What’s So Terrible About Inflation?

April 1 1970

What’s So Terrible About Inflation?

April 1 1970

THE TIME HAS COME to take a hard look at inflation, and to reject the blind panic with which our federal government is reacting to this economic phenomenon. We are being told that inflation is a terrible thing. Prime Minister Trudeau suggests it is so terrible it would be better to raise the level of unemployment in Canada than to endure more inflation. To an economist, what is irritating about that stance is not merely its inequity — when the unemployment rolls go up, you will find no cabinet ministers among the casualties, no bank presidents, no company managers — but its futility and danger.

Ottawa’s view is that rising prices rob us all, but particularly the poor, and those on fixed incomes, and that if we don’t halt the spiral by producing economic slack and unemployment today, we will pay with even more unemployment tomorrow, because our goods will become too expensive for world markets. I have been studying inflation in Canada for three years, and, while I don’t like to oversimplify my conclusions my doctoral thesis takes more than 200 pages to document many of the things I’m going to say here without qualification I think I can say that Ottawa’s view is just wrong.

I am not arguing that inflation is good, but that it may well be inevitable in a full-employment economy; if we would learn to accept it and plan for it, we would be better off than we are today, undertaking drastic anti-inflationary measures that may do far more harm than rising prices.

The federal government has already been told this by a body well qualified to know, the Economic Council of Canada. In its most recent report, the council noted, “Further fiscal and monetary restraint could conceivably result simply in higher rates of unemployment and economic slack with no more than marginal effects on current rates of increase in prices and costs.” What is more, the council warned, restrictive measures applied today will have their main impact in six months to a year from now, when a mild recession is expected in both Canada and the U.S.; they will tend to intensify the hardships imposed by that coming down| turn. The current plan, apparently, is to wait until the fire in our economic house is out, and then go in and kick down all the doors to keep the flames from spreading.

The Prime Minister and Finance Minister E. J. Benson have chosen to ignore the Economic Council because, like so many Canadians, they are the victims of a series of myths that make up conventional economic wisdom. (Among the staunchest defendants of this conventional wisdom are the business editors of most Canadian newspapers, which explains why business and government leaders can mouth palpable misconceptions about economics and be received as if they were unrolling divine writ.) The first of these myths could be called the Ah, Yesterday! Syndrome. We know, most of us, that our incomes have improved over the years, and we know that prices have advanced, but we don’t see the connection between the two. We can’t help thinking that if we had today’s wages at yesterday’s prices, we would be rich. The truth is that our economy doesn’t work that way. It never has and it never will. If your wages go up 10 percent and prices advance five percent, you feel you’ve been robbed; but without the price advance, your increase would probably have been only five percent. We talk about the declining value of our dollar; what really matters is rising real value of our income.

Consider for a moment what inflation is and how it is caused. Inflation is simply a general and persistent rise in prices. When these go up too much and too fast, the effects on the economy may be disastrous; when, instead of taking a walletful of money to buy a wheelbarIrow, it takes a wheelbarrowful of money to buy a wallet, the results are bound to be unsettling for everybody (with the possible exception of wheelbarrow manufacturers). But because runaway inflation poses a serious threat, it does not follow that every upward price movement promises runaway inflation. For the past few years, Canada has been experiencing price rises of about four or five percent per year. That’s inflation, but it is not runaway inflation, and it is counterproductive — to use a term much in vogue in Ottawa these days — to treat it as if it were. Our political masters haveheard the baby crying; they are resolved to meet the emergency by garroting it.

Inflation occurs when the demands of the economy approach the capacity of industrial plants and the labor force to produce them; there are more dollars chasing goods and services than there are goods and services available, and the price of these commodities tends to rise. Inflation is a product of a full, or nearly full, economy. It was once thought possible to have both full employment and stable prices, but we now know that is not the case. Even before full employment is reached, prices may start to rise, because of bottlenecks in particular sectors of the economy. Our choice today is between a burgeoning economy and some degree of price rise or a slack economy and some degree of price stability.

Everything I have said so far applies to inflation anywhere in the world, but we in Canada face the special problems of being neighbor to the United States, and the victim of spillover from the ups and downs of the American economy. When demand in the U.S. is on the upswing — as it has been through the Vietnam War period — we are unable to inIsulate ourselves from its effects, both real and psychological. By real, I mean that our exports to the U.S. increase, creating more jobs and fatter prices; by psychological, I mean that our manufacturers look across the border, see higher prices coming, and raise their own, and that our unions respond to the same magnetic pull. No action taken in Canada is really likely to stem imported inflation. Bear this in mind when considering that oft-offered panacea, wage-and-price controls. There are two difficulties to the control approach. The first is the problem of administering such a complex system fairly. Price and wage limits bear on only some segments of society; they don’t, for instance, control profits, or investment incomes, or incomes from rent, managerial salaries or professional fees. It would make more sense to establish an incomes control, covering everybody, but the Economic Council, after a study of this possibility, concluded that incomes control couldn’t work in a nation as decentralized as our own. The more fundamental difficulty, however, arises from the fact that any controls would tinker with the symptoms rather than the causes of inflation. Since these causes are mainly external to the Canadian; economy, an elaborate system to control wages and prices might be merely an exercise in futility.

But we are being pushed toward this futile exercise by the operation of the Ah, Yesterday! Syndrome, reinforced by another misconception, which suggests that those on low and fixed incomes are those most hurt by rising prices, while those at the top of the economic heap are the least affected. (It is this misconception that allows our Prime Minister to assure those he proposes to throw out of work that he is doing it for their own good.) That is not precisely true. My own research suggests that the distribution of income is not fundamentally altered by inflation or recession. Those who fare badly when money is plentiful also fare badly when it is scarce. In fact, ironically, they may do better in times of inflation because then, and only then, is attention drawn to their condition. If we look at one group of these people — old-age pensioners — the argument will become clear. In times of rising prices, pensioners are handicapped, it is true, by the fact that they must meet increased costs from fixed incomes. But when prices are stable, they are still at a disadvantage. Other groups in the economy are able to bargain for, and receive, increased incomes, pensioners are not, so that their share of the national income continues to fall. Their best chance of improvement comes during inflation, when their plight is more visible, and money is available to meet it. It was in the boom year of 1957 that pensioners received what amounted to more than a 30 percent increase in government support; their share of the national income was raised, not lowered. In short, the problem of the poor and elderly is not the price squeeze, but our miserly treatment of them in fair times and foul. They are not helped by government austerity programs that begin — as they all begin — by freezing welfare payments.

When we look at the other end of the economic scale we find, once more, just the opposite of what we have been led to expect. People anticipate inflation today, and they protect themselves by demanding higher wages and higher interest rates on loans as a hedge against coming price increases. From a corporation's point of view, this means that the costs of production rise, just as prices do. At the same time, depreciation allowances, which are fixed on an original cost basis, do not rise. In effect, companies are paying taxes on a higher proportion of their profits, which cuts into the aftertax profits in real terms, and this reflects itself in lower stock prices — as we have seen recently in Canada. In general, only the wealthy own stocks in significant quantities, so the net result is that inflation tends to distribute wealth more evenly.

We are being told today that the hardest hit victims of inflation are those on low incomes — which is not strictly true — and that to meet their needs we must bear down on these same people, by throwing them out of work — which makes no sense at all. Rather than braking the entire economy to let the poor catch up, it would seem more reasonable to share with them the benefits of expansion by tying minimum wages, pensions and other transfer payments to a cost of living index. This is not a wild, Utopian plan; comprehensive index systems already exist in many nations, including Denmark and Sweden, and, by and large, they work well. In Canada we are not willing to go quite so far. Instead, we offer old-age pensioners a maximum two percent cost-of-living adjustment even though prices are rising at double that rate. This is a cruel and perverse deception.

We must also remember that the battle against inflation is not costless. To stop prices from rising, classic economics tells us, we must create slack in the economy, which means throwing people out of work, and that is precisely what Prime Minister Trudeau has suggested. But unemployment exacts a terrible price. Every percentage point of increase in the rate of unemployment, because it means plants not used, workers not paid, goods not consumed, costs us about two billion dollars per annum in terms of Gross National Product.

Moreover, the billions we lose represent only a small part of the price we pay. Joblessness is never equally distributed in Canada; it tends to strike hardest in the Maritimes and Quebec, softest in Ontario, which means that those areas that can afford it least are asked to pay most, with possible consequent effects on national unity. If Quebec workers are asked to pay for the protection of the affluent of Ontario, they may not take kindly to the idea. Unemployment is demoralizing not only for the nation, but for individuals as well. Some people become unemployable after long periods of not working; they are, in general, those who are the least trained and poorest paid among us. Economic slack bears particularly hard on young people, who come out of school looking for a job, find none, and become progressively more bitter and less adaptable to the demands of job training. Finally, in times of full employment, the incentive for an individual worker to improve himself through retraining and after-hours education is strong; when jobs are scarce, the opposite is true. Why, for instance, should a New Brunswick fisherman take a plumbing course to fill a position he knows won’t exist when the course is finished?

All this being true, why do we turn so readily to unemployment as a cure for the ills of inflation? Because it is a sacrifice to be made by somebody else. Joblessness is not a threat to bankers, politicians and Chamber of Commerce presidents; it is a threat to the steelworkers of Hamilton, the lumbermen of Corner Brook, the shop clerks of Vancouver. When the economy goes slack, none of us in the middle and upper ranks is likely to be hurt; we can bear the anguish of those below with that stoicism we reserve for the ills of others. Let them pay for our Ah, Yesterday! Syndrome.

Another of our myths might be called the Fallacy of the Discriminating Dollar, which insists that government spending is somehow different from private spending in its effect on the economy. Thus, at times of price pressure our industrial captains can, at the same time, hail as worthy and wholesome a huge increase in private investment and damn as devilish and inflationary a similar increase in public spending. The $175 million spent by Ford and Chrysler last year to retool for new-model cars was, by the terms of this myth, good, while increased expenditure on education is bad. The promise of a new industry will wring huzzahs from the breasts of politicians, merchants and bankers, while a proposed increase in government spending on, say, art centres will furrow the brows above those very same breasts. In fact, of course, it doesn’t matter whether money is spent in the public sector, by government, or in the private sector, by individuals and companies; in terms of its effect on the economy, there is only one question: how much? When we want to cut back spending, we must look at all spending, and the decision on where to cut back should be based on social priorities and not on the misguided view that public spending is inflationary and private spending is not.

A final myth — perhaps the governing one — holds that government spending is bad, and private spending good, bej cause the former decreases our freedom of choice, while the latter enhances it. ; This Free Choice Fable would have us believe that any tax increase is inherently harmful, because it limits our ability to choose between a new car and a new television set. In fact, the opposite may be true; greater government revenues may allow us to choose between a new car factory and a new school, between financing another television station and improving the quality of Canadian cities. Our devotion to the free-choice myth means that when we come to deal with inflation, our first reaction is to cut government expenditures and fire civil servants, even though those expenditures and those civil servants may be directed toward more socially useful ends than their opposite numbers in the private sector. The myth goes even further, and argues that government spending for the public good may be bad, but government spending for the private sector may be good. When the decision to postpone Medicare for a year was taken in 1967, we were told the step was necessary to combat inflation. At about the same time, Canada plunged into color television, at a cost roughly comparable to the initial cost of Medicate, and with enormous cash benefits involved for private industry. Why? There is no reason, there is only a myth.

When we link together all the myths that guide us, our response to inflation becomes very limited indeed. Because of the Ah, Yesterday! Syndrome, we are bound to measure only the bad effects of rising prices, and to miss the essential connection with rising - money incomes. Having determined, therefore, that Something Must Be Done, we approach the task crippled by our other myths. We can tinker with monetary policy — the supply of money available — and we have done so, but because the major source of inflationary pressure comes from the U.S. this technique is bound to be limited in its effect. We can tinker with fiscal policy — the raising and spending of public funds — but only within the bounds of our mythology, which demands that we begin by cutting government expenditures and end by leaving the tax rate alone. We are disqualified, in short, from doing anything really effective except to provoke a mild recession, with consequent unemployment to be borne by somebody else.

What, then, should we do about inflation? My first suggestion is that we take a long look at it, and decide for ourselves whether it is so dangerous that we must bend every effort to halt it. Any such examination should bear in mind that our competitors in other industrialized nations are also undergoing a period of rising prices, and it is simply not true that we are in danger of pricing ourselves out of world markets. Even if it were true, we could protect ourselves by returning the Canadian dollar to a flexible exchange rate. (Today, Canada is bound to keep the dollar, within narrow limits, at a fixed rate of exchange with the U.S. dollar.) No matter how much or how little trade we have — and in essence that is what controls the demand for our dollar — it remains constant in value. If prices inside Canada go up, our goods become more expensive on world markets, and trade falls. With a flexible dollar, internal price shifts would not have the same effect.

Let’s look at a specific example. A Canadian hat manufacturer has been selling his product in New York for five dollars, but because of a rise in the price of goods and labor in Canada, he is forced to raise that price to six dollars. Demand for this more expensive hat falls off, and, since this is happening all across the economy, demand for Canadian goods, and dollars, falls off. The price of the dollar then declines, relative to the American dollar, and the U.S. purchaser can now buy the hat for the same amount in his own dollars as before, so demand goes back to normal.

It would be nice if, all other things being equal, prices didn’t rise; but since all other things aren’t equal — if we want stable prices, we must pay for them in unemployment; if we want full employment, inflation is pretty well inevitable — so we must make some allowance for it, by tying minimum wages and transfer payments to a realistic, comprehensive cost-of-living index. The cost of this would be far less than the cost of the six-percent unemployment the government is apparently willing to tolerate.

In sum, the current government approach seems to me wrong on every count. It is wrong because we should be pursuing the reality of prosperity, not the chimera of stable prices. It is wrong because the measures being used to combat inflation are either unworkable, as in the appeal for voluntary price-and-wage restraints (a minimum of reflection will show that there is no incentive for the individual company or union to abide by such restraints for any extended period of time, and every incentive to try to move ahead while competitors are standing still) or irrelevant because, basically, the speedup or slowdown of our economy is tied to activity in the U.S. Our approach is wrong, finally, because it asks the poorer sectors of the economy to pay with their jobs, their money and their dignity. Rather than fault the authorities for tolerating a decline in the value of money, we should instead question the policies that deliberately condemn 350,000 people to remain without work.