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What Happens During a Wage-Price Spiral?

Most economists would agree that inflation increases a country's average cost of living, and many competing arguments exist on what causes these higher prices for goods and services. The list of specific possible reasons a nation experiences inflation are many, but a few broad macroeconomic theories actually attempt to explain this phenomenon. One of those is the wage-price spiral.

Those who support this model suggest that rising worker wages contribute to inflationary pressures. While the wage-price spiral isn't the only explanation for inflation, it's an influential model in modern economics.

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What is a wage-price spiral?

The wage-price spiral––or the cost-push theory of inflation, as some economists call it––is an economic theory that argues increasing wages for employees results in higher costs for goods and services. Companies need to raise the prices they charge for their items as production costs climb. As product prices increase, workers are more likely to seek even higher wages to maintain their standard of living. This constant upward movement in wages and costs leads to an unending inflation spiral. 

What are the stages in a wage-price spiral? 

Higher wages are always a feature of the wage-price spiral, but it's difficult to determine a beginning stage for these price increases. Many factors can play a role in influencing an increase in a company's minimum wage. 

Often, workers will start to demand higher wages when there's already inflation in the local economy. If the prices of essential items like food, oil, and homes continue to rise, more people will notice their purchasing power decrease. As more employees feel strained to maintain their living standard, they’re more likely––in theory––to pressurize employers for higher wages. 

Once more firms increase wages, they're more likely to pass these cost increases onto the consumer. These higher costs result in further inflation, which drives wages up again. 

What contributes to a wage-price spiral? 

Wage-price spirals can happen at any time, but the following features increase the likelihood of wage increases impacting an economy: 

  • Strong economic conditions: It's more common for wage-price spirals to happen during times of economic growth. A high GDP (gross domestic product) often correlates with low unemployment. A stronger economy usually means employees have higher disposable income, which often fuels aggregate demand and average prices. 
  • Low interest rates: Central banks like the Federal Reserve often lower their borrowing rates to spur economic growth. These relaxed policies promote increased spending and lending from consumers, banks, and governments. The increased spending activity during these times might increase companies' willingness to approve wage increases.  
  • External inflationary pressures: Price increases on commodities like wheat, livestock, or oil usually hurt consumers’ purchasing power and potentially cause employees to demand wage increases. 
  • Growth in trade unions: The larger the trade unions are in a company, the greater the influence they may have on wage disputes. A country's laws surrounding unionization may also impact the likelihood of wage increases. 

How to break the wage-price spiral? 

It can be challenging for governments to contain an ongoing wage-price spiral, but here are a few strategies companies and policymakers can use to help curb its inflationary effects: 

  • Monetary tightening: During inflation, central banks often increase their interest rates to reduce demand, which may decrease the odds of consumers and businesses applying for loans. Instead, they focus on saving money and waiting for a low interest rate environment. While increasing interest rates help curb demand, there’s a risk that central bankers could drive the economy into a recession.
  • Growth in productivity: If wage increase is proportional to the overall increase in productivity, a salary increase may not cause noticeable inflationary pressure. In this scenario, GDP has to keep pace with a rise in minimum wages. 
  • Decrease in production cost: Alternatively, reducing production costs or commodity prices may reduce the need to hike prices for consumers, like greater reliance on automation and robots can contribute to lower production costs, decreasing the odds of inflated prices. 

What’s an example of a wage-price spiral? 

One classic example of a wage-price spiral is the energy crisis that happened in the 1970s. During that decade, wars and revolutions in the Middle East led to  substantial disruptions in the international oil trade, causing many Western countries to face significant oil shortages. As a result, oil prices began to rise.

As the cost of oil increased, inflation began to spread across the West. Trade unions in nations like the U.S. and the U.K. began demanding higher wages to meet the increased cost of living. These higher wages exerted further inflationary pressure on the economy, leading to rising prices. 

As a result, both the Bank of England and the Fed in the U.S. increased interest rates to help drive down demand in their respective countries. As oil prices plunged, inflation started to taper. 

Criticisms against the wage-price spiral

The wage-price spiral is an influential theory in macroeconomics, but it's not without its critics. Many respected economists like the Nobel Prize winner Milton Friedman have argued the wage-price spiral doesn't fully account for inflation and that only considering this misses out on much of the explanatory variables. Some economists have even suggested the wage-price spiral is actually a myth.  

Critics of the wage-price spiral often argue wage increases are symptomatic of pre-existing inflation. According to this theory, wage hikes may contribute to inflation, but they don't cause it. Economists who subscribe to the demand-pull theory, which refers to price increases due to demand exceeding supply, usually blame factors such as an increased money supply, higher demand, and lower supply. The demand-pull argument is popularly defined as "too many dollars chasing too few goods." As a nation's circulating cash increases while supply decreases, the citizens’ purchasing power decreases. The true answer doesn’t have to be one or the other. It’s likely a combination of multiple factors.

Some economists have also raised ethical concerns against the wage-price spiral theory. Unions and workers' rights advocates often claim the wage-price theory puts too much blame on employees. Critics argue businesses that believe in the centrality of wage prices may be less prone to raise the living standard of their workers. Rather than taking other cost-cutting measures, companies might keep their minimum wages low to avoid a wage-price spiral. 

Not everyone believes that the wage-price spiral causes inflation, but most experts agree it influences economic pressures. Some economists combine both demand-pull and cost-push to better explain how inflation functions. While demand-pull is often used to describe the cause of inflation, cost-push explains how inflation can intensify within an economy.

Wage-price spirals and crypto: How do they relate?

Many cryptocurrencies are labeled inflation hedge investments but aren't directly related to the wage-price spiral. Instead, many digital coins seek to address the monetary policies that can contribute to inflation. 

Most notably, Bitcoin (BTC) was designed to have a set supply of 21 million coins. Every four years, the amount of Bitcoin in circulation decreases by half until there are 21 million BTC in circulation. This gives BTC a pre-set inflation rate that’ll gradually decrease until it hits 0%.

Since Bitcoin is a decentralized and non-sovereign asset, no government or central bank can modify this supply. The crypto’s hard-cap supply and pre-set issuance schedule remove a great deal of uncertainty related to centrally controlled fiat currencies.  

Many blockchains are experimenting with deflationary issuance rates. Ethereum (ETH) has a coin-burning mechanism built into its blockchain, which may result in the total supply decreasing over time. Whenever crypto holders make transactions on the Ethereum blockchain, a small amount of ETH is eliminated from circulation. The more activity there is on Ethereum, the higher the daily ETH burn rate. If Ethereum's network activity increases, this burn rate could exceed its daily issuance. 

While cryptocurrencies are still a speculative asset class, many within Web3 are hopeful they can address the monetary policies that often contribute to inflation. Coins like BTC and ETH have issuance programs that are deflationary and resistant to third-party intervention. However, it's unknown whether the increased use of cryptocurrencies (especially for employee wages) will affect cost-push dynamics. 

Wrapping up 

The wage-price spiral isn't the only reason behind inflation, but it can contribute to rising prices. Economists and policymakers still use the cost-push theory to analyze inflation and develop strategies for addressing it. Remember, wage prices can spiral upward, too, which can significantly impact a population’s purchasing power.    

At Worldcoin, we believe cryptocurrencies will play an increasingly significant role as more countries deal with inflationary pressures. To ensure everyone has equal access to Web3, we're committed to spreading free crypto like the DAI stablecoin to as many people as possible. Subscribe to our YouTube channel to learn more.

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