Official forecasters use econometric models which assume all markets return simultaneously to general equilibrium in the medium term. Cost-push inflationary surges are transitory and subdued by equally transitory higher unemployment. Financial markets never upset the applecart. History and theory demonstrate that disequilibrium rotates between product, labour, financial and traded goods markets. Some are always out of kilter at any one time. When one market corrects it distorts others. Forecasters must explain what is happening in terms of general disequilibrium. Here is a crude attempt to do so. The key message is income and wealth distribution matter.
Market equilibrium is illustrated graphically by curves. Movement along and shifts in curves are the vital ingredients, best explained by the labour market Phillips curve. This plots wages against unemployment. The more unemployment, the weaker wages. Fiscal and monetary policy cause movements along this curve. Tax cuts stimulate demand, reduce unemployment and raise wages, fuelling demand-pull inflation. Shocks, such as oil price explosions, shift the Phillips curve with more inflation at all levels of unemployment. This is cost-push inflation. Reducing inflation to its equilibrium moves unemployment above its equilibrium and vice-versa.
The Hicks-Hansen model shows how product and money markets come into equilibrium with each other. Ex-post savings always equal 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 slopes downwards, with lower rates meaning more investment and more output. In product markets, interest rates drive output via savings and investment.
In financial markets, output drives interest rates for a fixed quantity of money. Output determines the transaction demand for money. Higher GDP leaves less money available for speculative and precautionary purposes so interest rates rise. The liquidity preference-money supply (LM) curve slopes upwards. Product and financial markets are in equilibrium where the curves intersect. Shifts in the curves change the levels of output and interest rates at equilibrium. The Hicks-Hansen model does not include inflation or the Phillips curve.
How does help explain today’s stagflation?
After China opened up its economy and the Berlin wall fell, the global economy enjoyed cheap and plentiful labour. Globalisation shifted the UK’s Phillips curve, meaning less inflation for any given pressure of demand. Cheaper labour relative to capital meant less investment, causing a shift in the IS curve and slower growth at any given rate of interest – the so-called savings glut. Slower growth, with an unchanged quantity of money, led to a movement down the LM curve. Lower interest rates were a consequence of slower growth, not a cause of faster growth.
The fiscal policy option to restore growth was increased spending or reduced taxation, running the economy hotter thanks to reduced inflation. The monetary option was to increase money supply and reduce interest rates further causing disequilibrium in financial markets and serial 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 exacerbated financial disequilibrium, greatly distorting asset prices relative to product prices. Not only was it then cheaper to employ more labour and less capital, but it was also safer and more profitable to buy existing assets rather than to produce new ones.
Pre-2020 UK tax and spending policies brought public sector deficits and debts to unacceptable levels, leading to corrections. Fiscal policy substantially increased income inequality, notably through cuts to progressive benefit spending and shifts to less progressive spending taxes. Monetary policy and asset price inflation have substantially increased wealth inequality. The bill for financial disequilibrium and inequitable income and wealth distribution is about to be presented through the resurgence of stagflation.
Covid-19 was a severe supply side shock, made far worse by Russian President Vladimir Putin’s war in Ukraine. The Phillips curve was dramatically shifted. UK cost-push inflation is now rampant, since inequitable income and wealth distributions mean few households are willing and able to lose income or continue to spend out of savings and credit. Moreover, most households must pay more for any increased spending through regressive taxes, exacerbated by proposed income tax cuts.
The intensity of the 2020s wage-price spiral is potentially as great as in the 1970s because of inequitable income and wealth distribution. The danger of depression is much greater thanks to financial market disequilibrium. Higher interest rates are inevitable because of the Bank of England’s policy obligations. Recession and brutal strikes mean indexation, especially of linked bonds, will deny the public purse an inflation bonus. A dramatic financial market asset price correction must follow and not from increased real incomes.
Income and wealth distributions are at the heart of the matter. They are totally neglected in official forecasts and policy planning. The Office for Budget Responsibility should be required to report on the distribution consequences of fiscal policy and the Chancellor of the Exchequer should aim to reduce Gini coefficients.
Brian Reading was Economic Adviser to UK Prime Minister Edward Heath and the first Economics Editor of The Economist in 1972. He is a Member of the OMFIF Advisory Board.