Monday, April 11, 2022

Inflation (2) Now

In a previous post, I describe the inflation that wracked the 1970s and early 1980s. Inflation is appearing again, but the situation is totally different now. This inflation is caused by a real increase in the cost of production and a consequent rise in the prices of consumer goods.

A number of factors are contributing to a significant rise in the costs of production.

  • The United States has imposed tariffs on goods produced in China, ostensibly to protect industries that no longer exist, but mostly for political reasons. Other nations are beginning to impose tariffs and import duties. The problem is that a tariff war quickly becomes a vicious cycle of tit for tat that harms everyone by reducing specialisation and pushing up the costs of production. This will lead to an increase in the price of consumer goods all over the world.

  • The United States has put sanctions on most of the world’s big oil producers: Iran, Venezuela and Russia. These trade restrictions will push up oil prices.

  • Saudi Arabia is the other big producer of oil. It is ruled by a corrupt dictatorship, so at some point, the US will impose sanctions on it, if it is not blown up by a rebellion first. This would make the oil situation worse.

  • Rising oil and gas prices are a serious problem because oil and gas are major inputs into the chemical industries that are essential for modern industrial economies. Their costs of production will rise.

  • Natural gas is an important input into fertiliser production, so gas shortages will push up fertiliser prices. This will push up the price of crop-based foods (including most kinds of meat).

  • A rise in the price of oil doesn’t just increase the price of fuel for commuters. It increases the cost of all transport, including sea, air, road and rail freight, which will increase the price of all goods, especially those that are imported. Truckers have to pay more for diesel fuel, which increases the prices of all delivered goods.

  • Increased transport costs also make many forms of specialisation and trade less viable. They also push up the price of all consumer goods that need to be transported in some way.

  • Rising oil prices even increase the cost of drilling for oil, by increasing the cost of things like fracking fluids.

  • The United States is using economic sanctions to drive a wedge between the Eurasian countries (China and Russia) and the United States and Western Europe (I have explained this in more detail in Big Picture). Dividing the world market into separate domains in this way reduces opportunities for specialisation and efficiency, so costs and prices will inevitably rise on both sides of the divide.

  • Real estate prices have increased rapidly over the last few years. This raises the cost of factories and warehouses, which will push up the price of manufactured goods.

  • Rising land prices eventually feed to rising food prices.

  • Rising interest rates will increase the cost of capital expenditure, which will eventually feed through to the price of final productions.

Most of these increases are real economic effects so the additional cost will have to be carried by someone. Unless they are reversed, which seems unlikely for political reasons, the world will face a permanent increase in prices, that will increase the cost of living for everyone. The cost will have to be borne by everyone but the impact will vary depending on each group’s political and economic power. Governments will probably adjust welfare benefits to compensate, but that will put extra pressure on their budgets.

Workers will want an increase in pay to cover the increase in their cost of living. Businesses will face a squeeze on their profits as they face an increase in the cost of their inputs, a bigger wage bill, and bigger interest payments, all at the same time. Unfortunately, the increased costs that the world economy is facing are real, so one or other of these groups will have to bear the cost.

Some people will be able to push up their wages, but unions are not as strong as they were, so many people will find their wages falling behind. In industries where labour is scarce, employees will be able to get compensated and the owners will have to carry the additional cost. Some businesses will not be able to put up prices, because they face too much pressure from competitors. Some will fail altogether because the increasing costs of production place a bigger squeeze on their profits.

The economic and political pressure across the world will not be even. Some countries will fare better than others. Those that produce minerals and oil will do better, especially those who control easy-to-extract mineral and oil resources. Countries that rely on imported food will suffer the most.

The problem for the United States is that its crop production is heavily dependent on oil-based fertiliser and most of its cheap-to-extract oil has been used up. (The prices of fracking sand, fracking fluids and labour costs are rising relentlessly).

The economic and political changes currently underway will eliminate some productive capacity, so some people will be made worse off. In the 1990s, a massive increase in productive capacity across the world made everyone better off. In the same way, a worldwide decline in productive capacity will mean that many people miss out on something they were used to consuming.

A tit-for-tat struggle between business and labour could develop and create an ongoing inflationary cycle, as occurred in the 1970s, but more competitive markets will probably prevent it from happening. Central banks seem to have used up most of their capacity to inflate the economy, so they may not be in a position to fund a wage-price inflationary spiral.

I will cover the role of central banks in the next post.

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