Impact of Political Economy of Inflation

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How does the political economy of inflation impact on different social and economic groups

Introduction

It is precisely because inflation is a highly controversial notion from an economic perspective that political economists have developed a particular interest for its political implications. The vast majority of the literature regarding the political economy of inflation seeks to demonstrate that macroeconomic indicators are inherently political. In other words, they are tools used by policy-makers to depict an economic reality in various ways. Macroeconomic indicators are political both in their origins – the choices or against particular formula to calculate them – and in their consequences – their use in public policy and the debate surrounding it’(Mügge, 2016).

The main idea behind this argument is that policy-makers make an interest-based use of macroeconomic indicators. In the case of inflation which, policy-makers use inflation indexes to attenuate or exaggerate certain macroeconomic dynamics. If this view has tended to be accurate over the vast majority of the 20th Century, it seems to lose in accuracy in periods of ‘very high inflation’. What do we consider as ‘very high inflation’? To the extent inflation is a controversial and complex notion, it is rarely at the epicenter of the political discourse. Thus, candidates and government officials do not have a particular interest to put an extremely complex macroeconomic issue such as inflation as a top priority of their political agenda. This objective reality changes in a very radical way, when inflation reaches levels sufficient to impact wages, pensions or mortgage interest rates. In these particular circumstances, when inflation becomes a key priority for policy-makers desirous to answer voters’ primary concerns, we can talk about a period ‘very high inflation’.

Thus, this paper’s main objective is to demonstrate that policy maker’s advantageous use of inflation indicators lessens in periods of ‘very high inflation’. In these specific periods, inflation reaches levels that makes it a ‘consensual notion’. As inflation directly affects social and economic groups, they are likely to punish incumbent governments. To this extent, the power shifts from the closed-doors of the Government’s buildings to the ballot box.

The United Kingdom from 1974 to 1979 offers a powerful illustration in support of this argument. During this period, Great Britain experienced an exceptional high rate of inflation which affected many socioeconomic groups. Wilson’s government inability to reduce inflation broke the ‘Social Contract’ between the Labour and the working class, ultimately leading to the party’s defeat in the 1979 General Election. During these five years, the political economy of inflation shifted from the closed-doors of Whitehall to Main Street.

The Current Political Economy of Inflation: when policy-makers take advantage of inflation indicators

A vast literature (Fioramonti, Mügge) describes the evolution of the economy as being an increasingly quantitative subject. This literature argues that more than ever we live, especially in the economic field, in a world of numbers. Such movement goes in pair with the rising importance of macroeconomic indicators in both the domestic and the global macroeconomic policy-making.

In this world of numbers and indicators, politicians make an extensive use of indicators to design polices while the electorate assesses the government’s performance in regard of these indicators. As for the GDP, inflation measurement has changed over time firing critics over the quality of data used (Fioramonti, 2014) or over the manner these indicators were built. Again, as inflation is a controversial notion, its measurement has never been an easy-going a process. As a result, indicators used have changed over time and this, even in countries which possess well-recognized national statistics institutions.

First, if inflation is higher than wages growth, people are naturally worse-off. This point is capital because as we will see later it is certainly the most painful consequence of inflation but also the principal reason why voters might punish incumbent governments in periods of ‘very high inflation’. Secondly, in many countries, pensions, benefits or public-sector wages are linked to inflation indicator. In countries with large welfare states, a little change in inflation can have significant impact. In France, for instance public expenditure represented 57% of the GDP in 2015 according to the annual report on public spending published every year by the OECD.  

Finally, if the prices of certain goods in the economy are growing faster than the interest rates required to acquire these goods, it can fuel a bubble which will potentially burst and ultimately lead to an economic crisis (Hay, 2009) involving heavy consequences for many socioeconomic groups.

Now we have outlined the potential impacts of inflation on various economic actors, we must explore the key issue of the political economy of inflation: the fact that the construction of inflation indexes is intresically political. In Great Britain, the inflation indicator is the CPI (Consumer Price Index) examines the weighted average of prices of a basket of goods and services. It appears clear that the inclusion of the exclusion of certain goods or services might have a significant impact on the ‘official’ inflation rate in a given country. Mügge reminds us the impact of inflation indicators limits in the United State. According to a 1995 report of the US Senate Advisory Committee, the US CPI overestimated inflation by 1%, meaning that inflation-indexed transfers rose by 1% over decades. If a given indicator carries in itself political choices it is even more the case when a country decides to change its inflation indexes. The example of Great Britain is striking. Over the course of the 20 Century, Her Majesty’s Government changed its main inflation indicators no less than three times. It first started with the RPI (Retail Price Index) which was replaced in 1947 by the CPI (Customer Price Index) in order to better compensate workers after huge sacrifices they made during the Second World War. In 2013, the CPIH emerged in place of the CPI. Four years after the crisis, the CPIH included mortgage payments.

All the points developed above aimed to describe the current political economy of inflation: in period of low inflation, policy-makers enjoy the power to use at their advantage indicators to ‘manipulate’ the electorate or socioeconomic groups. What happened in period of ‘very high inflation?

When Main Street Redefines the Political Economy of Inflation: The Case of the United Kingdom from 1974 to 1979

This second part will explore to what extent during the 1970’s in the United Kingdom, the ‘very high inflation’ broke the ‘Social Contract’ between the working-class and the Labour party ultimately leading to the arrival of the New Right in Whitehall.

The United Kingdom from 1974 to 1979 offers a prime example of the circumstances in which socioeconomic groups take back the power from governments by not accepting anymore the ‘politicisation of inflation’ (Mügge, 2016). Indeed, during this period inflation became one of most the important issue for both parties as it hit harshly many socioeconomic groups. Table 1 helps us to better understand why inflation constituted a burning issue during this period.

Table 1

The 1973 oil crisis marked the end of the ‘golden age’ of full employment, sustained economic growth and relatively stable prices (Peden, 1985). The conjunction of increasing oil prices, the Nixon shocks, flows of dollars coming from the United States aiming to help Europe rebuild its economy, provided a propitious global macroeconomic context for the emergence of inflation in the United Kingdom. By the end of 1974, the rate of inflation was 23% and between 1974 and 1975 it rose over 26% (Table 2). Domestically, the Conservative government formed after the 1970 General Election took several measures to fight inflation including limiting wages. Despite several successes on the short term, inflation remained at historic high levels. This fueled a growing dissatisfaction amongst large parts of the electorate including workers.

Table 2

This growing dissatisfaction partly explained the return in power of a Labour government led by Harold Wilson. As stated by Leys, ‘Wilson made Labour’s ability to repair the government’s relationship with the unions the cornerstone of his policy’ (Leys, 1989) what has been later called the ‘Social Contract’. Trade Unions expected from the government to stop limiting wages. However, limiting inflation rested on the ability to limit the growth of wages (Leys, 1989). As a result, the government attempted to increase public spending in order to attenuate the effect of inflationary policies.

As the 1979 General Election approached, inflation remained at the top of the political agenda.

3 May 1979, the Conservatives led by Margaret Thatcher take 44% of the vote with a majority of 21. What led to the election of the most liberal government since the first half of the 20th Century?

First of all, each party’s ability to fix inflation was seen by voters as one of the most important issue of the election. In both manifestos inflation was mentioned as being a key priority. As we said above, campaigning on a complex macroeconomic indicator such as inflation has never been a winning recipe for political parties. However, during the 1970’s in the United Kingdom as inflation was a primary source of concern for many socioeconomic groups this general rule did not verify. Table 3 outlines Labour party’s declining credibility over inflation.

Table 3

Butler estimates that Labour’s relationship to the working-class base is one of the main explanation of the outcome. Surveys conducted between 1978 and 1979 all place inflation as one of the three most important issues for trade unions members (Butler, 1980). Trade-unions excerced a strong influence on the working-class at a time when political identification was still very strong a changing attitude of trade-unions had serious electoral consequences for Labour.

The breaking of the ‘Social Contract’ was emphasized by James Callaghan at the Labour Conference in October 1979 when he spoke of his shock at a poll report during the campaign that the Conservative party was seen as having more concern for ordinary people than the Labour party (Butler, 1980).Table 4 shows that about 8% of trade-unions members (versus 1974) swing to the Conservatives.

Table 4

All these figures illustrate the fact that trade-unions and more broadly the working-class dissatisfaction to the Labour party greatly explain the General Election outcome (Butler 1980). Having been one of the socioeconomic group that were most hardly hit by inflation, the working-class broke the ‘Social Contract’ and punished Mr Callaghan’s party (Peden, 1991).

Conclusion

This paper attempted to offer an alternative political economy view of inflation: when inflation highly impacts socioeconomic groups the ‘politicisation’ of inflation comes to an end.

If it is true that most of the time, policy-makers enjoy the power to make an advantageous use of inflation indicators to serve their own interests, this widely acknowledged argument includes limitations in certain exceptional circumstances.

We recognize that our argument could attract critics from the proponents of the traditional political economy of inflation such as Mügge or Fioramonti to the extent it relies on the subjective notion of ‘very high inflation’. In our view, we can talk about ‘very high inflation’ when inflation constitutes a key priority for the majority of political parties. Why would political parties constitute a reliable indicator of socioeconomic groups’ primary concerns? Considering that policy-makers are self-interested, we think they perfectly know that it is in their best interest to resolve voters’ concerns. As a result, they offer an authentic mirror of society. Some would object that political parties are not anymore representative of society’s diversity. Today, they are probably true in as we are living in era characterized by persistent declining turnout and party identification. However, it was not the case during the 1970’s in the United Kingdom and in many other developed countries.

Mügge would certainly say that selecting the United Kingdom as an example of our argument involves a major bias to the extent its electoral system favours voters’ punishment of incumbent governments. Indeed, it is easier for voters to assign a blame in a single-party system in which political party cohesion is significant than in a coalition-system where parties’ responsability is shared.

In brief, we must acknowledge that the political economy of inflation has been and will continue to be a highly debatable issue.

Bibliography

Butler, David and Kavanagh, Dennis, (1980) ‘A Watershed Campaign?’, in The Macmillan Press Ltd, The British General Election of 1979, pp.336-51.

Fioramonti, Lorenzo (2014), ‘The politics of numbers in the age of austerity’, Open Democracy. https://www.opendemocracy.net/can-europe-make-it/lorenzo-fioramonti/politics-of-numbers-in-age-of-austerity

Hay, Colin (2009) ‘Good Inflation, Bad Inflation: The Housing Boom, Economic Growth and the Disaggregation of Inflationary Preferences in the UK and Ireland’, British Journal of Politics and International Relations 11(3): 461-78.

Leys, Colin (1983) ‘Into the New Crisis’, in Heinemann Educational Books, Politics in Britain from Labourism to Thatcherism, pp88-01.

Mügge, Daniel (2016) ‘Studying Macroeconomic Indicators as Powerful Ideas’, Journal of European Public Policy 23(3): 410-27.

Organisation for Economic Co-Opearation and Development (2015), General Government Spending. Paris France. https://data.oecd.org/gga/general-government-spending.htm

Peden, George, (1991) ‘The Challenge of Inflation, 1973-83’, in Philip Allan Publishers Ltd, Politics in Britain: from Labourism to Thatcherism,pp.196-13.

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