Sometimes I despair. Sometimes I wonder if the inflation fallacy is at the root of all the US and Eurozone troubles. It's so easy to get popular support for the idea that printing money will cause inflation, and inflation means a fall in our real income. So it's much better to have high unemployment, low employment, low real output, and errrr, low real income, than to risk having low real income.
The inflation fallacy is an invalid argument about why inflation is bad. Now, an invalid argument can sometimes have a true conclusion. Maybe inflation is bad. Maybe inflation does reduce our real incomes. But it's still an invalid argument. It doesn't give any good reason for thinking that inflation is bad, or reduces our real incomes.
A lot of non-economists believe the inflation fallacy. I'm an expert on what non-economists think about economics. That's because I have spent the last 30 years trying to teach non-economists how to think about economics.
Sometime in February, I will ask my ECON1000 students: "So, why is inflation a bad thing?"
I can anticipate the look on their faces. Some will give me that look of sympathy, normally reserved for those who aren't too bright. Others will look like they know this must be a trick question, since I wouldn't ask anything that were really quite so obvious. Finally one will answer.
"Because if all prices rise 10% we will only be able to afford to buy 10% less stuff. Duh!" Except the "Duh!" is silent.
That's the inflation fallacy.
You could try to counter the inflation fallacy by talking about the neutrality of money. But that's the wrong approach. Sure, if money is neutral, and so has no effect on real variables like real income, then the conclusion of the inflation fallacy would be false. But that misses the point. The inflation fallacy is an invalid argument. It is logically, conceptually, confused. Even if the conclusion were true, it would still be an invalid argument. Even if inflation did cause falling real incomes, the inflation fallacy would not be a good argument for believing that inflation would cause falling real incomes.
Why is the inflation fallacy a fallacy?
Apples bought must equal apples sold. What is an expenditure to the buyer of apples is a source of income to the seller of apples. Every $1 rise in the price of an apple means the buyer is $1 poorer and the seller is $1 richer. That's true whether we buy and sell one apple or buy and sell one billion apples. It's true whether or not we add in bananas, carrots, dates, and eggs. It's true whether all prices go up by the same amount, or percentage, or if they all go up by different amounts. It's true whether we measure prices in money, in gold, or in venus dust.
It makes exactly as much sense to argue that a 10% rise in prices is a good thing because it means we earn 10% more income from selling things and so can afford to buy 10% more stuff. Let's call that the inflation fallacy mark 2. It's the exact opposite of the original inflation fallacy mark 1.
Why is the inflation fallacy mark 1 so common, but the inflation fallacy mark 2 so rarely heard? I don't know, but I'm going to make a couple of guesses.
1. We live in an economy with specialisation and the division of labour. We sell one good, and buy hundreds of goods. Naturally, we are much more knowledgeable about the one good we sell than about the hundreds of goods we buy. We understand the forces that proximately determine the price of the one good we sell. We don't understand the forces that determine the prices of the hundreds of goods we buy. So we put a name to our ignorance, and call it "inflation".
"Inflation" means an increase in the price of the goods we buy. The price of the good we sell is determined in a quite different way. So, if we think like that, we will think of inflation as making us worse off.
Inflation is when other people increase their prices, not when I increase my price.
2. Most of us earn our income from selling our labour. And we think that other people are like us. When we think of the representative person, we think of ourselves. We have a special name for the price of labour. We don't call it a "price"; we call it a "wage". And we think of inflation as price inflation, not wage inflation. Since there's no obvious one-to-one link between price inflation and wage inflation, and we know that sometimes wages rise faster and sometimes slower than prices, we think that inflation reduces real wages, and makes people worse off. Even if it did, we forget that capitalists are people too. They are "the other".
If we excluded apples from the CPI, and gave the price of apples a special name, then "inflation" would mean a rise in the price of bananas, carrots, and dates. So of course inflation makes us apple sellers worse off.
The inflation fallacy is a conceptual fallacy. It's a fallacy of composition. It fails to recognise that "inflation is someone else's price increase, not mine" doesn't work at the macro level, when we add up all the buyers and sellers. It's a fallacy of someone who hasn't come across the "income = expenditure" accounting identity. It's a fallacy of someone who doesn't recognise that production is the ultimate source of our aggregate income and expenditure, not how much we pay each other.
It's a fallacy I think we will never eradicate. "Ours the task eternal", once again.
I have sympathy with some Austrians, who define "inflation" as an increasing money supply, not rising prices. But it doesn't really work, because both the demand and supply of money can change. And people will still find another way to talk about rising prices, even if you forbid them to use the word "inflation". And I have sympathy with Scott Sumner's approach too, in trying to ban the use of the "i-word", and talk about NGDP instead.
Because the question "is inflation a good or bad thing?" is a really stupid question. It doesn't have an answer. Inflation is an endogenous variable. It depends what caused it. If inflation is caused by a harvest failure, then it will make us worse off. But it's not the inflation that makes us worse off, it's the harvest failure. With lower output of goods, our real income is lower too. Inflation is only a symptom. It's the way a bad harvest will manifest itself to us, if we weren't directly involved in the harvest itself.
The right way to ask the question is to talk about monetary policy. If the Bank of Canada had a 0% inflation target, or a 4% inflation target, would either of those make us better or worse off than the current 2% inflation target? That's when we can move beyond accounting identities, and start to argue about the neutrality or non-neutrality of money (strictly, super-neutrality of money).
And if we could talk about the effects of a falling value of money, rather than a rising price of goods, that would help clear people's minds too. Speaking about a falling value of money suggests both that we will get more money from the goods we sell, and give up more money from the goods we buy. It leads us to think about both versions of the inflation fallacy at the same time — mark 1 and mark 2 — and to see that they offset each other. Then, and only then, can we start to think about the real question.
Paradoxically, one of the strongest valid arguments against targeting too high an inflation rate may be the very existence of the inflation fallacy itself as a sociological phenomenon. The fact that many ordinary people are so confused about inflation does suggest that inflation may be a bad thing.
Worthwhile Canadian Initiative 
This post reminds me of classic asset/liability mismatch risk of banks. Back in the days when interest rates were positive, the classic mismatch was fixed rate assets against floating rate liabilities. The “mismatch” risk was that a bank could get caught by rising rates.
Now substitute inflation for interest rate sensitivity, and households for banks. If you capitalize expected household income and expenditure as a near term balance sheet, then it has assets that include expected wages and liabilities that include expected expenditures. If inflation hits those two sides with different timing, then you have a mismatch risk comparable to bank interest rate risk. If wages are sticky but prices go up, the household will get caught in the mismatch by rising inflation.
In both cases, it’s the risk associated with timing differences, and how that hits individual balance sheets, not the level of interest rates or inflation per se. Although large first derivatives, i.e. changes to interest rates or inflation, exacerbate that timing risk.
Nick,
“an invalid argument can sometimes have a true conclusion”
Perhaps your “fallacy” is actually just a heuristic: a useful simplification of a complex phenomenon. For instance, you argue debt is neutral. Why do people insist it is bad? Perhaps because they sense that there are such things as financial frictions and different consumption propensities (across income levels) at work. Most people don’t know how to have that discussion, so they rely on an infuriating (for economists) rule of thumb: “it is bad for society to borrow too much”.
The raison d’etre for technocrats is that the employment of common economic heuristics leads to suboptimal outcomes. The counterargument is that apparently suboptimal heuristics may be useful safeguards against the creation of an fragile system prone to tail risk.
“It’s so easy to get popular support for the idea that printing money will cause inflation, and inflation means a fall in our real income.”
To a lot of people, inflation means an increase in the money supply.
To even more people, perhaps most, inflation means a fall in real incomes because prices increase faster than incomes.
These two meanings are common in informal, everyday speech. I don’t know if fallacy is the right word for that fact.
A lot of people believe that an increase in the money supply will lead to prices increasing faster than incomes. That, of course, is a fallacy.
Well, economists have to confess to their role in all this, Nick. Milton Friedman and his followers spent their careers arguing inflation was bad. People and politicians believed them. In response to high price inflation in the late 1970’s we had very high interest rates in the early 1980’s. That was before my time, but I have noticed a very prevalent view among those who remember that time that the high price inflation and high interest rates were “bad” and to be avoided at all costs.
We have a generation of economists who focused on justifying an explicit 2% inflation targeting rule for the Bank of Canada and explaining why this is a Good Thing, both to the academy and to the general public.
Economists went along for the ride as much as the rest of us did. You even took your turn in the driver’s seat. So you can’t complain when you don’t like the destination.
Now I’m game for saying that we do need to change our focus and we need to realize we are in a poor economic environment, poorer than we have seen in several generations. But let’s all remember how we got focused in the first place.
But I don’t have anything to sell, I buy with money I have saved, if you reduce the value of my savings, more and more my savings are being stolen.
A bit OT but delong censored it on his blog, so I’m trying here too:
Ghost cities in China supported AD/CPI/employment, you name it, for years. Good or bad? And should we emulate that?
Dave
* your inflation argument makes sense “maybe” in a closed system. just like keynesianism.
Are you sure that inflation is not a good thing? The first hockey stick graph I saw was one that showed inflation taking off around 1750. It seems that there are two different monetary regimes, pre-industrial and post-industrial, and inflation is characteristic of the latter. Is that mere coincidence?
Old joke:
A politician on the stump declaims:
“My friends, I am against inflation.” (Applause.)
“My friends, I am against deflation.” (Applause.)
“My friends, I am for — FLATION!”
Old Art: “I buy with money I have saved, if you reduce the value of my savings, more and more my savings are being stolen.”
Take your money out of the mattress and buy TIPS (Treasury Inflation Protected Securities).
“Sometime in February, I will ask my ECON1000 students: “So, why is inflation a bad thing?”
{snip}
“Finally one will answer.
“Because if all prices rise 10% we will only be able to afford to buy 10% less stuff. Duh!” Except the “Duh!” is silent.
“That’s the inflation fallacy.”
What if you then ask them what they mean by inflation? That might save you a lot of trouble. 🙂
Determinant: “Milton Friedman and his followers spent their careers arguing inflation was bad. People and politicians believed them. In response to high price inflation in the late 1970’s we had very high interest rates in the early 1980’s. That was before my time, but I have noticed a very prevalent view among those who remember that time that the high price inflation and high interest rates were “bad” and to be avoided at all costs.”
I don’t think that you can fault Uncle Milty. He thought we should have a steadily increasing money supply, right? He also convinced Nixon to go completely off the gold standard. (If only Congress was aware of that fact!)
Inflation is bad because it reduces their real income. What reduces the real income of others, unemployment, is not their concern, or even, a buying opportunity.
I expect that people could be trained to accept any reasonably predictable inflation rate as “good.” It seems to me that something a bit higher than the current target would probably have some advantages, and may actually help with inequality – in general, lenders are part of the wealthy classes while borrowers are lower on the pole. Increasing the inflation rate could be sold pretty easily as a wealth transfer, if there was a desire to do so. It would only work on existing debts, of course. It should also help encourage investment generally, since sitting with your cash in a mattress becomes more expensive.
It’s unpredictable inflation that seem like a bad thing. I would expect it to cause trouble in debt markets, since lenders and borrowers no longer have a good prediction of what their real returns/costs will be. I might be less likely to borrow at 5% if I can’t reasonably expect to get a 2% inflation discount on that. Likewise if I had money to lend, I’d want a higher rate to cover the risk of much higher inflation.
“I’m an expert on what non-economists think about economics.”
Great line.
“Inflation is bad ” because everybody ( including the statisticians) confuse it with real price level. The ’70’s were not inflationary. They were contractionary They were a time of real shock ( oil) and subsequent fall in real wages. But we viewed it as a “recession”, tried to use stimulative measure and ended up with a higer price level that we conofused with the cause of the problem. ( Though as a benefit, inflation brought back the terms of trade with the oil producers more in liine with the pre-schock equilibrium)
But the damage was done. And the hard-money types had a new “reason” to fight the welfare state
Most lay people use the term inflation to mean a price change, any price change, or often as is the case, price changes that bother them, e.g., sharp increases in food or fuel prices.
The notion of economy-wide weighted price changes is a tough one to grasp.
I vote for 0% inflation target with a -1% to +1% operating band range. As the socially responsible thing to do given to what extent folks are too readily confused by price changes. Higher inflation rates provide smart, nimble folks opportunities to make money in the markets. Socialism doesn’t mean having to make rich bond holders and others richer but I suppose there could be worse outcomes.
Lord, if I find out that Nick has committed suicide in the night, I am holding you personally responsible.
Given the nominal quantity of money, a 10% in the price level reduceds the real quantity of money by 10%. Given demand for money, you are short and the way to fix that situation is to buy less. Must you buy less? I am not sure, but the expectation is that people will want to buy less. And so firms will sell less.
At least, that is the way I see the effects of an “inflation” shock.
Nick:
A stimulating argument, good food for thought. Still, I think there are some problems here.
* Doesn’t your account assume a closed economy? In particular, unless wages or other inputs into a firm’s tradeable goods can be reduced to offset rising prices, wouldn’t that firm find, over time, that it is losing customers at home and abroad to competitor firms in countries with lower rates of inflation? Or is the inflationary economy supposed to see its currency adjust quickly downward?
.
* If the home-currency is falling steadily (compared to competitor countries’ currencies), won’t that further feed back as higher-costs of imported inputs to production in the home-country and cause ever higher costs to the finished goods? Or — maybe just as bad, since currencies can undershoot or overshoot all the time if they’re floating — at least might there not be more and more uncertainty in various firms’s investment decisions for the future? Might not many of them decide to relocate abroad where wages and prices are steadier or more predictable (and likely lower)?
,
* Savings: Sure, there are ways to offset rising inflation such as TIPS. But then won’t the need for savers — including those in retirement living on savings and fixed pensions — incur lots of opportunity costs in managing their portfolios. And exactly how many average-educated people, never mind others in such a situation, know how to find the right way to manage inflation? Especially if uncertainties about future rates of price-rises begin to multiply?
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* Market Power of certain labor forces: You assume that wages will, it seem, adjust pretty quickly upward to offset, say, even steady inflationary tendencies. Is that assumption true of all employees, in both the private and public spheres. Won’t unionized workers be able to extract quicker adjustments in wages from management (private or public) that those who aren’t organized? Which is way,when you get down to it, that powerful unions didn’t seem to mind higher inflation rates in the past in the USA . . . at any rate, until international competition in, say, the auto industry began to make more and more USA auto sales fall over time (apart from quality questions).
.
* You ignore the political side of all this, or so it seems.
Specifically, you assume that the Central Bank is private, that it won’t be subject to political pressures from elected governments to raise the money supply (and hence, let us assume, NGDP and overall prices) for self-centered or ideological reasons. Are you sure that this is the case? Wouldn’t uncertainty begin to creep into the savings and investment and consumption decisions of economic actors, convinced that at some time even in the USA or Canada, legislatures might revise the charters of central banks and make them more susceptible to political manipulation.
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* Menu Costs. Various retail and service firms would have to incur repetitive costs yearly (or more frequently, all depending on whether rates of inflation vary over the year up or down) to adjust their prices. Couldn’t that add real costs to their products?
.
* Finally, to get back to unpredictable changes in inflationary rates — leaving aside hyper-inflation, the definition of which will vary, seemingly, across countries for historical reasons (think of Germany vs. Italy or Greece today).
In particular, are you really sure that the Central Bank in the US or Canada or the EU or elsewhere can, once expectations of the average economic actor adjust to a certain inflationary rate, can maintain that rate in the face of all sorts of exogenous and unpredictable changes: wars in the Middle East and sudden spikes in oil prices (or any huge spikes as in 2007-2008)? Or a sudden surge in other raw materials and food, maybe owing to bad harvest or natural disasters (like the nuclear reactor breakdown in Japan recently) or unpredictable changes in “animal spirits” of home and foreign financial investors if a country like the US or Canada is experiencing sudden spikes, however temporary, and begin to set off a run on that country’s currency — itself self-feeding possibly.
Rightly or wrongly, for historical reasons — to return to Italy and Germany — have created far different outlooks not just among average people without economic backgrounds, but among policymakers . . . including intelligent Central Bankers. Maybe the German-influenced policy-ideas in the EU today are wrong. Maybe they will have to bend in the future, though just as likely the Germans will find ways to reorganize the Eurozone membership or policies. Are you sure that, given their historical experience with hyperinflation in the 1920s — which did wipe out the savings of average people and voters and turn them against the Weimar Republic (which solved the hyperinflation with a new currency) — the Germans are just subject to a fallacy?
…
Always enjoy your posts, Nick. This one too.
Best, Michael Gordon, AKA the buggy professor
*
Your comment that most people view inflation as price inflation and not wage inflation is the key. If wages are flat but inflation is 10% then you are worse off and that’s a situation that most people identify with without seeing the link between price and wage inflation. When inflation is 10% and wages are rising at a rate of 10% people think they “earned” that 10% raise and if only inflation wasn’t 10% they’d be better off without realizing without 10% inflation they would never get that 10% raise in the fist place.
Also, why do savers always manage to find a way to complain. Either inflation is too high so it eats into their nominal interest or their nominal rates are too low, without ever realizing that their real rate of return is more or less constant.
Finally, unpredictable inflation is probably bad as it hinders planning and inflation variability seems to be positively correlated with the actual rate of inflation, so even though 10% inflation is not inherently worse than 2% inflation, 10% plus or minus 4% is worse than 2% plus or minus 1%.
It depends. A little inflation is a good thing most of the time for most of the people. “Too much” inflation is a bad thing most of the time for most of the people. How much is too much cannot be specified in advance. Any absolute statement about inflation is a fallacy of hasty generalization.
In the 16th and 17th century there was not enough inflation in Europe and it was strangling their economies. Kings were commissioning alchemists to try to solve the problem through the creation of artificial gold. The deflation problem was solved instead by the institution of credit money.
Min:
Uncle Milty was also personally responsible for the American Welfare State and Big Government as we know it, he designed and implemented the payroll witholding regime for Income Tax that enables fuels Big Government.
But the Inflationphobes flocked to his standard; we spent the next thirty years putting them in positions of power. Now we reap our reward.
Of course Uncle Milty himself was contradictory but he was the star spokesman for the “I Hate Inflation, let’s have Free Markets” club.
Jacques:
I love it when you post about the 1970’s because I always agree with you.
The salient fact is that the United States reached domestic peak oil production in 1970. After that domestic oil became scarce and the US became dependent on oil imports to meet full market demand.
Sure much of the actual oil shock was political with the closure of the Suez Canal but depleted natural resources made the crisis possible the first place.
But according to Nick aggregate supply shocks don’t happen outside of war. Ummmmm…..
Another great post Nick. You are on a roll.
My first thought is to something Old Art said;
“But I don’t have anything to sell, I buy with money I have saved, if you reduce the value of my savings, more and more my savings are being stolen.”
This is the Austrian position, one that gives the saver primacy over everyone else. I think it was someone at Steve Waldmans site that talked about how savers seem to expect that they should never be on the bad side of the economy. When labor has to suffer low unemployment; “Well, its just that the marginal return on labor is falling and well you’ll just have to suck it up” But when the interest rate heads toward the negative ” Danger Will Robinson Danger Will Robinson!! Those poor savers are being punished, we cant have that!!”
Look, sometimes its just a bad time to save……………… deal with it!
I assume we are talking about a domestic basket of consumer goods. Much of the basket is imported so is not “my” output. So inflation is bad. This is generally true even in China, but almost 100% always true in Luxemburg. Domestic producer price inflation however is a good thing because some of it is exported. The converse is true for foreign inflation: CPI good, PPI bad. But if you ask me the question you ask your students, I’m going to assume you refer to domestic CPI. That’s the common meaning of “inflation.” And I’d say “bad.”
David Pearson: “For instance, you argue debt is neutral. Why do people insist it is bad?”
They used to put some debtors in prison, you know. Where are the creditors’ prisons? 😉
Nick:
I’m sorry to find out that you expunged my comment. I expect Delong to censor comments that criticize his views; the man’s egomania can’t tolerate them. Mark Thoma, who runs a good blog, has,alas,started to show temper-blasts of late too. They both want,apparently,only bah-bahhing sheeple who bray their approval, nothing less. A good way to massage their narcissism, no?
Then,too,The libertarians at EconLog,to their shame,have shown that they can be as intolerant of hard,evidence-driven criticisms as left-wingers,politically correct to the core, and in bad ways, tend too often to do.
But I never expected you to emulate their censorship, just the contrary. It seems a shame . . .doubly so since I share you overall commitment to fight serious inflation by means of NGDP monetary policy.
Michael
Min:
The Creditor’s Prisons are located next to the Customer’s Yachts.
Michael: Your post was the victim of an overzealous spam filter. Our apologies.
I always thought inflation was one of those things rich people disliked, so they made sure to spook the rest of us into not liking it either. Like taxes.
My understanding is that money is just debt, like any other financial product. It’s backed by the tax payers of the country who issued it, and gold was commonly used as collateral. You trade your apples for an IOU from society.
The printing of money means the dilution of debt, which means the lowering of its value, which means inflation, which means those with money have lost. Rich people don’t like that. The debt is being forgiven, but not forgotten.
And for us rubes, living paycheck to paycheck? Inflation means nothing. And frankly, we don’t even pay much taxes! There’s freedom in having nothing to lose.
Determinant: “The Creditor’s Prisons are located next to the Customer’s Yachts.”
Great minds think alike. 😉
I agree. (I guess that’s no big surprise.)
This is closely related to points made by JKH and others, but if price dispersion is correlated with the rate of inflation then the fallacy is not a fallacy.
As Nick says, people are consumers of many goods and sellers of just one. By some law of large numbers, any consumer can expect her average costs to closely track the inflation rate. However, while on average earnings rise in parallel, the dispersion of any consumer’s earnings around that average is large. She may receive a windfall, as her earnings outpace increasing costs, or she may find that her wages fail to track the price change. If she is risk averse, she prefers the low price dispersion that accompanies low inflation.
Ironically, if she is leveraged (directly via loans or operationally via high not-very-discretionary expenses relative to income), she will be particularly risk-averse. If she is leveraged via fixed nominal debt, she’ll need to trade off the riskiness of price dispersion against the benefit of an expected reduced debt burden. If she is leveraged by lifestyle, her burden rises with inflation, so all she experiences is acute risk.
If our consumer’s wages are sticky downward and she is secure in her employment, then it’s likely that inflation will correspond to a real wage cut in expectation, not just unpleasant but symmetrical risk. This consumer’s “shadow wage” — the wage that would obtain under flexible pricing — might be lower than her money wage, but be censored by the downward stickiness. Inflation exposes her to the risk of taking a pay cut towards the market-clearing level. Even if our consumer’s sticky wages start at the “right price”, higher inflation reduces a favorable asymmetry in the distribution of her future wages since her nominal wage cannot fall.
I would love to see a nice wage-price cycle take hold right now to reduce the burden of nominally contracted debt. But it is not stupid for people who are not financial creditors but hold secure jobs to dislike inflation, once you add uncertainty to the analysis. Those of us who want looser money are advocating an increase in risk and probably some loss of wealth for this group of people, even if the distribution of market-clearing wages shifts upward just as much as the distribution of goods prices.
It is people whose employment is uncertain or nonexistent and people who are significant financial debtors who most surely benefit from a general inflation. But these are groups with less political clout than financial creditors and the securely employed, for whom risk avoidance rather than wealth maximization is the most pressing concern.
Sandwichman: In the 16th and 17th century there was not enough inflation in Europe and it was strangling their economies. Kings were commissioning alchemists to try to solve the problem through the creation of artificial gold. The deflation problem was solved instead by the institution of credit money. Please look up any reference to “the Price Revolution“. Increased silver production from Central European mines and then American silver flooded into the European economy. In the early C16th, there was an expansion in paper credit instruments. In the mid C16th, England and the Netherlands greatly debased their coinage. The combination of these factors led to sustained price rises as expansion in the money supply continually outpaced output.
There was a “bullion shortage” in the mid C15th, but technological advances (better pumps and ore separation techniques) made Central European mines productive again.
Jacques René Giguère: The ’70’s were not inflationary. They were contractionary They were a time of real shock ( oil) and subsequent fall in real wages. Spending continually outpaced output at a considerable, if variable, rate. That led to considerable and continuing rises in the price level: to most people, that’s inflation.
The problem with your statement is that the opposite of ‘inflation’ is ‘deflation’ and the opposite of ‘contraction’ is ‘expansion’.
Whatever policy is chosen, there will be winners and there will be losers. If a higher inflation rate is chosen, individuals who are borrowing at a fixed rate or dependent on income from real goods that appreciate during inflation (e.g., oil) will prosper, while those who are lending at fixed rate or dependent on income that lags inflation will lose. Indebted governments will win, at least at first, as the debt they’ve issued at fixed rate is inflated away, but eventually interest rates will rise and this advantage will be lost. The beneficial impact of inflation will vary across the people and institutions of the economy.
So when considering the impact of higher inflation, the question shouldn’t be whether on average the economy will benefit but rather whether the majority of the people in the economy will benefit. Or perhaps, whether the negative impact on the segment of society which will lose under the new policy can be justified by the gains of those who are well positioned to take advantage of the new regime.
I believe this is the basis of many of the left’s suspicion of NGDP targeting. It is unclear if the policy will benefit everyone in society, and in particular whether it will benefit the middle class. Rather, the fear is that a small subset will gain from the higher inflation at the cost of the majority.
No one seems to have mentioned the obvious drawback of excess inflation, namely the bureaucratic costs it imposes on businesses and every other institution, public and private. If everyone has to adjust their prices once a month rather than once a year, that is a significant administrative burden. As to carting around wheelbarrow loads of Reichsmark notes as during the Weimar period, that is hardly an efficient way of doing business.
Re Min’s suggestion that anyone worried about inflation can buy TIPS, I’m not sure about the details in the US, but in the UK, the volume of inflation proofed government bonds is restricted. Moreover, buying inflation proofed bonds in the UK is a bureaucratic process and I would imagine 90% of pensioners have no idea how to go about it. In short, inflation robs savers, pensioners in particular.
Inflation has well known costs and benefits and a 2% inflation target simply represents the existing consensus on the best trade-off between those costs and benefits. The problem is that this trade-off may no longer be optimal if the natural rate of interest becomes negative (for example, the classic Taylor rule with a -1% real interest rate and a 2% inflation rate leaves virtually no room for countercyclical monetary policy) and needs to be reevaluated, but it may take a while for a new consensus to emerge.
Great post, Nick.
Ralph: “inflation robs savers, pensioners in particular”
Pensioners are surely dis-savers, not savers, by definition. How many pensioners really rely on income from fixed income bonds? It would be interesting to see some stats. I’d wager not many. At least in the uK:
a) the state pension has always been linked to a price index, now earnings too
b) defined benefit schemes always link payments to a price index (by law I think?)
c) those with DC schemes can always buy index-linked annuities
d) National Savings (the govt) has offered index-linked savings bonds at retail forever. Though they’ve withdrawn from that market at times over the last couple of years, due to high demand, commercial banks have started providing similar products.
I agree that inflation is not that terrible. Menu cost are not that great (especially in the internet age). But variable inflation is a pain as it’s diffucult to predict and I think most people identify high inflation with high inflation variability.
I think there is also another side on the equation: people like risk-free assets. And NGDP-targeting would reduce the safeness of nominal bonds (which are the main safe asset). Any real shock in the economy would result in a depreciation of nominal assets. Only inflation-linked bonds would be the “safe” asset. That’s a big change. It’s the basic agreement between bond-holders and equity-holders, equity takes the upside and downside… In nominal targeting bond-holders take a lot more risk because economy wide shocks will hit the bondholders more directly. You could argue that it’s an illusion since they are just trading highly variable default risk for much more gentle inflation depreciation, but I don’t think people see it that way…
Also one could argue that the additional cost of default in the current framework are much higher than inflation menu cost (and I strongly believe that point). But that’s not what people think. They want something that stores value and it’s hard to convince them that it’s counterproductive…
Yep,
I think acarraro has it right – it is not inflation that is the problem it is variable inflation (i.e uncertainty about what real prices are).
I’m surprised no-one here has put this in a simple behavioural / availability / Kahneman-Tversky framework.
We have simple brains, trained to notice things that change, and to ignore things that do not change. Just as importantly, to notice things that cause us pain (price rises) and not to balance against things that benefit us (or to discount them).
Even in a zero inflation situation, if things are changing, prices will change. Some will go up, some will go down. People notice and complain about the prices that rise, but do not comment on prices that go down.
I have seen this in action personally, living in a quasi-dollarised economy. Whichever direction the foreign/local currency goes, people only ever comment on the resulting changes that harm them. Dollar goes up? We can now afford less dollar-based stuff. Local currency goes up? The dollar contracts we had before are now worth less. (Many more examples possible but I see variations on these inconsistent responses all the time)
Can it be that a non-zero inflation makes it easier when relative prices of goods have to change, due to some structural or external pressure, or a political motive to increase or decrease in incomes? A low inflation makes it more difficult to change the relative level of sticky prices. A higher inflation makes adaptation of relative prices somewhat easier: it forces relative pricing of goods to be renegotiated, at the rate of inflation. Having to renegotiate all the time is a hassle, and takes away attention and energy from ‘normal’ productive processes. So too much inflation is obviously bad. But with changing scarcity of resources, or political pressure to improve social inequality, it may help to force the renegotiation of certain relative prices that need to be changed.
The median salary for a full-time worker in the UK rose 1.4% in 2011 to £26,244, against a headline CPI inflation rate of 5% or higher, according to the Annual Survey of Hours and Earnings from the Office for National Statistics. Overall earnings growth was even lower, with the average UK salary increasing just 0.5% on 2010 levels once part-time workers are included.
Perhaps you should explain this to the ONS?
Because clearly, if the empirical observation disagrees with our axiomatic principles, the observation must be wrong.
Sorry for not responding. I’ve been a bit busy.
Sorry about the spam filter, everyone. (I found one of Kosta’s old comments on another post, and think I managed to publish it).
One very general point: Look, there are dozens of arguments for and against inflation. Some are good arguments, and some are bad arguments. The “inflation fallacy” is just one argument. And it’s a bad argument. It’s invalid. That doesn’t mean all arguments against inflation are bad.
Returning later. Gotta do a lot of admin stuff. Hangover of committees I was on when I was a semi-real administrator.
Alex, that is exactly my point about CPI being more input than output in an open economy. Which is why Nick’s students are right.
It wasn’t that long ago that I was in an intro economics class, and I might have answered your question the same way as your hypothetical student.
Here’s the thing, though. If you had asked, “What happens if the government passes a law that raises all prices by 10% and adds a zero to every bill?”, I probably would have said that nothing happens.
So maybe Bill Woolsey is on the right track. People believe the inflation fallacy because they are thinking about what happens to their stock of money, not their flow of income.
Whichever direction the foreign/local currency goes, people only ever comment on the resulting changes that harm them.
This is very true. I was in Austria for the deployment of the € notes and coin, and although inflation didn’t actually go anywhere, everyone was convinced it had soared, and of course people were full of friend-of-a-friend stories about café prices. Prices had been double-labelled for months, and of course, € monetary policy had been in force for a couple of years.
Okay, in Nick’s absence, I will point out that restating the inflation fallacy is not the same thing as explaining why it is, in fact, correct.
For example, why are you assuming that changes in consumer prices and changes in wages are unrelated?
Actually you could argue that high inflation is bad for saving only if it’s a surprise (and then potentionally only in the short term). I’ll get compensated for it as long as I am willing to lend the money (even if taxes are a problem in this case as we are usually taxed on the nominal income rather than real).
And you need to think on a multi-year basis. It’s like insurance companies: sometimes a disaster is not bad for insurances as it increases the demand for insurance and they can push preiums up above the true cost (it also allows them to spread fixed cost on a wider basis given higher demand).
The same could be true for savers: if inflation raises inflation premiums embedded in nominal rates goes up it could be positive for saver in the medium term (especially if inflation goes down more quickly than expected). Unless you have ever accerelating inflation that is…
But the variability is a true cost. We are risk averse… Variable inflation is bad as it increases uncertainty.
As for the UK inflation, that’s not evidence: I think it’s reasonable to assume that if the BOE had kept rates higher and killed inflation, wage inflation would be now negative (or unemployment massively higher)… Look at Spain (or Ireland) if you want counterfactual: do you prefer 20% unemployment?
Actually the tax argument is quite important… Given most tax system are nominal based, high inflation would increase taxes on saving and investment in an undesirable way…
It’s probably more of an argument for changing teh tax system, but there you go…
Stephen: “For example, why are you assuming that changes in consumer prices and changes in wages are unrelated?”
Because they are only partly related. To the extent that the consumer basket is produced with domestic wages they are related. To the extent that it’s imported, not so much. In the limit of a small open economy (independent of the trade balance) the relationship will be weak.
Here’s another point: In a closed economy (and in the long run in an open one), there’s a firm relationship only between income and the price of the consumer basket. But the relationship between income and median wages is weak (they’ve been diverging by over 2% per year for the past 40 years). Given sufficient technological development, it’s entirely possible for all wages to drop to zero while the CPI keeps going up (all consumed by the owners of capital). So CPI can indeed suck for the vast majority of the population. (If that fact hasn’t been fully reflected in the past, it’s only because the CPI doesn’t properly weight the price of private islands and foreign registered luxury yachts.)
I have no quarrel with the substance of what Steve Waldman said, but I don’t think it vitiates Nick’s interpretation. I mean, if I am collecting rents via a sticky-downward wage + secure employment my compositional fallacy is that I think I am better off in relative terms because I forget that others will do the same.
It remains true, as several people have observed, that when price levels change, or the rate which they change changes, there will be winners and losers. I believe that this is what provokes the anxiety manifested in most compositional fallacies: as Yossarian famously put it in Catch-22 when asked what would happen if everyone behaved the way he did, “then I’d be a damned fool do any different.”
Compositional fallacies are uncomfortable for us to think about because if we think we are winners we feel guilty and if we think we are losers we feel, well, like losers. You see this in quite mundane settings. For instance, it is impossible to make the original meaning to stick to the word “gridlock”; it naturally evolves toward “traffic jam.” Because who wants to think that the traffic jam that is delaying him is his own fault?