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Inflation: the real problem

Summary:
Everybody says we have an inflation problem. Everybody is wrong. What we have is a relative price problem. The biggest reason for high inflation is that petrol prices and utility bills are soaring – up by 22.3% and 23.1% respectively in the last 12 months, contributing 1.5 percentage points to February’s 6.2% CPI inflation. Imagine, though, that prices in the rest of the economy were flat, so that inflation were below its 2% target. Would everything be OK? No. We would still be handing over a bigger chunk of our incomes to monopolistic utility companies and to foreign despots. What we have is a relative price problem. And this is a real problem in the sense that it’s a transfer of real resources. This echoes an old phenomenon, described by David Ricardo in 1815. As the economy and

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Everybody says we have an inflation problem. Everybody is wrong. What we have is a relative price problem.

The biggest reason for high inflation is that petrol prices and utility bills are soaring – up by 22.3% and 23.1% respectively in the last 12 months, contributing 1.5 percentage points to February’s 6.2% CPI inflation.

Imagine, though, that prices in the rest of the economy were flat, so that inflation were below its 2% target. Would everything be OK? No. We would still be handing over a bigger chunk of our incomes to monopolistic utility companies and to foreign despots.

What we have is a relative price problem. And this is a real problem in the sense that it’s a transfer of real resources.

This echoes an old phenomenon, described by David Ricardo in 1815. As the economy and population grow, he said, farmers would have to cultivate less and less fertile land to meet demand for food. That, he said, meant that food prices would rise over time. Which would squeeze real incomes and thus eventually kill off growth. It would also mean, he said, that owners of the best land could charge higher rents and prices, thus transferring income from renters to themselves. Elygas

Ricardo’s theory was wrong for food; thanks to trade and technical progress (two similar things) their prices fell after he wrote. But the gist of it was right. We are transferring a growing portion of our incomes to a different type of rentier – owners of utility companies and gas and oil reserves*. And this is not merely a short-term problem: in the last 20 years, gas and electricity bills have doubled relative to wages**.

This threatens to have the same effect that Ricardo predicted. If we are handing all our cash over to utility companies, we’ve nothing left to spend in more dynamic sectors. And so growth will slow. This is a version of Baumol’s cost disease.

The OBR thinks we’ll escape this fate this year because households will respond to the squeeze on incomes by saving less and borrowing more: it foresees the savings ratio dropping to a 60-year low. Even if this happens this year (which is questionable) it still leaves us with a longer-term problem. Stagnant productivity, a rising relative price of services (not least of which are government services) and the fading away of the effect of cheap imports from China all threaten to continue to squeeze real incomes. If fuel and utility costs continue their long-term uptrend, the squeeze will only be worse.

So, what’s the solution?

We should accelerate decarbonization. As Eric Lonergan and Corinne Sawers point out, this requires more than tax changes. It requires a greater availability of alternatives to carbon-based fuels and greater ease in switching to them.

There’s also a case for nationalizing utilities and oil companies so that their rents are socialized and could be recycled back to us. This would prevent the growth-depressing transfer of real resources that Ricardo feared.

Neither of these, however, fully solve the problem. As long as productivity is stagnant, so too will be real incomes. Which means that any big change in relative prices where demand is inelastic will cut someone’s real income.

Which brings us back to what all sensible economists have been saying for years – that our fundamental problem is a lack of productivity growth.

* And not just these: Ricardo's theory also applies to prime commercial and residential land. 

** The course of oil prices in is trickier. Although these are much higher now relative to consumer prices than they were at the start of the century, they are much lower than they were in 1980.  

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