Wages, inflation and the Great Depression: The Reserve still does not get it

Gerard Jackson
Monday 4 October 2010

The mining boom is making it very clear that the Reserve Bank and our commentariat are unlikely to ever grasp the relationship between inflation and wages. Whenever it appears that wages are rising ‘too’ fast and that a shortage of skilled labour is emerging we are invariably warned that the RBA could be forced to raise interest rates to counter the inflationary effects of wages increases. This is nonsense. The view that rising wages in themselves can have an inflationary impact seems to have its roots in the discredited cost-of-production theory of prices.

Regardless of what economic commentators assert wages are not the “key to inflation”, money supply is. (To be more precise, the value of money is determined by its supply and the demand for its services.) That inflation is frequently discussed in this country in terms of wage growth only serves to underline just how pathetically third rate much of our so-called economic debate really is. In a free market wages are set by the supply and demand for labour. As the supply of labour is usually taken for granted, economists focus their attention on the demand side. Now the demand for labour is nothing more than a schedule of the marginal value of its services over a given range.

In an unhampered labour market there is a tendency for labour to receive the full value of its marginal product, i.e., its market price. Where, for any reason, labour costs exceeds the market clearing price unemployment will emerge. Conversely, labour shortages will appear if labour is paid less than its market rate. If, as happened in 1981-82, unions push for above market wage increases for the workforce the result will be large-scale unemployment. To suggest otherwise is to assume that union wage increases lead to an automatic increase in money incomes for the whole workforce. (This seems to imply that the money supply passively adjusts itself to accommodate wage increases). This is a patently absurd proposition, yet the Cohen Council (Council on Prices, Productivity and Income, 1959, UK) actually concurred with this view. But as the eminent economist Professor W. H. Hutt pointed out:

But if certain wages rates are pushed up, in the absence of inflation other wage rates and prices will fall, or a cumulative withholding of capacity elsewhere must follow”, meaning a rise in unemployment. (The Keynesian Episode: A Reassessment, LibertyPress, 1979).

Of course, if the wage push is on a broad front large-scale unemployment will be the result. In other words, inflation could only occur if the government expanded the money supply to underwrite the wage push. How else could aggregate money incomes rise? Greg Sword, former ACTU senior vice-president, tacitly admitted this on one occasion when he stated that any refusal by the Reserve to underwrite union wage claims by inflating the money supply would be ideologically motivated.

The 1930s are a tragic example of what happens when wage rates are maintained above their market rates. When depression struck the U.S. the quantity of money contracted by about 33 per cent from June 1929 to June 1933 and consumer prices fell by 25 per cent. However, the Hoover Administration fought against any cuts to money wages in the belief that maintaining them would increase purchasing power and so lift the economy out of depression. Statistics from the United States Bureau of Economic Analysis painted a stark picture of what this policy did to profits. In 1929 the two-way division between employees and corporations was 81.6 per cent and 18.4 per cent respectively. In 1933 employees share had rocketed to 99.4 per cent, payrolls fell from $32.3 billion to $16.7 billion and unemployment rose to a horrific 25 per cent.

Obviously this policy only served to prolong and deepen the depression. The point, however, is that Hoover and his advisors believed that holding wages at pre-depression levels would generate incomes and restore the previous price level. This, in principle, is no different from the Cohen Council view that union wage increases “naturally” raise money incomes which in turn raises the price level. Another example from the 1930s is the union wage push that sabotaged the country’s economic recovery. The American economy had begun to rally 1935 in response to the unanimous decision of the United States Supreme Court to declare the National Recovery Act unconstitutional (NRA). The result: unemployment fell from 10.6 million in 1935 to 7.7 million in 1937. The chart* below reveals what happens when wage rates exceed the value of the worker’s marginal product.Then tragedy struck. In 1937 Roosevelt’s pro-union Wagner Act was upheld by the Supreme Court. Unions immediately exploited the situation with a widespread wage push. The effect was to crush the rally and send unemployment leaping from the 1937 level of 7.7 million to 10.4 million in 1938. Now, according to the thinking of our own Reserve this wage push should have caused inflation. The facts tell another story. In 1939 the wholesale and consumer price indexes stood 81, 19 percentage points below their 1929 level.

The 1973 OPEC oil hike is often cited as a graphic example of cost-push inflation and the cause of the Western world’s inflationary woes of the 1970s. If this explanation was correct, then the biggest oil importers would have the highest inflation rates. They did not. Germany is wholly dependent on imported oil, as is Japan, yet after the oil hike its inflation rate was 7 per cent while the Japanese rate was 25 per cent; Australia’s inflation rate was 17 per cent, even though it was 75 per cent self-sufficient in oil; America, which imported about 50 per cent of its oil, had a 12 per cent inflation rate; Britain, which had become an oil exporter, laboured under an inflation rate of 25 per cent; Saudi Arabia, the world’s largest oil exporter, had a 35 per cent inflation rate.

The reasons for the different inflation rates is quite simple. Those countries with the lowest rates of monetary expansion enjoyed the lowest rates of inflation. What the vast majority of commentators are totally unable to grasp is that the OPEC price hike was basically deflationary. The monetary response of the Western world completely swamped what was initially deflationary. (Only Austrian economic theory draws attention to all of these facts and provides a comprehensive analysis). Sound economics (something the Reserve Bank is supposed to know about) has long since debunked the myth that inflation is a cost-push phenomenon. That media commentators and third rate academics should peddle this myth is, unfortunately, to be expected — that the reserve should do so is a damn disgrace.

Therefore any significant wage push, including oncosts, would have the effect not of raising prices but of confiscating productivity increases, strangling investment and raising unemployment. The sooner the unionocracy is held account for its anti-social actions the better. It can never be sufficiently stressed that living standards can only be raised by increasing the amount of capital invested per head of the population. In other words, a continual increase in real wages for everyone can only be achieved by making labour increasingly scarce relative to the quantity of capital.

To suggest that by continually forcing wage rates up unions can accelerate the process of capital accumulation by forcing business to raise the level of investment should be too ludicrous for words. Yet many of our so-called journalists and social commentators write as if this is the case. It is not, never has been and never will be.

*The productvity adjusted wage is one in which money wages are first adjusted to changes in prices and then to changes in productivity. If the result is that the actual wage rate exceeds the value of the worker’s product unemployment will emerge.

Gerard Jackson is Brookesnews’ economics editor