Groucho Marxism

In a previous blog post, I derived the following simple expression for the price level: p = vw(1+H/wu), where v is the value of labour (that is, the inverse of labour productivity), w is the average wage, H is total profits, and u is the level of employment. I also derived the following expression for total profits, known as the Kalecki profit equation: H = C_H+I+G+N–S_L–T_L, where C_H is consumption out of profits, I is investment, G is government spending, N is net exports, S_L is saving out of wages, and T_L is taxes on wages. From these expressions we can deduce that an increase in the price level can be caused by an increase in the value of labour, the average wage, consumption, investment, government spending, or net exports, or a decrease in the level of employment, saving out of wages, or taxes on wages.

As an increase in the average wage can cause an increase in prices, many commentators argue against wage increases during times of inflation and point to the possibility of a ‘wage-price spiral’. This is where an increase in wages causes an increase in prices, which causes a further increase in wages, and so on. There are a few problems with this argument however. First, note that we can write p = vw(1+m), where m = H/wu is the referred to as the average markup. As the average wage appears on the denominator of the profit rate, an increase in wages will result in a decrease in the average markup, which will reduce the impact on prices. Second, note that increasing the average wage will also increase saving out of wages, which will reduce profits and also reduce the average markup.

These technical considerations aside, it is clear that an increase in the average wage will still in general lead to an increase prices. But we need to bear in mind that inflation is bad mainly because it means workers cannot afford to buy goods and services; if wages keep up with inflation, this is not a problem. In fact, if wages were indexed to prices, inflation would arguably be a good thing, as inflation erodes the real value of debts, which means that it is good for debtors and bad for creditors. Debtors tend to be poorer than creditors, so if wages were indexed to prices, inflation would result in a redistribution of wealth. This is the real reason that central banks raise interest rates in times of inflation: to compensate rich creditors.

The idea that increasing employment will reduce prices runs counter to the logic of the so-called ‘Phillips curve’, named after the economist William Phillips, which posits a positive relationship between employment and inflation. The reasoning behind this is that an increase in employment gives workers more leverage to bargain for higher wages, and, as we have seen, higher wages mean higher prices. (Phillips’ original paper actually only demonstrated the first link, between employment and wages.) The problems with the ‘higher wages implies higher prices’ argument have already been discussed. In addition, the ‘higher employment implies higher prices’ argument ignores the fact that higher employment also means a lower profit rate.

To see this, note that the level of employment appears in the denominator of the profit rate (see above). In fact, what appears in the denominator is the product of the average wage and the level of employment. But this only strengthens the point, as if wages increase in response to an increase in employment, this product will increase even further, which will result in an even bigger decrease in the profit rate. Intuitively, this makes sense: higher employment means a greater supply of goods and services, and therefore lower prices. Thus, on the one hand, increasing employment will decrease the profit rate; but on the other, it will increase wages, as Phillips demonstrated. It is therefore impossible to say whether an increase in employment will cause an increase or a decrease in prices.

The preceding argument demonstrates that trying to fight inflation by increasing unemployment – as governments have sought to do for some time now – makes little sense. So what should governments do to combat inflation? We might conclude from the above that the most effective way for a government to curb inflation is to increase taxes on wages. However, as firms set prices, it seems unfair to punish workers if firms set their prices too high. Also, a tax on wages would mean that workers are less able to afford goods and services, which, as noted above, is the main reason inflation is a problem in the first place. There is an alternative though: a government can intervene directly by imposing price controls, an idea put forward recently by the economist Isabella Weber.

If total profits remain constant, it follows from the analysis above that introducing price controls will result in an increase in employment; conversely, if employment remains constant – for example, if the economy is already at or near full employment – introducing price controls will result in a reduction in total profits. Either of these would be considered a desirable outcome at present. We have seen that the traditional approach to combating inflation by increasing unemployment makes little sense theoretically. Moreover, to the extent that it works in practice, it involves replacing one problem (inflation) with an even worse problem (unemployment). To ensure price stability in a way that doesn’t unfairly impact on workers, governments must take a more direct approach.