Iflation pressure and the economy "carpet" (I)

Recently, for a few hours, Prime Minister Mugur Isarescu put on a teacher’s coat to explain to a few students-reporters some of the secrets of inflation.

Tossed into the “lions’ den” for failing to meet the year 2000 inflation target, professor Isarescu tried to explain to the audience why the nation is forced to put up with the cost of inflation.

The economy is not a “lion” that can be tamed to obey the orders of the god-state. The results of a scenario cannot be commented ignoring the changes in the evolution of things. A

chieving some inflation goals below two digits is a lengthy process that could generate more suffering. Romania has not yet seen periods of significant deflation so the populace should miss the “sweet poison” of inflation.

Although he was criticised for a stuffy economic language, professor Isarescu tried to explain as simply as possible the true causes that caused the inflation target to be missed.

Their mere enumeration does not satisfy the audience (with a certain economic culture) and much less the populace at large.

Therefore we will attempt to unravel this evil, so often “savoured” by the Romanians on the pages of specialised media.

Going up, up, up…

After ten years of transition, after the price liberalisation in the ’90s, Romanians have grown accustomed to the notion of “growing prices.” We often hear statements such as: life is more expensive, “prices are more expensive” (?!), subway is more expensive, power is more expensive, etc.

An economics professor explains to his students “why goods and services grow expensive.” In other words, why do prices grow? The simplest explanation is found when we go out shopping.

A market allows buyers and sellers of a given commodity to converge. In the Obor food market, the tomato market consists of the “totality of counters” and their clients.

The market is the place where tomato producers display their commodity and their prices, and it is the place where consumers decide whether to buy tomatoes or not, depending on their taste for this particular product and the price that is claimed.

When tomatoes are cheap (5,000-6,000 lei/kg) compared to other products, a lot will be sold. If the price is 10,000-12,000 lei/kg, less will be sold. Every tomato producer is therefore obliged to set a “reasonable price” if he desires to sell and watch the price of competing counters.

But the producing peasant also wants to make money for himself. He needs to buy books, boots or seeds for the next crop.

And if he sets the price too low, it may turn out that tomatoes “are not worth it” and he may turn a loss.

Consequently, the resulting selling price is a compromise between two conflicting risks: on one hand, the risk of losing customers if the price is too high, on the other, of compromising revenue if it is too low.

Therefore, production costs, expected revenues and competition lead tomato producers to establishing prices. Most often, higher prices are blamed on higher costs.

For instance, as fuel and energy prices grow, an edible oil producer might be tempted to raise the profit margin if it needs to invest (in new equipment) or deems that the profit rate has dropped too low. A bad financial situation in oil factories might cause the price of edible oil to grow.

In the face of rising prices, competition is a brake, because it forces every edible oil producer to lower costs and profits. But the biggest obstacle in the way of rising prices is productivity.

Therefore, the oil price depends on numerous parameters influenced by producers’ behaviour, their financial situation (past and desired), salaries, fiscal pressure and productivity. But prices also depend on demand. Let’s ask what happens to the oil price if consumers’ income grows.

The seller has a choice. He can maintain the price (in which case he will sell more). Or he can be happy with how much he was selling and let the price grow, restoring the profit margin.

He will choose this if the profit seems too low. Sales data analysis indeed confirms that a recovery of consumer spending, when the profit rate is insufficient, leads to renewed inflation.

From simple to complex

Not long ago, government counsellor Adrian Vasilescu explained that a price growth is not inflation. Logically, you will ask: why did then professor Isarescu enumerate the oil price among the causes of inflation?

We must accept that there is a fundamental difference between the market for a commodity and the overall functioning of the economy. General conditions have a direct influence on a commodity’s market, but price-setting decisions have a modest influence on overall economic conditions.

For instance, a 15% growth in railwaymen’s salaries is very important for the price of a railway trip, but this price growth has no major impact on salaries in the railway industry.

To understand the real price of a trip, one must therefore analyse production conditions in the railway sector, especially productivity.

Lending, currency, arrears, etc., can be ignored. Given the complexity of an economy, any movement of an economic parameter necessarily triggers the movement of all other parameters.

Any price growth (for instance, the oil price) propagates into the entire economy much as a rock sends waves on the water surface. Because someone’s expectations are another’s costs. If, for instance, the oil price grows 10%, electricity producers will raise their own prices by 3-4%, bread producers by 1.2%, and bread retailers by 0.5%.

One could expect that, progressively, after a series of “waves,” prices should return to normal (become stable) as the lake settles down after a few moments of agitation. In a (complex) economy this return to a calm state does not necessarily occur.

Inflation mechanisms will not merely record and propagate growth, they will fuel and intensify it in many ways.

Let’s focus on prices. The price of a given commodity is the sum of manufacturing costs and the profit margin. Increasing the scale from one commodity to the whole economy, it can be observed that both costs and producers’ profits are revenues for workers.

Social contributions go to the social security fund, which redistributes them to workers. Taxes go to the state, which uses the money to pay public servants, to subsidise (some sectors) or perhaps to buy fighter jets. As to profit, it is the producer’s income, which may show up in shareholders’ dividends or in the company’s investments.

Consequently, the equation verifies: national output equates total distributed revenue. In the case of inflation, the price of commodities and services grows.

As a compensation, consumers find that their income grows, for instance, in the form of a salary growth (the railwaymen’s case). But overall, the amount of purchasing and therefore the level of economic activity have not changed.

Only prices and revenues measured in money have grown, a somewhat useless development, because economic activity has not changed.

This is the correlation between prices and revenues, and revenues and prices, known as the “inflation spiral” professor Isarescu spoke about in the recent seminar “Inflation – forecast and reality.”

By understanding it, we can sense how inflation can be initiated and maintained. The two factors emerge that (for each economic agents) press on prices: costs and demand.

The failure to meet the inflation target, set in agreement with the IMF, cannot be blamed on prime minister and professor Mugur Isarescu. Had the government been formed only of the premier-consumer, and the economy of a single producer-supplier, they could achieve a truce as to the prices-salaries ratio.

But in the real economy there are millions of producers and consumers, plus intermediaries such as banks, insurance companies, administrations, foreign partners, etc. All these mechanisms are in a permanent state of imbalance that sends perturbation into the system.