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 
Money printing and inflation may be all well and good as a re-balancing (and declining standard of living) of U.S. and European labor. They have to re-balance one way or another.
It’s most brutally unfair in picking investment winners and losers…..via financial repression of savers (what’s the interest rate on a CD these days) and sophisticated investors who see the obvious hedge in real estate, agriculture and commodity based options.
If we want to talk about the Inflation Fallacy, let’s define terms. What is inflation?
“Increase in the overall level of prices over an extended period of time.”
— http://www.babylon.com/define/35/Economics-Dictionary.html
“A persistent tendency for prices and money wages to increase. Inflation is measured by the proportional changes over time in some appropriate price index, commonly a consumer price index or a GDP deflator. . . .”
— http://www.enotes.com/inflation-reference/inflation-594295 (The Oxford Dictionary of Economics)
Note that the Oxford Dictionary specifically mentions wages, while the other dictionary does not. That may be unnecessary, since the price of labor is wages, but in ordinary parlance a distinction is made between prices and wages.
Here is another definition.
“a. an increase in the amount of money and credit in relation to the supply of goods and services
“b. an increase in the general price level, resulting from this, specif., an excessive or persistent increase, causing a decline in purchasing power”
— http://www.yourdictionary.com/inflation (Webster’s New World College Dictionary)
Wow! That’s almost two fallacies for the price of one. š Note the reference to decline in purchasing power in b. I think that most people interpret that as a decline in the purchasing power of people, not money. (After all, people are agents, not money.)
I think that b. pretty well expresses the common understanding of inflation: an increase in prices that causes a decline in people’s purchasing power. What’s good about that?
And it is not like we do not see that phenomenon. But that is not the technical meaning of inflation in economics, is it? The Oxford Dictionary definition is better, no?
I don’t think it helps much to think in terms of simplified models that never occur in the real world. If all prices adjusted instantaneously and uniformly as a result of monetary changes, without any informational lags, costs or frictions – even the price of servicing debt liabilities – then it is true that inflation would be an utterly insignificant phenomenon. But real world inflation is never like that. Some prices rise more than others during any inflationary period, and the changes in price are diffused and communicated one to another via a complicated causal pattern. Every agreed price in the world represents a contract of some kind, and in a period of accelerating price changes with an accelerating average upward trajectory, all of these contracts are renegotiated and there will be many winners and losers. And it is entirely possible for their to be more losers than winners.
Whether any individual regards the prospect of some inflationary episode as a bad thing, even in the absence of any confusion about the totality of effects of the inflation, will depend on whether they expect themselves to be a winner or loser from the episode.
In the real world, even anticipated inflation is costly. Here is part of an Economic Commentary I wrote for the Cleveland Fed back in January 1992:
“Every $1 rise in the price of an apple means the buyer is $1 poorer and the seller is $1 richer.”
If the sellers that benefit from inflation invest that extra $1 in a way inferior to how the buyers would have deployed it, then real income will decline.
Due to the way inventory and depreciation are accounted for, at higher rates of inflation, real corporate taxes increase and more resources flow from the private sector to government. If government is an inferior allocator of capital, then an inflation rate of 4% will result in lower real income than a 2% rate.
Alex: Suppose I argued like this: “Over the last 100 years, wages and incomes in Canada have increased faster than prices. Therefore inflation has increased real wages, and real incomes. Therefore inflation is a good thing.”
Nobody would, or should take that argument seriously.
Lorenzo from Oz:
“Jacques RenĆ© GiguĆØre: 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. ”
Nominal spending could go up because of accomodative monetary policies. Even real spending could go up because it was botth a period of strong technological progress and incresed high-quality labor from the baby-boom and push for education from both GI Bill and National Education Act following the Sputnik scare( and corresponding actions in other western countries.) Those real effect compensated for the real shock. And the monetary stimulation on an overall relativaly stagnant did produce inflation. Which everybody confused with the source of their stagnant living standard , peak oil.
Confusing cause ans effect is a basic feature of the human mind.
Here’s a list of good (i.e. not obviously bad) arguments against long run inflation caused by monetary policy. Straight out of the textbook:
1. Shoe-leather. It’s a tax on holding currency that has all the normal deadweight costs associated with any distorting tax.
2. Menu costs. You have to print new menus more often.
3. Menu cost/relative price distortions. If you don’t print menus more often, relative prices fluctuate for no good reason.
4. It’s hard to index the tax system (God knows why, but it seems to be).
5. It’s harder to remember when you last saw a price, so you can tell if the current price is a good deal or not.
6. It confuses accountants and other ordinary people.
7. Poorer people hold a bigger percentage of their wealth in cash, so the inflation tax hits them relatively more.
Here’s a list of good long run reasons why monetary policy-caused inflation is good:
1. It avoids the ZLB on nominal interest rates.
2. It avoids the ZLB on nominal wage changes.
3. It’s a good way to tax criminals who use cash.
4. It’s a tax with low collection costs.
5. It’s expensive to print banknotes, so the users should pay.
6. ?
Then there are lots of good short run arguments why changes (variability) in the rate of inflation may be bad:
1. Unfairly (and inefficiently?) redistributes wealth between creditors and debtors. (The “short run” here could be a very long time, since there are lots of 30 year nominal bonds and pensions, etc.)
2. If some prices are stickier than others, it screws up relative prices.
3. It may cause inefficient fluctuations in output and employment.
4. People use “rules of thumb” that seem to work in practice that tell them (for example) how big a mortgage they can afford. A change in inflation and nominal interest rates means the old rules of thumb don’t work properly any more, and it takes ages to learn new ones.
5.?
And then there are really bad arguments. Like the inflation fallacy.
Spam filter ate my comment, and Jeff’s. I retrieved both.
So if your comment doesn’t show up, don’t panic. I will check periodically. We very rarely delete comments.
Nick Rowe: “Most of us earn our income from selling our labour.”
Old Ari: “But I don’t have anything to sell, I buy with money I have saved”
There’s something about labour, and the value of time, that take a while for people to wrap their heads around. Nobody seems to see themselves as “selling” labour before learning economics in an academic setting.
My guess is that the inflation fallacy is related to why every public policy seems to need to be phrased in “jobs” for it to get any political traction. [insert Stephen Gordon rant here]
I recall having a discussion about prices which led to me talking about market clearing through queuing, and someone else flat out refused the idea. It’s as if because if I waste time in a queue, there’s no obvious gains from my use of time this way (except for lower than market clearing priced goods, which seems to be forgotten), so it doesn’t count as a cost because it’s not “paid” to anyone else.
Nick: “monetary policy-caused inflation”
Hey! You didn’t say that! You said “inflation”! I feel tricked. What exactly do you ask your students?
Anyways. Made me think about how stupid it is to define inflation relative to a basket of goods that a typical wage earner can afford (and not include e.g. the price of the right to name an elite business school). What a scam!
From Reuters “Disastrous” bond sale shakes confidence in Germany
The German debt agency was forced to retain almost half of a sale of 6 billion euros due to a shortage of bids by investors. The result pushed the cost of borrowing over 10 years for the bloc’s paymaster above those for the United States for the first time since October.
The move in yields is small (~10 basis points) but are German Bunds about to get risky?
For example, why are you assuming that changes in consumer prices and changes in wages are unrelated?
I’m certainly not doing anything of the sort. I’m assuming that they are related through the wage bargaining process, which is an utterly unremarkable observation that pretty much every economic policymaker and literally every wage bargainer uses as an operational decision rule. Whenever anyone talks about a wage-price spiral, wage restraint, a tight labour market being an indicator of inflation, etc, they are asserting this. Similarly, whenever anyone talks about setting expectations of low inflation, they are asserting this. Central bankers quite often explicitly say that they want to set wage bargainers’ expectations of inflation!
I mean, how else do we get from higher prices of goods to higher wages? There has to be a mechanism of action, a microfoundation for the macrophenomenon.
Change the wage bargaining process, and the effects of a given amount of inflation (or indeed deflation) will be distributed differently. And because wages are by far the biggest source of demand, this has consequences for GDP.
Lorenzo:
In a previous post, I got on my hobby-horse and said there was more than one kind of recession. Jacques agreed with me and in order to be clear about what exactly we are talking about, we defined the following terms:
Recession: A demand-side phenomenon in which the supply of money falls. An economy is choked by the lack of money. I was at a breakfast discussion with Torben Drewes of Trent University in early 2009 where he gave a brief overview of the current Crisis and his first point was that the broad money supply had taken a nosedive.
Contraction: A supply-side problem where the production possibilities frontier of an economy shrinks due to loss of some supply. Oil is the poster child for what can cause this because it is our main fuel for transportation and our main feedstock for carbon-chemistry derived products, plastics, synthetic oils and polymers of all kinds. It is embedded in our economy like nothing else.
A contraction is a supply problem and a recession is a demand problem. Both are economic problems and both lead to a fall in wealth, production and standards of living but the suite of appropriate tools to solve them is very different between the two.
I have a little soapbox here and a gong where I bang away saying there is more than one kind of recession.
Nick of course doesn’t believe in general supply-side contractions but admits he’s radical in this regard.
Glad that was cleared up–now all those Germans from 1918-1935 know how foolish they were to worry about inflation. I guess their only concern should have been the size of their wheelbarrows?
Inflation is a silent and stealthy thief that robs from the prudent and those who are willing to postpone consumption. It ruins pensioners and those on fixed incomes. Because inflation breeds inflation it is like playing with fire.
This paper has a glaring fallacy in that it doesn’t matter what a company’s gross revenue is, it is the net income that is important. Inflation makes predicting net income very uncertain if not impossible. Uncertainty . Some select companies or individuals may benefit but the majority do not.
If you can name one country that was benefited by sustained inflation that might make this argument stronger. Surely through all of history you could find an example of a country that could see through the “inflation fallacy”–if that is indeed what it is.
If inflation is neither good nor bad then it shouldn’t matter if there is inflation or not, so let’s not have inflation.
Whether an increase in price(s) is good or bad depends on the case. If there is a general increase in prices as a result of a fall in production, then this is just part of the market mechanism dealing with a supply problem. That’s “good inflation”. If there is a general increase in prices as a result of excess money growth, then that’s sending false prices signals throughout the economy. That’s “bad inflation”.
(Compare with good deflation and bad deflation: the former is the price mechanism responding to a general increase in productivity. The latter is a distortion of the price mechanism as a result of deficient money growth.)
The inflation fallacy, which does indeed form part of a lot of thinking about inflation, fails to look at the causes and therefore leads people astray. Recognising that the inflation fallacy is a fallacy has nothing to do with thinking that inflation is good or neutral.
It is SAVINGS not income. Inflation reduces the value of all savings and investments. It encourages the reduction of savings and investment leading to a drop in production, which in turn leads to a drop in employment.
It didn’t work for the Qing emperor and it won’t for us.
The students’ answer, “Because if all prices rise 10% we will only be able to afford to buy 10% less stuff. Duh!” is not as bad as the writer makes it sound. It is true as far as spending saved dollars goes. It’s also true if the prices of the goods and individual buys rise faster than his wages.
The Austrians (such as Mises) demonstrate why inflation is never a simple x % across-the-board increase in prices. People who receive the newly-created money sooner will bid up prices for the goods they buy before other prices are affected. For example, if new money goes first to wealthy bankers, you will see prices rise at the Louis Vuitton store before they rise at Big Lots. There is no reason they will eventually even rise by the same amount. In the real world there is simply no situation where everyone wakes up one morning to find their money has simultaneously increased by the same amount.
Wage increases tend to lag behind consumer price increases because employers do not feel pressure to raise wages until after their employees see price increases in the goods they buy. They may not even rise to fully keep pace with the increase in prices of the consumer goods. Indeed, centrally-planned inflation is often carried out specifically as a means of lowering real wages.
Whether inflation benefits or harms an individual depends on whether their buying prices rise slower or faster than their selling prices, and by what amount. It also depends on how much wealth the person has kept in the inflated currency. But there are certainly cases where a 10% price increase can lead to a 10% decrease in an individual’s purchasing power.
Nick:
“4. It’s hard to index the tax system (God knows why, but it seems to be).”
Because most of the times we think as “inflationnary” are contractionnary ( mine and Determinant hobby horse if you will) and so real tax revenues fall. A good way to keep what you need to keep gunmint going is not to index tax forms. Otherwhise, we can go the german 1923 route and monetize all G expenditures. Then you get hyperinflation. Only then.
JD:
Grrr, this is a pet peeve of mine.
Germany decided to finance WWI out of borrowing, not by levying an income tax as France and the UK did. Thus they had very, very large war debt. Then they had to pay reparations in gold. So they inflated away their own war debt and tried to get gold by hook or crook.
Belgium and France occupied the Ruhr (Cologne and area) in 1923 to ensure payment of reparations in goods, not now inflated and nearly worthless marks. The occupation caused a general strike in the Ruhr and the German government paid to workers to say on strike. In order to pay for this they printed yet more money.
All of this stabilized in 1924 when Germany moved to a new Rentenmark and the old Reichsmark was repudiated. The first round of Reparation restructuring also began at this time.
Hyperinflation was OVER by 1924. By 1933 it was 9 years in the past. Hyperinflation did not lead to Hitler in the way that is popularly believed. Weimar Germany in fact prospered in the 1920’s. The ruin of the German economy after 1930 was a separate and distinct crisis.
Of interest, Germany’s WWI reparations were restructured in 1935 by the Lausanne Conference and rolled into a bond series. After WWII they were suspended but not forgiven. The principal was repayable but the interest was suspended until Germany reunified. That happened in 1991 with the “Treaty of Final Settlement with Respect to Germany”, the anticipated final peace treaty, was put into effect. Germany resumed payments on the reparation bonds. The final bonds were paid off in full in 2010, at which time we finally closed the books on WWI.
Inflation is only bad if you aren’t stocked up on inventory and it hits.
I’ve sold structural steel for the last 12 years. When we have deep inventories and the price of steel jumps we make more profit. 10% markup on 100 dollars of steel = 10 dollars in my pocket. 10 % on 200 = 20 dollars and so on.
What sucks is when the price of steel drops and you are sitting on steel bought at 50 cents a pound and your competitor is empty and gets to buy at the new low mill price of 45 cents per pound and now you have to sell your steel at 48 cents per pound. Thats when stuff gets nasty.
Rick,
A very good perspective. I wish economists would take more about inventories when analysing business cycles. Ceteris paribus, an anticipated fall in input prices means “don’t buy now” and an anticipated rise in input prices means “buy now”.
(Of course, that can’t be true, because we all know that the economy is like a hydraulic machine and people don’t act on the basis of forward-looking expectations; otherwise it would be possible for a policy to have effects simply because it had been announced. [/bitter sarcasm])
Determinant:
Perfectly right on german WWi financing.
It would have worked if
1) they had won and exacted tribute or
2) at least they had done what the Allied did in WWII and borrowed from their workers the pay they had just received. But they monetized first and then paid the workers. Inflation had started during the war as you noted.
In WWII , Hitler “simplified” matters in his usual management style. He refused to mobilize women plundered either directly (the Easte)or through “occupation taxes (France)and avoided paying the workforce by taking slaves,including domestic ones(no wonder you were happy with the regime if it meant your own Ukrainian peasant girl in the kitchen…The average germans knew a lot…)
Determinant,
I’ll second Jacques compliments on your German WWI financing. But more about Hitler’s rise — in response to the start of the Great Depression, German Minister of Finance Burning clung to the Gold Standard and balanced his nation’s budget, leading to a 30% drop in price level by 1933. It was this grinding deflation (and resultant high unemployment) which set the stage for the Nazi’s election.
In contrast, the U.K. left the Gold Standard in 1931, after which her unemployment and industrial output stabilized (see these recent summaries).
One could argue that the UK’s actions in abandoning the Gold Standard in 1931 are an excellent example of the benefits of inflation.
You sir, should not be teaching economics.
What a very simplistic explanation of inflation. Its so nice to be schooled by a real “economist”, of the same sort that is literally burying Europe and North America into an economic collapse probably never seen before.
Of course most people referring to “inflation” are referring to an increase in money supply, not some harvest drought! Thus it is so commonly referred to “printing money.” Wise up man!
You seem to completely ignore the issue of the velocity of money and seem to think that when the supply increases everyone has it at exactly the same time.
So, what is so bad about inflation? How about it destroys people’s life savings… especially when there are interest rates held at near 0 percent. If there is no effect of inflation, why has the price of every single commodity, even those completely unrelated, rather it be gold, silver, corn, oil risen between like 200%-1000%?
Inflation is nothing more than an attempt by countries to devalue their debt because they are about to implode under its weight. By doing this they completely destroy the wealth of people who have saved (how about retirees who have saved their whole life and have their money wrapped up in the ‘safety’ of govt bonds returning 2%).
You seem to be just another bitter economist that is coming to the realization that they have committed their life to learning an economics system that is becoming completely discredited before their eyes and can’t accept this reality. Sort of like the people getting “green degrees” and can’t find a job, it’s hard to admit that your entire skill set is worthless.
I think when I was like 10 years old I remember asking my parents “why ‘they’ didn’t just print more money so everyone can be rich”. Unfortunately today’s “economist” is peddling an economic theory that would be absurd to a more intelligent 10 year old.
IIRC, Kaldor attributed the fall in UK unemployment to the adoption of tariffs by the National Government, rather than to leaving the Gold Standard. This left him in a bit of a crisis: did that mean that Neville Chamberlain was a good chancellor? Apparently he never quite could answer that question.
I’m fascinated by the idea that the UK’s economic policy under the National Government (fiscal austerity offset by a loose monetary policy) could get some credit. The classic view, which comes mainly from Keynes, is that the UK’s problems in the 1930s were demand-side rather than supply-side. Though NGDP statistics say otherwise, the idea was that the 1930s were a period of low demand and this caused high unemployment during the decade. Hence anyone who proposes cutting the deficit in a period of sub-trend growth is accused of wanting to go back to the economics of the 1930s.
Interestingly, this myth of 1931-1939* as a period of disastrous demand-side policy in the UK led to the Keynesian revolution and has therefore shaped modern economics:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1874205
* Some British history textbooks now attribute the recovery to increased armaments spending from 1936 onwards. I have heard many things said of fiscal policy, but I never knew it could cause a reduction in unemployment that occured five years previously!
GA: “I’m surprised no-one here has put this in a simple behavioural / availability / Kahneman-Tversky framework.”
GA might be onto something. (Though it’s something I don’t pretend to understand much.)
Dr Why: “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.”
Yep. That’s roughly my position. Plus, 2% is the rate that Canada has gotten used to, so any change in the inflation target would mean variation in inflation.
Alex: “Because clearly, if the empirical observation [that UK real salaries fell in the last year] disagrees with our axiomatic principles, the observation must be wrong.”
I wrote this post for Alex. At least, I wrote this post for Alex and all the millions of people like Alex. Clearly, I have failed miserably. Alex wonders if I think that it is theoretically impossible for real wages ever to change.!!!!! I wonder how many times I have drawn a diagram with real wages on the vertical axis, shifting curves around, showing why real wages might change. I wonder how many times I have played around with different theories of sticky prices and/or sticky wages showing how even monetary policy might have short run effects (in either direction) on real wages.
Suppose Alex were right, in arguing that since real wages = W/P, then a monetary policy that caused higher inflation would increase P and therefore reduce W/P and make people worse off. What policy conclusion would I draw? I would recommend an extremely tight monetary policy, to create massive deflation, and a massive fall in P, which would, mathematically, increase W/P and make people very very rich. Oh God.
I really did try in this post. Clearly I have failed miserably.
Thanks to all those who liked the post, and those who gave good arguments on the costs and benefits of inflation.
But the one thing I have learned, especially from the sheer number of comments on what was really a very boring post on what should be a totally uncontroversial point (the inflation fallacy is a bad argument against inflation, though there might be other good arguments for or against inflation), is that the subject of inflation really arouses passions. And that the inflation fallacy (as well as conceptual confusion about inflation) is really deeply entrenched.
Plus, I used to think that the inflation fallacy was more of a righty meme. Now I’ve learned that lefties are sometimes equally susceptible.
I had to take two electives in First Year university; one was European History from the French Revolution to 1945. We did the 19th Century and WWI in spades. C’mon, this is economics blog, we believe in getting value for money!
The Depression was a separate disaster in Germany and I thank you for your point about the Gold Standard, Kosta
People forget that the Weimar Republic was doing OK economically by the late 1920’s. Germans seemed to settle in to democracy and things actually worked, if only for a while. Hyperinflation was in the past and the German economy got over it soon enough.
But hyperinflation and then a toruous deflation combined with bitterness over reparations led to disaster.
To get back to Jacques’ point, we really have to remember that the days prior to 1914 were a different world. This is a wonderful website to remind of the economic contradictions of the era: http://www.loc.gov/exhibits/empire/work.html These are colour photographs (using composite process; researchers recently put them together) of Tsarist Russia. This is a world, in colour, that truly is no more. Notice how you have camel drivers and peasants whose lives haven’t changed in centuries next to electrical generators from Hungary.
It was an era of unbridled capitalism (see the Singer Sewing Machine office in St. Petersburg, Russia), low taxes, small government and expansive empires. People didn’t think the way they do today. It was also the time where the government had to face up to poverty too, the health of Army volunteers from inner London was deplorable and it was common for them to put on weight in basic training simply through having more calories.
I have one great-great grandfather who immigrated to Canada from England in 1912 to escape the new Income Tax after the People’s Budget. Canada advertised itself heavily as having no income tax. In 1914 nobody had any clue what the real costs of running a mass conscript army with the capability and expenses of industrial warfare were.
Austria-Hungary never figured it out, they were a complete basketcase in terms of war organization which wasn’t helped by the fact that their government arrangements were also a basketcase. Russia decided to pay in men instead of material and suffered disaster after disaster at the hands of the better-equipped German army. For the first time material and organization mattered more than men and you couldn’t simply swamp an enemy with conscripts anymore.
Germany almost figured it out by the German imperial government wasn’t a real democracy, the Reichstag was a sham. There was little financial capability and even more importantly little way to procure popular consent to wartime taxes.
It was France and Britain who barely figured it out in time. The British had a shell shortage crisis in 1915 but managed to have fully functional industrial mobilization and excellent financial arrangements by 1917. France had the same thing roughly.
And finally to follow on from Jacques point about WWII, the UK was much, much better organized than Germany ever was. It was Britain who had the more pervasive and effective command economy. Bevin boys in coal mines, effective rationing with substantial compliance, mobilization of women to do almost everything, industry that was robust and able to make up losses easily. Plus finanacial arranagments that worked, including Lend-Lease and Mutual Aid in Canada’s case.
Britain reached its full economic potential in WWII, Germany wasted their potential.
I think it is the division of those who think inflation is bad for themselves and those who think it is good for themselves, regardless of whether it is good or bad for the whole, the focus on narrow self interest, and that it is easier for most to see the bad than the good that leads to such beliefs. If they don’t see it in their personal interest, they refuse to see it in anyones, or if they do, have motive to reject it anyway. This is why greed is good was so popular.
W. Peden raised the interesting topic of inter-war British economic policy, which is very relevant today.
Britain had 6% unemployment in 1914 and was on the Gold Standard. Per normal practice for Really Big Wars the Gold Standard was suspended during the war.
In 1918 it was government policy to return Britain to it’s pre-war condition as soon as possible. Back to 6% unemployment as all those peace-time jobs returned and everyone settled back into what they were doing in 1914. And of course back to the sound policy of the Gold Standard.
Demobilized soldiers were given an “Out of Work Donation Policy”, one of the the first Unemployment Insurance policies of its kind, payable for one year. It was to help soldiers get back to their pre-war routines.
But things never returned to the prewar routine. In fact the UK developed stubbornly high unemployment in the 1920’s. It never got below 8%. Those Donation Policies had to extended repeatedly. Their experience was exactly the same as what the United States is experiencing right now. Stubbornly high unemployment, lack of job creation and the need to extend benefits repeatedly.
Britain didn’t break the 6% unemployment barrier in peacetime until 1945. Full employment did not return to the UK until the late 1940’s and early 1950’s. That’s the conundrum of interwar economic policy. What happened to the jobs?
Yes, I know hell or high water policy of returning to the prewar Gold Standard was part of it, but the question remains.
I still don’t get it. When you ask your students why inflation is a bad thing, why is it that they are supposed to answer from the perspective of the representative agent rather than say from the perspective of the representative wage earner? Or median wage earner? Or student? Depending how you define and chain your consumption basket (it’s not easy) they may be getting poorer. In the future robots may make them extremely poor through a process which, with a bit of help from monetary expansion, will appear as price inflation (to avoid wage deflation). Maybe they’ve already sensed the beginning of this process. They are certainly getting relatively poorer. I just don’t see the relevance of income=expenditure for the vast majority of the population. Why is wrong for them to forget about the capitalist?
Nick: it’s been a toy theory of mine for a decade or so that inflation may ‘need’ to be higher for a period in economies that ‘need’ to reset relative prices (meaning that ‘prices’ had been set arbitrarily at the starting point, or if you prefer, that prices have been subjected to a dramatic external shock). The origin of this idea is spending a lot of time in former Communist (or whichever term you prefer) economies.
Basically, assume prices at the starting point are completely arbitrary, and that wages at that same point have been calibrated to permit purchases of an acceptable basket of goods. The price mechanism is not the sole or primary means of allocation of goods (i.e. there are things like quotas and coupons for certain goods, or queuing, or whatever). (I’m going to ignore monetary overhang of savings which can’t be spent because there aren’t sufficient goods available – which, when prices are freed, would just result in a brief, one-off superinflation – in other words I’m arbitrarily going to ignore monetary policy to start).
Prices are freed at the starting point. Information and other frictions abound. Supply response is not instantaneous. Some prices are still regulated and/or provided by government monopolies, which may not be allowed to raise/change prices at will. Price discovery has to be iterative.
I think only one condition has to be true to make it clear that this economy ‘needs’ higher inflation to allow relative prices to adjust (somewhat) more efficiently. That condition is that for whatever reason, all sellers of goods, services, labour exhibit much greater reluctance to lower their prices than to raise them (directional stickiness, which could be seen as a form of loss aversion).
I’m not the mathhead to build the model for this, but the conclusions to me are obvious. Inflation ‘needs’ to be higher than in countries that start with a non-arbitrary dispersion of prices and a functioning price mechanism.
Relax a few assumptions but keep the central one (reluctance to lower prices, or stickiness) and even price stability (in the zero percent inflation sense) would also be seen as problematic. (This is without interaction with the financial sector, asset inflation, etc). May be one gut sense for why the Blanchard inflation target makes more sense. In fact, the arbitrary condition is an extreme but ultimately not that special case.
We can say that acclerating and very high inflation is ‘bad’, but the positives of price stability quickly disappear if one realises that there is no such thing. Price formation and adjustment is a process by which relative prices change – and any impediments to adjustment throw the assumptions about the benefits of price stability out the window. They’re not stable – they’re moving around a central tendency.
And monetary policy may need to accommodate this adjustment process.
(And before the objections start, I’m not arguing for aribtrarily huge,unlimited inflation – but perhaps 5% inflation is ‘too low’ for Russia for some time until prices have done the bulk of their adjustments.)
K: Suppose someone said that an increase in inflation would change the distribution of income, because wages were stickier than prices, so that real wages would fall, so labour’s share of income would fall, even if total income stayed the same.
Anyone who made that argument would not be guilty of the inflation fallacy. It’s a totally different argument. Given the assumptions (wages slower to adjust than prices) it makes sense. Many macroeconomists (arguably Keynes) have made this same argument.
The argument is usually made in reverse. Starting at “full employment”, a fall in AD will cause prices to fall, but wages will stay the same in the short run by assumption, so real wages will rise, and employment will fall. Because employment falls, real output will fall, and real income (which is the same as real output) will fall too. Real wages per hour rise, but total real wage income may either rise or fall, depending on the elasticity of labour demand.
Empirically, however, this argument doesn’t seem to work very well. Soon after Keynes’ General Theory was published, econometricians started looking to test it, to see if real wages were countercyclical as this theory predicted (rising in recessions, falling in booms). And they didn’t seem to be.
My (cursory) reading of this empirical literature is that it’s hard to find strong empirical evidence of either counter-cyclical or pro-cyclical real wages. The results seem to be rather sensitive to how exactly you measure things. So New Keynesian macroeconomists abandoned the assumption that wages were slower to adjust than prices. (Most New Keynesian models actually make the exact opposite assumption, but that’s only for analytical convenience, since it makes little difference in NK models). My working assumption is that wages and prices are roughly equally sticky. But I wouldn’t go to the wall to defend that assumption.
“Why is wrong for them to forget about the capitalist?”
1. Because capitalists are people too.
2. Because retired pensioners are capitalists.
GA: most/many(?) macroeconomists believe some version of your argument. It’s normally slightly restated by assuming it is money wages that are sticky downwards, and there is empirical evidence to support this. If you look at a frequency distribution of nominal wage changes, there’s a big spike at 0%, and a sort of gap in the distribution just below 0%. And the usual estimate is that something like 2% inflation is enough to avoid most of the problems this zero lower bound on wage changes could cause.
Matt: “You sir, should not be teaching economics.”
You know, if you would open your mind, Nick could teach you some economics, too. š
GA
Excellent. And I can think of good reasons for the reluctance to lower prices.
1. Uncertainty – if buyers arrive in a Poisson distribution – a period without a sale may just be bad luck.
2. Expectations – if buyers see prices falling they may wait in the hope that they will fall further.
Tip: if you see analyses of economic change that are missing those two words don’t believe them.
“Clearly, I have failed miserably.”
Nick,
I sympathise, inflation phobes are very persistant (those pots of money under the mattress must be more common than I thought). I put it this way – I lives through the seventies. My parents lived through the thirties and I’m alive today (although where I am it is not so bad – yet). The seventies were not so bad. Discuss.
Old Ari
“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.”
When did you save the money and what was the inflation rate then? And why didn’t you buy bonds which pay positive real interest rates – coming due when you are ready to consume? And did you invest your savings in productive assets that would insure that the goods you wanted to consume later would actually be produced? This comes to heart of the question – what is money for?
Suppose someone said that an increase in inflation would change the distribution of income, because wages were stickier than prices, so that real wages would fall, so labour’s share of income would fall, even if total income stayed the same.
This is, in fact, my argument. In a political economy heavily biased towards capital, it’s easier to put up the price of goods than it is to put up the price of labour. Therefore, if you decide to deliberately inflate the economy, which of these two actors will benefit? As I pointed out again, and again, and again, if you call the two actors “debtors” and “creditors” nobody would be surprised for a moment that inflation has different impacts on them!
In a recessionary environment, where investment is low (which is observable empirically), I expect this to reduce aggregate demand because the corporate sector will save the difference (and we observe this empirically – firms are stuffed with liquidity) and – obviously – workers will have to cut back (which is also observable).
If you say “We want full indexation and if we don’t get it, not a single wheel will turn” and get it, then there will be a nice stable NGDP growth path and an inflationary settlement of the debts from the Great Bubble. If you say “I want full indexation” and they say “You’re fired”, there…won’t.
Determinant,
Perhaps the return to the Gold Standard was less important in the long run than the rise in the real value of benefits in the 1920s.
In other words, the demand-side explanation explains a lot of the cyclical unemployment and the classical explanation explains why the unemployment turned into persistent structural unemployment that took about two decades (and a huge reduction in real wages/benefits) to eliminate.
Nick,
What would you call it if CPI rises by 5% per year but wages only rise by 2%? I’d say wage earners are getting killed by inflation. I suspect your students would too. Ā Of course, it’s not the kind of inflation monetary policy can do anything about. It doesn’t matter if it’s 5 and 2 or 3 and 0. It might occur due to a loss of bargaining power versus foreign labour and robots.
And the idea that we are all the capitalist is just silly. The vast majority of the population are poorer than average throughout their lives. If all the capital was in the hands of one person would you still be happy with your argument? Should we all just feel happy for that person? When does it become absurd?
Alex: somewhere, deep in your mind, there’s some sort of macroeconomic model. But for the life of me I can’t figure out what it is. (Forget for a minute whether it’s right or wrong).
First off, by standard conventions of national income accounting, real output = real income. And real output is an increasing function of employment, for the obvious reason that the more people you have working (given technology and capital stock) the more output=income gets produced.
Get a bit of paper. Draw axes of a graph. Put P (the price level) on the vertical axis. Put Y (for real output = real income = roughly speaking employment) on the horizontal axis.
Now, assume we are in the short run, so that W (the nominal wage per hour) is fixed. Assume P is perfectly flexible, for simplicity.
I want two curves.
The standard macroeconomic model with these assumptions looks like this: There’s an upward-sloping Short Run Aggregate Supply curve (a 10% exogenous increase in W shifts that SRAS curve vertically up). There’s a downward-sloping Aggregate Demand curve. A loosening of monetary policy (bigger money supply, lower interest rates, whatever) shifts that AD curve up and to the right. In that standard model, if you want to increase real output, real income, and employment, you loosen monetary policy to shift the AD curve right. A side-effect of loosening monetary policy and increasing Y is that P rises (if the SRAS curve slopes up). This causes a fall in W/P (real wages per hour). But total real wage income (W/P times person-hours of employment) will usually increase (unless the SRAS curve is very steep, so that P rises by a greater percentage than employment).
Now, I don’t really believe that model, because W/P is not, empirically, negatively correlated with employment over the business cycle. But never mind that.
How does your model differ (if at all) from that standard textbook model? Does your SRAS curve slope down? Does your AD curve slope up? Are you arguing that the Bank of England should tighten monetary policy (reduce the money supply/raise interest rates) to create deflation in order to increase real wages, AD, output and employment? Or what? Is there actually an internally consistent model underlying your words, and what is it?
K: “What would you call it if CPI rises by 5% per year but wages only rise by 2%? I’d say wage earners are getting killed by inflation. I suspect your students would too. Of course, it’s not the kind of inflation monetary policy can do anything about. It doesn’t matter if it’s 5 and 2 or 3 and 0. It might occur due to a loss of bargaining power versus foreign labour and robots.”
I call that “falling real wages due to loss of bargaining power as a result of foreign competition and robots”. And if that is indeed the case, and it is indeed something that monetary policy can do nothing about, then it is not caused by an inflationary monetary policy. By assumption.
reason: “I put it this way – I lives through the seventies. My parents lived through the thirties and I’m alive today (although where I am it is not so bad – yet). The seventies were not so bad. Discuss.”
My father, who lived through both the Great Depression and the Stagflation, told me, “Inflation is bad, but deflation is worse.”
K: “And the idea that we are all the capitalist is just silly.”
What does a capitalist look like? Someone like me. Depending on when I retire, my future wage income is probably worth less than my pension plan, house, and savings. So I’m probably more of a capitalist than a worker, from this point on. Do I not bleed when you cut me? First they came for the 1%, and I said nothing, because I was not one of the 1%…..then I found I was one of the remaining 1%. You are talking to someone who is “the other”. We look just like you “regular folk”.
Alex: “In a political economy heavily biased towards capital, it’s easier to put up the price of goods than it is to put up the price of labour. Therefore, if you decide to deliberately inflate the economy, which of these two actors will benefit? As I pointed out again, and again, and again, if you call the two actors “debtors” and “creditors” nobody would be surprised for a moment that inflation has different impacts on them!”
Let me risk dipping my toe into this. First, you are calling the capitalists debtors and the workers creditors, right? At first blush that sounds counterintuitive, since, aside from the employment situation, it is likely to be the other way around. But the capitalists do have an obligation to pay the workers.
Second, I am uncomfortable with the phrase, “deliberately inflate the economy.” First, at least in the U. S., I am not sure that we can talk about the economy. On its face, there appear to be two tiers to the economy. The top tier has recovered from the recession, the bottom tier has not. Policy makers focus on the top tier, and so the recession officially ended a couple of years ago. Sometimes I wonder if the best hope for the bottom tier is if the top tier goes back into recession.
Second second, “inflate” the economy is vague. (“Inflation” is vague, which is part of the problem with this discussion. ;)) Doesn’t who benefits depend upon how we inflate the economy? If we give money to bankers, that’s one thing, if we give it to paupers, that’s another, no?
Are you arguing that the Bank of England should tighten monetary policy (reduce the money supply/raise interest rates) to create deflation in order to increase real wages, AD, output and employment?
I’m arguing that having it create inflation in order to fight the recession (or the lesser depression…) is not a sufficient condition of recovery, although it’s probably a necessary one. That the distributional impact of the inflation, if wage-bargaining is really weak, could be enough to outweigh the shift in the AD curve (or shift it back).
I’m not sure if I’d call it a shift or a skew in the curve, but essentially what’s happening is that additional nominal income is going preferentially to actors with a higher propensity to save, so the elasticity of Y with respect to P is changing.
Alex: Let’s break this into two parts:
1. Suppose I built a model in which wages are determined by the relative bargaining power of workers and firms. Lots of economists build models like that. But, unless I put something else into the model, that still gives me a model in which real wages are independent of monetary policy and inflation. Workers and firms care about real wages, not money wages, so relative bargaining power determined equilibrium real wages, not money wages. Real wages in that model will (usually) be lower if workers’ bargaining power is weak, but real wages won’t be affected by monetary policy. You need sticky wages (or sticky prices, or money illusion, or something) to get real wages depending on monetary policy. Weak bargaining power alone won’t do it.
2. Forget bargaining power, because it doesn’t give you the sticky money wages you need to make your argument work. Let’s just assume that money wages are sticky, for some unknown reason. And let’s take a standard Keynesian (ISLM) theory of the AD curve, but modify it by assuming that the marginal propensity to consume out of wage income is greater than the mpc out of non-wage income. That modification will tend to make the AD curve flatter. (The reason is that a rise in P, for given W, and given Y, changes the distribution of income away from workers and so reduces consumption demand, and hence reduces aggregate demand). But in that model your conclusions still do not follow from your assumptions. A looser monetary policy will shift the AD curve right, and it will increase output, the price level, real income, employment, and increase real wage income, even though it reduces real wages per hour (W/P). To get your intuition straight on this you need to carefully distinguish between real wages per hour, and real wage income (=(W/P) times employment). Consumption (in your model) depends on real wage income, rather than real wages.
i (not an economist) always thought that the reason “inflation” (as in an expectably nominally larger economy over time) is good is to avoid artificial rigidities that occur around sticky prices. menu costs go up, and that’s annoying, but that’s the downside.
A further thought, Alex. Macro is hard. I like to think I’m quite good at converting verbal reasoning into graphs and vice versa and seeing if it really makes sense. But when I did the first draft of my comment above, I screwed it up.(I had your mpc assumption making the AD curve steeper, rather than flatter.) Fortunately I realised this just before I posted it, and fixed my mistake.
We are talking about a simultaneous system where everything depends on everything else. And words sometimes just don’t do the job.
Now, if I played around with your model, I could even make the AD curve very flat, and flatter than the SRAS curve. Which would give really weird results, because (I think) you would actually have to tighten monetary policy (reduce the money supply) to increase output and employment in that model. And that model would actually make your verbal reasoning correct. Except, that model has an unstable equilibrium, so none of those weird results make any sense at all. Because we wouldn’t get to the new equilibrium.