15. Inflation Resulting from Downward Inflexibility of Wages

Professor Hayek reiterates the central role of wage rates in determining the volume of employment. Reasoning in terms of wage levels rather than in terms of the structure of wage rates obscures the inflationary implications of refusing to reduce wage rates where necessary. If union-determined wage rates are treated as the datum to which all other economic values must adjust themselves, the monetary consequences of such a course must be clearly recognised. If we wish to avoid the latter, trade unions must treat the flow of money incomes as the final datum to which they must adjust their wage rates. Professor Hayek here explicitly and unambiguously analyses the specific interactions of union wage policy and official monetary policy in creating one of the major dilemmas facing the developed economies.

Contrary to what is widely believed, the crucial result of the ‘Keynesian Revolution’ is the general acceptance of a factual assumption and, what is more, of an assumption which becomes true as a result of its being generally accepted. The Keynesian theory, as it has developed during the last twenty years, has become a formal apparatus which may or may not be more convenient to deal with the facts than classical monetary theory; this is not our concern here. The decisive assumption on which Keynes’s original argument rested and which has since ruled policy is that it is impossible ever to reduce the money wages of a substantial group of workers without causing extensive unemployment. The conclusion which Lord Keynes drew from this, and which the whole of his theoretical system was intended to justify, was that since money wages can in practice not be lowered, the adjustment necessary, whenever wages have become too high to allow ‘full employment’, must be effected by the devious process of reducing the value of money. A society which accepts this is bound for a continuous process of inflation.

Importance of Relative Wages

This consequence is not at once apparent within the Keynesian system because Keynes and most of his followers are arguing in terms of a general wage level while the chief problem appears only if we think in terms of the relative wages of the different (sectional or regional) groups of workers. Relative wages of the different groups are bound to change substantially in the course of economic development. But if the money wage of no important group is to fall, the adjustment of the relative position must be brought about exclusively by raising all other money wages. The effect must be a continuous rise in the level of money wages greater than the rise of real wages, i.e., inflation. One need only consider the normal year-by-year dispersion of wage changes of the different groups in order to realise how important this factor must be.

The twelve years since the end of the war have in fact in the whole Western world been a period of more or less continuous inflation. It does not matter how far this was entirely the result of deliberate policy or the product of the exigencies of government finance. It certainly has been a very popular policy since it has been accompanied by great prosperity over a period of probably unprecedented length. The great problem is whether by the same means prosperity can be maintained indefinitely—or whether an attempt to do so is not bound sooner or later to produce other results which in the end must become unbearable.

The point which tends to be overlooked in current discussion is that inflation acts as a stimulus to business only in so far as it is unforeseen, or greater than expected. Rising prices by themselves, as has often been seen, are not necessarily a guarantee of prosperity. Prices must turn out to be higher than they were expected to be, in order to produce profits larger than normal. Once a further rise of prices is expected with certainty, competition for the factors of production will drive up costs in anticipation. If prices rise no more than expected there will be no extra profits, and if they rise less, the effect will be the same as if prices fell when they had been expected to be stable.

On the whole the post-war inflation has been unexpected or has lasted longer than expected. But the longer inflation lasts, the more it will be generally expected to continue; and the more people count on a continued rise of prices, the more must prices rise in order to secure adequate profits not only to those who would earn them without inflation but also to those who would not. Inflation greater than expected secures general prosperity only because those who without it would make no profit and be forced to turn to something else are enabled to continue with their present activities. A cumulative inflation at a progressive rate will probably secure prosperity for a fairly long time, but not inflation at a constant rate. We need hardly inquire why inflation at a progressive rate cannot be continued indefinitely: long before it becomes so fast as to make any reasonable calculation in the expanding currency impracticable and before it will be spontaneously replaced by some other medium of exchange, the inconvenience and injustice of the rapidly falling value of all fixed payments will produce irresistible demands for a halt—irresistible, at least, when people understand what is happening and realise that a government can always stop inflation. (The hyper-inflations after the First World War were tolerated only because people were deluded into believing that the increase of the quantity of money was not a cause but a necessary consequence of the rise of prices.)

We can therefore not expect inflation-borne prosperity to last indefinitely. We are bound to reach a point at which the source of prosperity which inflation now constitutes will no longer be available. Nobody can predict when this point will be reached, but come it will. Few things should give us greater concern than the need to secure an arrangement of our productive resources which we can hope to maintain at a reasonable level of activity and employment when the stimulus of inflation ceases to operate.

Inflation—A Vicious Circle

Yet the longer we have relied on inflationary expansion to secure prosperity, the more difficult that task will be. We shall be faced not only with an accumulated backlog of delayed adjustments—all those businesses which have been kept above water only by continued inflation. Inflation also becomes the active cause of new ‘misdirections’ of production, i.e., it induces new activities which will continue to be profitable only so long as inflation lasts. Especially when the additional money first becomes available for investment activities, these will be increased to a volume which cannot be maintained once only current savings are available to feed them.

The conception that we can maintain prosperity by keeping final demand always increasing a jump ahead of costs must sooner or later prove an illusion, because costs are not an independent magnitude but are in the long run determined by the expectations of what final demand will be. And to secure ‘full employment’ even an excess of ‘aggregate demand’ over ‘aggregate costs’ may not lastingly be sufficient, since the volume of employment depends largely on the magnitude of investment and beyond a certain point an excessive final demand may act as a deterrent rather than as a stimulus to investment.

I fear that those who believe that we have solved the problem of permanent full employment are in for a serious disillusionment. This is not to say that we need have a major depression. A transition to more stable monetary conditions by gradually slowing down inflation is probably still possible. But it will hardly be possible without a significant decrease of employment of some duration. The difficulty is that in the present state of opinion any noticeable increase of unemployment will at once be met by renewed inflation. Such attempts to cure unemployment by further doses of inflation will probably be temporarily successful and may even succeed several times if the inflationary pressure is massive enough. But this will merely postpone the problem and in the meantime aggravate the inherent instability of the situation.

In a short paper on the twenty years’ outlook there is no space to consider the serious but essentially short-term problem of how to get out of a particular inflationary spell without producing a major depression. The long-term problem is how we are to stop the long-term and periodically accelerated inflationary trend which will again and again raise that problem. The essential point is that it must be once more realised that the employment problem is a wage problem and that the Keynesian device of lowering real wages by reducing the value of money when wages have become too high for full employment will work only so long as the workers let themselves be deceived by it. It was an attempt to get round what is called the ‘rigidity’ of wages which could work for a time but which in the long run has only made this obstacle to a stable monetary system greater than it had been. What is needed is that the responsibility for a wage level which is compatible with a high and stable level of employment should again be squarely placed where it belongs: with the trade unions. The present division of responsibility where each union is concerned only with obtaining the maximum rate of money wages without regard to the effect on employment, and the monetary authorities are expected to supply whatever increases of money income are required to secure full employment at the resulting wage level, must lead to continuous and progressive inflation. We are discovering that by refusing to face the wage problem and temporarily evading the consequences by monetary deception, we have merely made the whole problem much more difficult. The long-run problem remains the restoration of a labour market which will produce wages which are compatible with stable money. This means that the full and exclusive responsibility of the monetary authorities for inflation must once more be recognised. Though it is true that, so long as it is regarded as their duty to supply enough money to secure full employment at any wage level, they have no choice and their role becomes a purely passive one, it is this very conception which is bound to produce continuous inflation. Stable monetary conditions require that the stream of money expenditure is the fixed datum to which prices and wages have to adapt themselves, and not the other way round.

The State of Public Opinion

Such a change of policy as would be required to prevent progressive inflation, and the instability and recurrent crises it is bound to produce, presupposes, however, a change in the still predominant state of opinion. Though a 7 percent Bank rate in the country where they originated and were most consistently practised proclaims loudly the bankruptcy of Keynesian principles, there is yet little sign that they have lost their sway over the generation that grew up in their heyday. But quite apart from this intellectual power they still exercise, they have contributed so much to strengthen the position of one of the politically most powerful elements in the country, that their abandonment is not likely to come without a severe political struggle. The desire to avoid this will probably again and again lead politicians to put off the necessity by resorting once more to the temporary way out which inflation offers as the path of least resistance. It will probably be only when the dangers of this path have become much more obvious than they are now that the fundamental underlying problem of union power will really be faced.

(Studies in Philosophy, Politics and Economics, pp. 295–99)