Although the relationship between inflation and economic growth has interested economists for some time, the nature of this association is still not well understood. Early discussions deliberated on the relative merits of a rising compared to a falling price level on profits, confidence, investment and other macro variables as these affected the growth of the economy, especially productivity. No noticeable consensus emerged from these deliberations. In more recent times, in particular the post World War II period up until the early 1970s, the historical record gives ambiguous if not misleading clues. For example, cross-country comparisons of rates of inflation and productivity growth in the developed capitalist economies reveal virtually no association between the two. And if the period of rapid growth of productivity of the 1950s and 1960s is compared with the period of stagnation since the early 1970s, over time a negative correlation between inflation and productivity growth is found in each of the economies. The rise in inflation rates is associated with a slowdown in productivity growth.

The Political Economy of Inflation and Growth

Conventional economic theory is equally inconclusive on the causal connection between the two. However, since the early 1970s, activist government intervention in the various economies has introduced a connecting link, resulting in a definite causal connection between inflation and growth that is likely to persist for some time to come. As a result, a correct understanding of this relationship involves a conceptual framework that is broader than that assumed by conventional economic theory. The causal relationship between inflation and growth must be seen as a problem in political economy, for it is the response of governments to inflation, both actual and predicted, that has and will determine the ultimate impact of inflation on the growth of productivity and output.

To put the matter in its simplest form, inflation leads to slow growth or stagnation because in those countries in which inflation cannot be brought under control by other means (e.g. an incomes policy) governments respond by implementing restrictive aggregate demand policies. Such responses lead, as they have since the early 1970s, to high rates of unemployment and low rates of capacity utilization, investment and productivity growth.

Taking the analysis one step further, in studying the mechanism by which inflation leads to stagnation under existing institutions it is useful to divide the developed capitalist economies into two groups. First, there are economies that experience accelerating rates of inflation under conditions of sustained high employment. To put the matter differently, there are countries in which the non-accelerating inflation rate of unemployment (NAIRU) is greater than the rate of unemployment at which all unemployment is voluntary.

No successful incomes policy can be implemented that would allow involuntary unemployment to be reduced to a minimum without the strong demand conditions leading to accelerating rates of inflation. As a result these countries will adopt restrictive aggregate demand policies in order to increase unemployment enough to reduce the rate of inflation. The fear that stimulative fiscal policies will lead to greater budget deficits and the fear of increased power of labour under full employment conditions, partly because it is believed that each causes inflation rates to accelerate, will reinforce this trend towards restrictive aggregate demand policies.

These economies can be said to suffer from an inflationary bias (Cornwall, 1983, ch. 6). Because of the policy response to this bias, inflation (or even the fear of inflation) will lead to high rates of unemployment and low rates of growth of productivity, that is, economic stagnation.

In contrast there is a second group of economies which, because of favourable institutional arrangements, could achieve full employment without accelerating rates of inflation if restrictive aggregate demand policies were not adopted by the first group of economies. These countries would be likely to adopt full employment policies if restrictive policies were not in effect elsewhere. But when they are, this group of economies is also forced to pursue restrictive aggregate demand policies but for quite different reasons than the first group. However, the effect of policy on the growth of output and productivity is the same; it will be greatly reduced.

Pluralist Economies

Thus the first step in understanding the relation between inflation and productivity growth is a recognition that the simultaneous achievement of full employment and non-accelerating rates of inflation is not an automatic feature of capitalist economies. Moreover any failure to achieve these goals is not to be attributed to a failure of the authorities to follow some monetary or fiscal rule. Instead, the failure of an economy to handle inflationary pressures while maintaining full employment must be attributed to existing institutional and political arrangements. These make the coordination of wage and price settings in individual markets with the national goal of overall wage and price stability impossible.

These institutions can be said to act as constraints limiting the number and kinds of policy instruments available to the authorities for combating inflation. Going further, since the authorities in these economies respond to accelerating inflation by creating whatever unemployment is politically tolerable in an attempt to reduce inflation, the use of aggregate demand policies as an instrument for realizing desirable employment goals is, therefore, severely constrained by an inflationary bias. The authorities in these economies can be expected to pursue stagnationist policies under existing institutional and political arrangements.

The relation between inflation, the political response to inflation, and growth just described is similar to that seen by Kalecki (1977). However, it is more accurate to limit the kind of ‘political theory of the business cycle’ foreseen by Kalecki to a special group of capitalist economies which will be referred to as ‘pluralist’ economies. Pluralist economies share certain features in common. Governments play an essentially passive role in governing, primarily reacting to demands by special interest groups; there is a widespread belief among the powerful economic and political groups that an invisible hand or system of countervailing power exists that guarantees some kind of social optimum; the industrial relations system can be characterized as adversarial; and decision-making within the trade-union movement is decentralized.

The countries today that suffer from an inflationary bias and whose institutional features most clearly coincide with those just mentioned are the developed English-speaking countries, particularly Canada, the United Kingdom and the United States. Very likely, other countries with somewhat different institutions suffer from an inflationary bias, for example, France and Italy, and for the purposes at hand could be included in this group (Barber and McCallum, 1982; Crouch, 1984; McCallum, 1983).

Corporatist Economies

There is a second group of economies which will be referred to as ‘corporatist economies’.

Corporatist economies are characterized by a tradition of state intervention in the economy, a high degree of cooperation and collaboration between the major economic groups in policy formation, a disbelief in invisible hands, and a system of industrial relations that can be described as cooperative. Primarily because of these institutions, these economies have been able in one form or another to implement relatively successful voluntary incomes policies in the past. Inflation has not been eliminated to be sure but has been kept at rates lower than would likely have resulted had union and managament been unwilling to cooperate with government in the interests of achieving wage and price stability. More certainly, as Table 1 reveals, economies with these characteristics and with powerful trade union movements as well, for example, Austria and Sweden, have been able to reduce unemployment to extremely low levels without experiencing inflation rates much higher (if higher) than those in the pluralist economies.

Inflation and Growth, Table 1 Annual average rates of unemployment (U) and inflation (\( \dot{p} \)), 1963–73 for selected capitalist economies
Full size table

Unfortunately given the high degree of economic interdependence between economies, most of those economies best able to contain inflation at full employment can no longer do so when the pluralist economies adopt restrictive policies. The economic importance of the pluralist bloc in the world economy forces restrictive policies on the second group of countries. Their importance guarantees that by restricting aggregate demand in their own countries, depressed conditions in the pluralist countries will be exported to the others in the form of a decrease in demand for their exports. Furthermore any attempt by any of the corporatist economies to offset declining exports through stimulative demand policies will lead to current account deficit that cannot be sustained through continuous borrowing (Thirlwall and Hussain, 1982). As a result, the full employment goal must be sacrificed.

Basic to this argument is the assumption that in the face of depressed demand conditions in the pluralist bloc, any corporatist economy acting on its own is not able to offset the adverse effects of a full employment policy on its payments position through an exchange rate policy. Unfortunately changes in the exchange rate are not sufficient to induce the kind of expenditure switching needed to bring the current account of the corporatist economies more or less into balance at full employment. These economies can be said to be limited or constrained in their use of aggregate demand policies for attaining full employment because of a payment constraint.

It is useful for pedagogical reasons to divide the capitalist world into two mutually exclusive groups, pluralist and corporatist. With this simplification in mind, the stagnating capitalist economies fall into one or the other of two groups: those in which restrictive demand policies are employed out of a fear of inflation and those in which a fear of payments problems at full employment caused by the restrictive policies of the first group leads to the same policies. The causal mechanism at work today, whereby inflation (or merely the fear of inflation) in one group of countries leads to worldwide stagnation, now becomes clear. As long as the pluralist group restricts aggregate demand because of an inflationary bias, less than full employment conditions are forced upon the rest of the world. As a result, an inflationary bias in the pluralist group, that is, a tendency for inflation rates to accelerate at or before full employment, leads not just to breakdown in those countries but to worldwide stagnation.

The Failure of Conventional Policies

As just argued, worldwide stagnation can be attributed to an inflationary bias in a group of key countries. Seen in another way, the difficulties or sources of stagnation can be traced to a failure of the traditional policy instruments, that is, monetary, fiscal and exchange rate policies, to work successfully in realizing full employment, price stability and external balance. Underlying this failure are certain structural and institutional changes that develop over a prolonged period of full employment such as the quarter of a century following World War II. Simply put, in democratic capitalist societies the rising affluence attributable to a long period of full employment is accompanied by the extension of the welfare state. This greatly increases the relative power of labour. As a result wages (and prices) are no longer determined primarily by the traditional market forces of demand and supply (Hicks, 1974; Okun, 1981; Scitovsky, 1978). This makes aggregate demand policy a highly inefficient means of fighting inflation. While wages and prices may respond eventually if restrictive policies are pushed far enough, the quantity effects on output and employment are substantial and immediate and persist while the policy is in effect. Futhermore, any implementation of an expansionary demand policy following a ‘successful’ restrictive policy that has brought down inflation rates will merely bring back the inflation in the pluralist economies. Restrictive policies whose aim is to permanently reduce inflation will fail in these countries because they fail to attack the sources of the inflationary bias.

Increased affluence and greater labour power also contribute to the ineffectiveness of exchange rate policy. First, consider that the trend in international trade has been increasingly towards the more highly fabricated goods that are desired for their non-price qualities, for example, design, durability, reliability, delivery dates, etc. This trend can, to a large extent, be attributed to affluence. It results in a downward trend in price elasticities of traded goods making it increasingly unlikely that the Marshall–Lerner conditions will be satisfied. When they are not, devaluation leads to a worsening of the trade deficit, other things being equal.

Second, the successful use of the exchange rate as an instrument for relieving a payments constraint is severely compromised by the existence of real wage resistance. A cheapening of exports relative to imports following devaluation likely leads to a decline in real wages. Under full employment conditions labour will have a strong incentive to press for higher money wage increases in an effort to protect their real wages. The resulting wage–price spiral can lead to the real exchange rate returning to its previous level. Like the inflationary bias, this difficulty arises out of the increased power of labour under full employment conditions and the affluence full employment brings.

Real wage resistance can be a real problem even in corporatist economies that may have had success in the use of income policies in the past. In earlier times the incentive for acceptance by labour of a voluntary incomes policy was provided by a promise of full employment and the rising real wages that full employment encourages. Unfortunately a devaluation of the currency, forced upon the authorities in their pursuit of full employment by restrictive policies in the pluralist bloc, may lead to non-compliance with the incomes policy.

If the reduction in real wages can be limited, real wage resistance might be avoided. However, the international interdependence of capital markets can and has lead to situations in which the local authorities have little control over the magnitude of the actual depreciation of the exchange rate. A deliberate devaluation generates fears of accelerated inflation in the minds of managers of exceedingly large and mobile capital funds. This leads to large withdrawal of funds from the country, a further depreciation of the currency, greater fears of inflation, etc. As the experience of several countries in the recent past make clear, governments are soon forced to reverse their employment policies in order to protect the exchange rate.

Conclusions

In order to break the causal chain leading from inflation to restrictive policy to stagnation that prevails under modern capitalist conditions, major structural-institutional changes are required. Most important are changes that would relieve the pluralist economies of their inflationary bias. A different conception of the role of the state in the economy, the development of a cooperative industrial relations system and possibly of centralized collective bargaining would be extremely helpful because these changes increase the possibility that a successful incomes policy could be implemented. The benefits of its success for the rest of the world are apparent.

A second programme for recovery is more limited in that it is restricted to the corporatist bloc. This would take the form of the corporatist economies adopting coordinated trade and lending policies that discriminate against the pluralist group, in order to ease possible payments difficulties from full employment policies.

There are other possibilities involving one or more countries, but, however much they differ in detail, they share one thing in common: all require radical and basic structural changes in key economic and political institutions. Without these adaptations, the present political economy of inflation and stagnation will continue indefinitely and will be worldwide.

See Also