Inflation and the Wage-Price Spiral

E. R. Riverton

[Reprinted from Progress, March, 1972. Originally published
by ESSRA Magazine, U.K., 1971]

There is still considerable controversy as to the nature of inflation and consequently controversy and confusion as to the remedies required to stop it. Unfortunately, this word "inflation" is now being used to describe not only an increase in the money supply (original dictionary definition) but a variety of its effects. Thus, when prices rise as a result of increasing the money in circulation, this is described as demand-pull inflation as though rising prices were the cause of inflation instead of the effect. Similarly, when wage earners success in getting their wages brought into line with rising prices, this is called cost-push as though this itself were a cause of inflation.

It would be tedious to give other examples derived from the describing of any, price increase - for whatever reason - as "inflationary" which bedevils any discussion on the subject. The situation is made clearer, however, if it is understood that, where by analogy all women are people, yet not all people are women, so, while inflation always causes prices to rise, not all rises in prices are caused by inflation.

Different Causes

Perhaps the greatest difficulty one encounters in a discussion on inflation, arises when two distinct and separate causes of rising prices are operating together. If, in a truly inflationary situation caused by an increase in the supply of paper money, prices are also rising for other reasons, one single cause is often sought to account for both phenomena. Thus if wage earners in a strong union demand and receive a wage increase considered "excessive" the cost is passed on in higher prices. Similarly if taxes on commodities are increased, or the world cost of raw materials goes up or selective employment tax is passed on, they all contribute to higher prices.

But, and this is most important, whereas with monetary inflation all prices go up and in the same ratio with each other, other price increases are "local", that is to say they are confined to the particular service or commodity concerned. For instance, if taxes on tobacco, beer or petrol were to be increased, anyone not buying these commodities would not be affected. Such taxes are not inflationary within the strict sense of the word. But whether or not we call such taxes "inflationary" the effects must be distinguished from those caused by monetary inflation which affects everyone and all prices. It is because all prices increases are called "inflation" that wrong remedies are advocated. There cannot, of course, be one remedy for two distinct and different operating causes. If we isolate these causes we can then seek a remedy for each.

It is inevitable with a steady fall in the purchasing power of money that wage earners will demand higher money wages - simply to keep up with prices. This means that inflation leads to higher wages, not that higher wages lead to inflation.

Fallacy Exposed

In spite of the repeated assertion by some economists (not the monetarists) and some politicians that higher wages lead to inflation, this is not so and a simple illustration will establish the point.

Suppose that the money supply is stable and has been for some time. Now according to the "wage inflation" or cost plus theory, an inflationary wage/price spiral can be caused simply by each section of the workers in turn receiving a wage increase.

Let us now suppose that at the beginning of the spiral, the average rate of wages for workers was S30 per week and that after everyone in the community had had their increase, the average was up to $40 per week. Pay packets which previously contained $30 in notes now contain $40 in notes. If wages were paid through a bank, wage earners would still require the extra S10 of notes to draw on for their weekly or monthly expenditure.

The question now is: where does this extra money come from? The extra money has been put into circulation "in response to demand", says the exponent of "wage inflation". But how? Employers are not able to draw money from their banks as though it were a gift from the Treasury. The Bank of England does not hand out cash to industry simply in response to "demand" while receiving nothing in return. Put simply, the government does not give money away. Nor can the commercial banks ask the Bank of England for money for nothing, to give to their customers for nothing.

If then, there is no increase in the money supply, it is quite impossible for earners to have a £5 increase - the money is simply not there!

But, it may be argued, it has happened; wage earners have had and are continually having more money in their wage packets. And of course they are. But to get a real picture of the process we must reverse the spurious reasoning that leads us to the apparent contradiction. Since wage increases in themselves cannot force or produce an increase in the supply of money to pay for them, the only explanation is that the money supply is increased first through government action, and spent into circulation by the government.

The presence of this money in the community - "too much money chasing too few goods" - causes prices to rise and then wages. Now, the money is there to pay higher paper wages but not, of course, higher real wages.

Another Impossibility

Finally, let us take another look at the situation we have described as impossible, i.e., higher wages all round without an increase in the money supply.

When a group of workers gets an increase in wages, where can and does the money come from? The answer is from other workers by way of higher prices paid for the goods or services supplied. The employer simply passes the increases on to his customers. Clearly, however, if people have to pay more for some goods or services they must spend less on others. In short, there is competition for the fixed amount of money in circulation. They cannot all have it. The strongest will win, but in many instances the demand for the higher priced goods and services will decline and unemployment will follow. Many workers who sought a bigger share in the cake will have priced themselves out of a job.

Put another way, if everyone is seeking a wage increase and the money is not there except by taking from others, prices cannot be forced up as the relationship of total money to goods will not have been changed, the demand (money) remaining at equilibrium with supply (goods and services).