Struggling with inflation: The Tribune India


Aunindyo Chakravarty


Senior Economic Analyst

INFLATION is a political hot potato. Governments fear it like the plague and one of their main objectives is to guarantee the stability of food prices. The working classes are the most affected. If the prices of basic necessities increase, they are forced to reduce their other “discretionary” expenses. They buy fewer clothes, they stop buying hair oil or shampoo, they switch from toothpaste to tooth powder, or they downgrade to cheaper brands and smaller packaging. Indian FMCG companies are already complaining that high food prices have made it difficult for them to sell their products in rural India.

Inflation targeting is a way to increase returns to financial capital and has very little to do with protecting the poor.

But what if someone’s income is growing at a faster rate than inflation? Would they care about the price increase? The answer is no. A few years ago, when I was a full-time information professional earning a very nice salary, I didn’t care how much things cost. This was because my family’s “essential” budget was a very small part of my total income. Even a 10% price increase did not reduce my ability to spend much. I put things in my cart without looking at their price, and I never checked the final bill to see what cost how much. Old habits die hard, but my profligacy has been considerably tempered by the sharp decline in my income now that I am self-employed.

This suggests that inflation can only be seen in relation to income. If incomes are high and growing at a rapid rate, inflation is of little importance. Thus, the best way for governments to counter the political consequences of inflation is to create a political environment that increases people’s incomes. One could argue that such a move will only make inflation worse: if people have more money in their hands, they will want to buy more goods and services. Demand will rise and quickly outpace supply, pushing prices up. And this will plunge us back into an inflationary spiral that will soon spiral out of control.

This is simply not true for a country like India – or any current economy, for that matter. Indian factories can produce much more than they currently do. While they have 10 machines installed, they are currently only using seven. They can easily increase production by 40% before there is even the slightest hint of a supply shortage. As they use more idle machines, their cost per unit of output goes down. This means that if demand increases, companies should be able to increase their capacity utilization, reduce their average costs and make more profit, even if they sell their products at the same price.

An initial government-led demand surge will encourage companies to increase production as they receive new demand signals from the market. They will employ more people, which, in turn, will eventually increase the total pool of wages to spend on purchasing goods and services. It’s a virtuous circle of demand creating supply, creating demand. As capacity utilization decreases, the unit cost of goods, profit margins increase, there will be more funds available for future investment. Companies will then buy more machines, establish new factories and offices in anticipation of future demand. With a small shift, it will create more supply. Thus, increased employment and income growth are the only antidote to long-term inflation.

Yet governments react to inflation by reducing employment. How do they do this? By reducing budget deficits, raising interest rates and tightening the money supply. Thanks to monetarist dogma, introduced in the United States by Reaganomics in the early 1980s, and spread to the rest of the world via the Bretton Woods institutions in the 1990s, governments and central banks around the world are reacting to high inflation through monetary tightening policies. The underlying logic is that the excess money supply has created artificial demand that cannot be met by the current state of supply, so demand must be cooled by reducing the money supply. Lower interest rates will reduce consumption fueled by credit, be it final consumption by households or productive consumption by industries. It will also reduce wages and employment and lower aggregate demand, which will reduce inflation.

There is the other side of the coin: controlling inflation by reducing employment. It is claimed that when economies reach full employment, businesses are unable to expand without paying much higher wages. This drives up their costs, which, in turn, translates into higher prices for goods and services. Also, as wages increase, workers have more money to buy things. Demand is growing at a faster rate than supply, again causing high inflation. Although these two arguments come from two opposing camps within the mainstream economy, they are both betting on cutting jobs and wages to calm inflation.

Logically, this should be a problem for the corporate world, as lower output and higher cost of capital affect capital accumulation. Yet corporations universally support inflation targeting by central banks. Indeed, since the 1980s, the capitalist world has been dominated by finance. Inflation reduces the value of financial assets and eats into the returns of speculative capital. This is why financial capital must always protect itself against inflation, even to the detriment of the accumulation of corporate capital.

It could be argued that stock prices could decline if investors believe that a company’s business is not going to grow. However, in reality, stock prices generally follow immediate earnings and cash flows, rather than a company’s long-term growth. In the immediate term, a drop in the wage bill and in the cost of inputs helps companies to increase their profit margins. We saw this happen during the Covid lockdown, when India Inc posted record profits despite declining overall revenue.

Inflation targeting is a way to increase the returns to financial capital. It has very little to do with protecting the poor against a higher cost of living. After all, no worker would trade his job for lower prices.

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