… a more fundamental proposition [is] that any large change in commodity prices – irrespective of whether it is in favour or against the primary producers – tends to have a dampening effect on industrial activity; it retards industrial growth in both cases, instead of retarding it in the one case and stimulating it in the other. There are, as I shall now show, two reasons for this. It is partly a consequence of the fact that whilst a fall in commodity prices tends to be an effective instrument in moving the terms of trade against the primary producers, a rise in commodity prices is not likely to be nearly as effective in moving the terms of trade in their favour. It is partly also a consequence of an asymmetry in the behavioural consequences as between a gain and a loss of real income, the result of which is that any sudden shift in the distribution of world income, caused by a change in the terms of trade, is likely to have an adverse effect on industrial demand (in real terms).

The important cause of the first asymmetry is that while commodity prices are demand-determined, industrial prices are cost-determined, and because of that the rise in commodity prices has a very powerful inflationary effect operating on the cost side. The rise in the price of basic materials and fuels is passed through the various stages of production into the final price with an exaggerated effect – it gets ” blown up ” on the way by a succession of percentage additions to prime costs which mean, in effect, an increase in cash margins at each stage. This causes (initially) a rise in the share of profits in the value added by manufacturing which in itself is a powerful factor (in countries where trade union power is strong) in causing pressure for wage increases. Added to this is the price-induced rise in wages caused by what Sir John Hicks called “Real Wage Resistance” – the reluctance of workers to accept a cut in their standard of living (which is not paralleled by similar reluctance to accept a rise). For these reasons a swing in the terms of trade in favour of the primary producers is not likely to last for long. The industrial sector with its superior market power, resists any compression of its real income by countering the rise in commodity prices through a cost-induced inflation of industrial prices.

Moreover – and here we come to the second reason mentioned above – the inflation itself has a deflationary effect on the effective demand for industrial goods in real terms, partly because the rise in the profits of producers in the primary sector is not matched by a rise in their expenditure – this was particularly marked on the present occasion through the vast accumulation of financial assets by the oil producers – and partly because the governments of most, if not all, of the industrial countries are likely to react to their domestic inflation by fiscal and monetary measures which reduce consumer demand and put a brake on industrial investment. Thus the rise in commodity prices may well result in a wage/price spiral-type of inflation in the industrial sectors which in turn causes industrial activity to be restricted. The latter tends to eliminate the shortages and thereby reverse the trend in commodity prices. A good example of this has been the U.S. inflation of I972-3, which was clearly cost induced but not wage-induced; it was caused by the rise in commodity prices (with wage rises trailing behind the rise in living costs) and which led to strongly restrictionist monetary policies in order to counter the inflation, which in turn brought about a considerable economic recession. (Somewhat later similar restrictionist policies were adopted by governments of other leading countries, such as Germany and Japan.)

If the above analysis is correct, the market mechanism is a highly inefficient regulator for securing continuing adjustment between the growth of availabilities and the growth in requirements for primary products in a manner conducive to the harmonious development of the world economy.

The emergence of commodity surpluses which should, in principle, lead to accelerated industrialisation may have a perverse effect by diminishing effective demand for industrial products. Similarly the emergence of shortages which should accelerate the growth of availabilities of primary products through improvements in the terms of trade may lead instead to an inflation of manufacturers’ prices which tends to offset the improvement in the terms of trade, and by its dampening effect on industrial activity, worsens the climate for new investment in both the primary sector and the industrial sector.

– Kaldor, Nicholas. 1976. “Inflation and Recession in the World Economy”. The Economic Journal 86 (344). [Royal Economic Society, Wiley]: 703–14. doi:10.2307/2231447. Link