployment, to one where the balance became an objective in its own right and deficits were vilified.

Barre claimed that harsh fiscal austerity was necessary and that the economy would emerge stronger, with lower unemployment.

The ‘bitter pill now, better future health’ message he preached is strikingly similar to the policies and narratives that remain current today on both sides of the political fence.

His plans were met with strong resistance, not the least because the austerity was targeted at workers, leaving those who could evade taxes and enjoyed high incomes relatively unscathed.

Giscard d’Estaing and Barre thus beat the British Tories under Thatcher by a few years to the questionable fame of being the first Monetarist government along the lines espoused by Milton Friedman and the so-called University of Chicago boys.

But like Thatcherism, the so-called ‘Barrisme’ failed to achieve its stated purpose.

The economy deteriorated just as his Keynesian opponents had predicted. Economic growth came in well under the forecasts. The unemployment rate, which in 1976 was just over 4 per cent, rose to 5.2 per cent in 1978, and by the end of his Prime Ministership it had risen to 7.4 per cent.

Further, inflation was not reduced substantially and the currency continued to depreciate.

One commentator noted on the third anniversary of his Prime Ministership, that after three years of anti-inflation austerity, “Everything is more expensive, even the price of a baguette”.

It is true that the French economy, like much of the oil dependent world, was caught up in the second oil crisis in 1979, after the demise of the Shah of Iran upset oil supplies and world financial markets overreacted by pushing prices up far higher than was warranted by the actual contraction in supply.

But the Barre Plan had failed long before 1979 and the oil crisis just sealed his political fate (along with that of Giscard d’Estaing) and paved the way for Chirac to return.

However, as I argued in this blog – Mitterrand’s turn to austerity was an ideological choice not an inevitability – the path that Barre laid down was picked up in the early 1980s by the Socialist leader and it was that “austerity turn” that spooked the Left and things never recovered after that.

But the ground work was done for this “austerity turn” during the 1970s when nations struggled to understand the stagflation that followed the OPEC oil shocks.

In the 1970s, the high inflation that followed the OPEC oil price hikes was accompanied by high unemployment as governments tried to suppress economic activity to control the inflation. This era of stagflation provoked a major shift in economic thinking.

The Keynesian macroeconomic orthodoxy, that dominated the post World War II period, was predicated on the view that the total spending in the economy determined the level of unemployment.

Firms employed people if they had sales orders. After the cessation of the war and with the mass unemployment of the Great Depression of the 1930s still firmly etched in the minds of policy makers and the population, governments generally committed to using fiscal and monetary policy to maintain states of full employment where everybody who wanted a job could find one.

This led to an acceleration of prosperity across the advanced world.

We should be careful though to understand what this is ‘orthodoxy’ actually represented.

In the period after the publication of Keynes’ The General Theory in 1936, economists from the neo-classical tradition (for example, John Hicks) developed a popularised version of the narrative which essentially nullified many of the key points of departure that Keynes had emphasised in relation to his rejection of the orthodoxy of the time.

Instead, they incorporated some aspects of the General Theory into a neo-classical framework, which for example allowed them to conclude that unemployment was due to excessive real wages.

This blog is not the place to discuss this and I provide more discussion in this 2009 blog – Those bad Keynesians are to blame.

But is the macroeconomic orthodoxy in the 1960s and 1970s was referred to as the neo-classical synthesis and that way of thinking became the dominant approach in textbooks and policy discussions.

Accompanying this approach was a view that inflation would only result if the spending outstripped the capacity of the firms to produce goods and services, leaving them no option but to increase prices.

Accordingly, high unemployment should be associated with low inflation and vice versa.

So for economists operating in this tradition, Stagflation thus presented a new situation and a major quandary. They understood that unemployment could be easily prevented through demand-side stimulus, that is, more spending.

But they also thought that inflation was the result of too much spending – “too much money chasing too few goods”.

So how could policy deal with Stagflation?

However, there were economists in the post Second World War period who understood that inflation could also emerge as a result of sudden cost pressures (for example, imported oil price rises) which then squeezed existing profit margins and the real value of the workers’ wages, and under certain circumstances, could trigger a struggle between labour and capital over who would bear this loss.

Inflation would result if workers gained wage rises and firms responded by pushing up prices or vice versa. The correct policy response was to address the incompatible demands for more national income from labour and capital by seeking some sort of consensual approach to sharing the costs of the imported raw material price rise.

In my own PhD study, I investigated the work of Arthur Joseph Brown, an English economist, who in 1955 published his major work The Great Inflation, 1939-51, which was a wonderful explication of the way in which struggles between labour and capital over the distribution of national income could result in inflation.

He sought to understand and explain the underlying causes of inflation and said that to characterise the process as a:

… propensity of the community to spend more than its current income … does not throw much light upon the causes of inflation …

Brown saw the changes in real income shares as being a crucial determinant of inflation and that the motives for demanding “wages increases and price increases are connected to distribution” and that tje “aims of the two parties who are competing for the real income of the country or their success in achieving those aims” defines the wage-price spiral.

In other words, the inflation process results from incompatible claims on total nominal income by workers, and firms, which exceed the total available.

Workers negotiate real wage targets via money wage demands on firms, who in turn pursue some target markup (as a vehicle for a desired rate of return). Prices may be slow to adjust in a time of rising costs due to the costs of price adjustment.

If the sum of the claims exceeds national income, either or both parties may use their price-setting power to achieve their targets. Inflation is the outcome of the distributional conflict.

I won’t go into anymore detail about Brown’s work here except to say that if it had have been more widely accepted in the mainstream policy debate much of the wind that blew Monetarism (via Milton Friedman) into our lives would not have blown.

It is clear, that this understanding was lost on policy makers when responding to the OPEC oil price hikes and they sought to stifle the accelerating inflation by suppressing spending using policy measures we now refer to as fiscal austerity (public spending cuts and/or tax increases) and tight monetary policy (increasing interest rates).

The resulting stagflation created a perception that the ‘Keynesian’ policies had failed and bestowed a sense of legitimacy on the free market approach, which had claimed that inflation was the result of lax government policy. This view had been wholly discredited during the Great Depression by the work of John Maynard Keynes and others, but remained alive and well in the more conservative academic departments.

The result was that the long-standing dominance of ‘Keynesian’ policy was thus abandoned by a large number of economists in the 1970s.

American economist, Alan Blinder said that by:

… about 1980, it was hard to find an American macroeconomist under the age of 40 who professed to be a Keynesian. That was an astonishing turnabout in less than a decade, an intellectual revolution for sure.

The resurgence of the free market approach, which we now rather roughly refer to as neo-liberalism manifested initially as Monetarism, and Milton Friedman and his University of Chicago colleagues championed the entry of these ideas back into the mainstream policy debate.

Raymond Barre and his French government was certainly influenced by this paradigm shift in economic thinking.

But remember, the so-called paradigm shift in macroeconomic thinking from ‘Keynesian’ to Monetarist should not be interpreted as a failure of the State or a recognition that the State can no longer pursue domestic policies that ensure all productive resources, including labour, are fully employed.

That was the interpretation that was put on the shift and which was subsequently taken as doctrine by the Left along with other myths that I will discuss in subsequent blogs. But the shift was driven by ideology and a misrepresentation of what Keynes and other progressive economists believed.

We should also acknowledge that the spike in inflation that followed the outbreak of hostilities in the Middle East in October 1973 (the 1973 Arab Israeli War) and the accompanying oil embargo imposed by the Organization of the Petroleum Exporting Countries (OPEC) those serious, was not the first experience of inflation that the advanced economies had encountered.

Sure enough, when the Arab nations increased the price of oil by 17 per cent on October 16, 1973 and indicated they would cut production by 25 per cent as part of a leveraged retaliation against the US President’s decision to provide arms to Israel, this was a major shock to the world.

The price of oil rose by around three times within eight months and the US dollar appreciated by 17 per cent in the six months to February 1974, basically taking it back to the December 1971 value at the time of the signing of the Smithsonian Agreement.

Accompanying the rise in the US dollar was the major depreciation of the European currencies and the yen.

On 19 January 1974, the French government decided to float and exit the exchange rate arrangement in place at the time – the so-called ‘snake’ – because it was facing a major strain on its foreign exchange reserves as a result of its dependence on imported oil.

The inflationary surge accompanying both the oil price rise and the depreciating exchange values was significant.

But wages and prices had already been rising in the late 1960s, well before the OPEC cartel pushed up oil prices in 1973. These wage and price pressures persisted into the early 1970s.

The late British economist Nicholas Kaldor, who was located at Cambridge University, published an insightful article in The Economic Journal in 1976 entitled – Inflation and Recession in the World Economy – which provides further avenues for understanding the root cause of the Stagflation in the 1970s and the appropriate policy response that was required.

[Reference: Kaldor, N. (1976) ‘Inflation and Recession in the World Economy’, Economic Journal, 86(344), 703-714].

Most politicians on the Left-side of politics are probably unaware of Kaldor’s analysis.

Kaldor wrote that after a period of relative price stability following the Second World War “from about 1968 things began to change”.

He wrote:

The rise in labour costs per unit of industrial output began to accelerate in all the main industrial countries, though at differing rates. There was an increasing strain on the international payments system which led to the general abandonment of the system of fixed exchange rates in 1971. This was followed by rapidly rising commodity prices in the course of 1972 and 1973 … which preceded the sudden fourfold rise in oil prices following the Arab-Israeli war.

His explanation deployed an understanding of commodity buffer stocks and their role in maintaining stable prices. I have discussed this concept before in the context of the Job Guarantee, which is also a buffer stock approach to price stability.

The idea goes back in the centuries (Egyptians and grain stores, for example) and involves commodities being bought and stored when they are in surplus and sold when they are in deficit.

Kaldor distinguished between commodity prices, which he said were demand-determined and so-called industrial prices, which are cost-determined.

So when demand pressures rise for certain commodities (for example, oil) their prices rise and penetrate the industrial sector via their impact upon costs. Each stage of production is thus impacted.

The industrial sector is dominated by powerful firms with market-power which at the time interacted with powerful trade unions. Both sides – labour and capital – resist cuts to their real incomes arising from a commodity price increase that impacts on the broader industrial goods.

The industrial firms pass on the rising commodity prices through their markup at each stage of production, which boosts their profit share in real income but then triggers retaliatory wage demands by workers, intent on preserving their real wages.

The source of the problem was thus identified to be the behaviour of commodity markets and the increasing manipulation of them by speculation in the absence of significant government regulation.

Conclusion

Thus to understand the problem of inflation in a contemporary monetary economy, we also have to understand the behaviour of primary commodity markets, and the pass-through mechanisms whereby demand-determined price rises escalate through the cost structure of the economy and provoke conflict between labour and capital over the distribution of income.

I will return to that theme in another blog. That is the end of my line of thought today.

That is enough for today!

(c) Copyright 2015 William Mitchell. All Rights Reserved.