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Blog: On Fighting Inflation and Inequality

By Prof. Dr. Bart Los (University of Groningen)

Policymakers all over Europe are concerned about the current high rates of inflation. Lockdowns to mitigate the health effects of the Covid-19 pandemic have created supply shortages in markets for a wide variety of products. These effects were exacerbated by disruptions in international maritime transport, which caused enormous problems for firms operating lean just-in-time production processes. On top of this, sanctions against Russia have led to serious price hikes in energy markets. For example, in The Netherlands, the year-on-year rate of inflation was as high as 12% in March. This implies substantial losses of purchasing power, which are worrisome and led national governments to introduce various kinds of (often ill-advised) compensation policies to alleviate problems in the short run.

But should we worry about a long period of high inflation? It seems unlikely that the prices of energy will continue to increase at the pace of the last few months simply because energy cannot become much scarcer than it currently is. The recent Covid-19 lockdowns in China might well cause new problems regarding the global supply of manufactured products, but this will also be a temporary problem. However, the main worry is that a detrimental long-run wage-price spiral will emerge: to sustain purchasing power in these times of high inflation, employees would demand higher nominal wages. In turn, employers would increase the prices of their products to make up for the higher labor costs and remain profitable, leading to further nominal wage hikes, etc. Such a spiral should be avoided at all costs.

The most straightforward approach to this problem would be to avoid an initial rise in nominal wages. If this would not happen, the main cause of long-term high rates of inflation would most probably disappear altogether. In several European countries, the power of unions has waned over the past few decades to such an extent that a strategy like this might be successful. As I recently argued (with five fellow economists at the University of Groningen) in two articles in the Dutch newspaper Dagblad van het Noorden, I think this is not the right way to deal with the problem. It would aggravate inequality within countries, which was a major concern already before inflation started to soar. The GI-NI research project actually focuses on the implications of rapid digitalization and rapid international fragmentation of production processes for different types of workers. It is widely believed that high-skilled workers and capital owners in advanced countries benefit from these transformations, while low-skilled and medium-skilled workers lose out. They face more unemployment, lower wage growth and much more job insecurity. Poorer households were already hit disproportionally by the short-run energy price hikes (because they tend to spend larger fractions of their incomes on energy) and would then have to bear most of the burden of fighting long-term inflation as well. One can hardly think of better ways to create fertile ground for more populism. Are better alternatives available?

Reforms of tax systems seem to be more necessary than ever. It is a bit tricky to generalize across EU countries because of the differences in tax systems, but still… If labour income taxes were reduced, a given wage rate would yield more disposable income. And if the costs for firms to employ people would be reduced, their profitability would remain intact. It might even become more attractive to continue hiring medium- and low-skilled workers rather than replacing them with computers or robots, or with Chinese workers. Employers might even have opportunities to offer longer-term contracts, increasing job security for the most vulnerable workers. One might be afraid that reductions in tax revenues would hurt future generations, but this fear would not be justified if taxes on wealth (or income derived from wealth) were increased.

We are at a major crossroads. Technological change and globalization have increased inequality during a period of more than two decades. Populism was fueled by a lack of policies to distribute the associated welfare gains. The victims of this lack of redistribution in times of transformation are also the victims of the energy price hikes caused by the sanctions imposed on Russia, aggravated by prolonged scarcity of products due to consequences of Covid-19. Letting the weakest parts of society bear the burden of avoiding high long-run inflation seems a good recipe for election victories of populist parties. The presidential elections in France were nearly won by a populist. It is high time that unequal tax systems in advanced countries (like The Netherlands) are radically overhauled before it is too late and disaster really strikes.