Inflation is a supply-side problem

When you damage the supply side of an economy, the result is inflation.

This ought to be obvious. But forty years of monetarist orthodoxy seems to have rendered people unable to see the obvious.

When the supply of a good is disrupted, there isn’t enough of it to meet existing demand. So the price rises, driving poorer people out of the market and thus reducing demand to the level at which the supply is sufficient.

Of course, a price rise due to disrupted supply in a single good doesn’t necessarily cause inflation. Inflation is a rise in the general price level across the whole economy. So if the price rise in that good is offset by price falls in others, there won’t be any headline inflation. But this doesn’t necessarily mean there isn’t inflation anywhere in the economy. For example, if prices of essential foodstuffs are rising but prices of designer handbags and iphones are falling, poorer people will experience inflation even if headline inflation is zero. This unfortunate distributional impact of price rises can lead people to reject official inflation figures because they do not accord with their own experience.

A damaged supply side necessarily causes inflation, all other things being equal.

But when the entire supply side of an economy is damaged, there is insufficient supply of goods and services in general to meet demand. So there is inevitably a rise in the general price level. A damaged supply side necessarily causes inflation, all other things being equal.

Milton Friedman’s famous statement that “inflation is always and everywhere a monetary phenomenon” appears to imply that inflation due to supply-side damage either doesn’t happen or is short-lived. But for some reason, the second half of his statement is almost always omitted. The complete quotation says:

 “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

During the pandemic, governments and central banks between them vastly increased the quantity of money in circulation. Simultaneously, large parts of the supply side shut down, either by government order or simply because of lack of demand as people stopped socialising and stayed in their homes.

Consumer prices fell during the pandemic, though this largely went unnoticed.

Clearly, the money supply was increasing much faster than output – in fact output shrank considerably. But there was no inflation. To the contrary, consumer prices fell during the pandemic, though this largely went unnoticed – after all, if you weren’t allowed to drive anywhere, or even leave your house, how would you know that the price of petrol had fallen below £1 per litre?

Despite the exorbitant monetary stimulus, the pandemic was a period of deflation. But this does not mean that Friedman was wrong. Inflation was merely delayed, not absent. Much of the new money that went into circulation was saved. And much of it went into asset markets, vastly increasing prices. Supply and demand economics work in asset markets too.

It was always inevitable that there would be inflation when the economy reopened after the pandemic and the demand that had been suppressed by lockdowns and other restrictions reasserted itself. Governments and central banks had kept people alive, but they hadn’t paid enough attention to supporting the supply side. Many businesses had closed, never to reopen. Those that survived were forced to put in place covid-safe measures that raised their costs and reduced their capacity. Many experienced staff shortages because their former staff had taken new jobs in pandemic growth sectors such as healthcare and delivery driving, or had left the workforce out of fear of infection. Severe disruptions to shipping and transport networks raised the price of goods such as lumber.

It’s actually good for there to be a period of high Inflation in the aftermath of a severe deflationary shock.

We’ve become accustomed to thinking of inflation as a terrible evil that must be avoided at all costs, but it’s actually good for there to be a period of high Inflation in the aftermath of a severe deflationary shock. It indicates that the economy is recovering quickly. Inflation is the rate of change of prices, so when prices rebound quickly from abnormal lows, the rate of inflation can be very high. This is known as the base effect. It is short-lived and should be ignored by central banks and journalists. Sometimes the price briefly overshoots before falling back to the level it had been before the abnormal price fall. This too should be ignored.

It’s also not a bad thing for demand to outstrip supply when the supply side has been weakened by a shock. An excess of demand incentivises business investment, which is essential for supply-side recovery. Raising interest rates to dampen inflation when the supply side is damaged restricts business investment. It is bad policy. Better to tolerate higher inflation and enact policies that help the supply side to recover, such as cutting taxes and reducing red tape for small businesses.

But the present inflation in the UK has a darker side. Rising barriers to trade, a tight labour market due to immigration restrictions, and a falling exchange rate all contribute to inflation, and unlike the pandemic-related inflation, their effects are neither benign nor short-lived. Brexit is inflationary.

And inflation is going to get worse. We now have a war between a major producer of fossil fuels and one of the world’s biggest exporters of essential foodstuffs. Supplies of gas and grain are already  seriously reduced, and prices are rising rapidly. And Western sanctions on Russia are disrupting global supply chains. Even though the UK is not directly involved in the war, the global impact means higher energy prices, higher fuel prices, and higher prices for food and other consumables.

Furthermore, output directed at producing the means to blow up another country is fundamentally unproductive. The UK government’s plan to increase defence spending might improve national security, and it could even reduce the whopping trade deficit somewhat if the UK sells armaments to Nato frontline countries, but it will do nothing to help domestic supply of goods and services to meet demand. Indeed, as John Maynard Keynes pointed out in his 1940 book, How to pay for the war: when the civilian population is fully employed producing goods no-one can purchase, inflation inevitably rises. Wars are inflationary.

Many people have been comparing today’s inflation with the 1970s. And to be sure, there are similarities. Notably, wars.

Many people have been comparing today’s inflation with the 1970s. And to be sure, there are similarities. Notably, wars. The oil price spikes of 1973 and 1979 were both caused by wars in the Middle East, and the US’s spending on the Vietnam War generated the inflation that forced President Nixon to suspend the gold standard. But we don’t have the strong unions of the 1970s, and there’s no sign of a wage -price spiral. Rather, governments seem determined to repress household incomes.

The real problem is the prevailing economic orthodoxy. Today’s central bankers were taught that adjusting the monetary levers will always and everywhere control inflation. And fiscalists are equally convinced that raising taxes and reducing government spending will always and everywhere control inflation. But when the fundamental problem is a damaged supply side that is being repeatedly hit with negative shocks, raising interest rates, increasing taxes and cutting government spending will only make matters worse. No wonder central bankers appear to be making it up as they go along.

Governments and central banks must pay more attention to protecting the supply side from shocks.

Governments need policies to encourage business investment, skills development and productivity growth. They also need to cooperate to reduce barriers to trade and minimise disruption due to wars: the belligerent, isolationist behaviour too often displayed by the UK government is distinctly unhelpful. And both governments and central banks must pay more attention to protecting the supply side from shocks.

Monetarist policies have had their day. But that doesn’t mean we need to discard Friedman. Looking through the opposite end of the telescope, we can rewrite Friedman’s aphorism thus:

“Inflation is always and everywhere a supply-side problem in the sense that it is and can only be tamed by a more rapid increase in output than of demand.”

It’s time for a new economic paradigm that gives primacy to the supply side.