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Sunday, May 08, 2011

What is Inflation

Paul Krugman notes that wage growth has slowed and asks why are very serious people worried about inflation. I comment.

Your effort to discuss inflation is doomed, because people don't agree on the meaning of the word "inflation." There's been some progress since 1923 when Reichsbank Presiident Rudolf Havenstein wrote the mortal book entitled (in translation) "There Has Been No Inflation In Germany," but not by much.

Most people in the USA use "inflation" to refer to increased prices and assume that inflation does not cause increased nominal wages. They will not be surprised by the graph. That's what they imagine when they say inflation is a problem. Most US adults would not object of told "inflation reduces the amount of goods workers can buy with their salaries." They hate inflation (considering 10% inflation by far the biggest problem for the USA in the 70s) exactly because they assume that price increases don't cause wage increases even in the long run.

Evidently the idea is that lower inflation (and they ask economists how to achieve it) means higher real wages and the same employment. Then in a sick twist the older New Keynesians (Fischer, Taylor, Gordon) argue that central banks are tempted to cause surprise inflation, since lower real wages are clearly desirable.

Most people who fear the inflation monster under their beds don't fear a wage price spiral, they don't hope for a wage price spiral. They think higher inflation means lower real wages forever which are not compensated by any benefit such as higher employment ever.

The debate is schizoid because economists and not totally ignorant policy makers accept the public view that inflation is hugely costly (assuming complete nominal wage rigidity) and also assume that high inflation is persistent and hard to eliminate because they know how nominal wages really respond to inflation.

At the moment this is all irrelevant (as you note) since core inflation is low, wage inflation is low and a higher relative price of petroleum really does reduce US aggregate real income. But the current insanity is made more likely by the general inflation insanity. Basically policy makers know that high gasoline prices make people vote against incumbents and they demand that Bernanke save them from the effects of increased Chinese demand for petroleum.


Anonymous said...

Good point. People other than union employees with COLA adjustments built into their contracts don't see wage increases as part of inflation -- they see it as themselves getting what they deserve (just like beneficiaries of social insurance don't see themselves as on welfare, but as getting what they paid in).

I'm curious now what this unhappy German could possibly have had to say.

Nick Rowe said...

I don't think it's specifically *wages* that people assume exogenous wrt inflation; I think it's nominal incomes more generally.

And anyone who has taught first year economics has first hand experience of the inflation fallacy. You ask the students "why is inflation bad?", and the answer comes straight back: "Because it means we can't afford to buy as much stuff, duh!" And even after you have taught them why that's wrong, because one person's buying price is another person's selling price, you still get to read it again and again in the final exam.

Ken Houghton said...

"Basically policy makers know that high gasoline prices make people vote against incumbents and they demand that Bernanke save them from the effects of increased Chinese demand for petroleum."

Tightening the margin requirements seems to have done more for this goal than even China's ever-tightening monetary policy.

Robert said...

Wow three comments. Also none of the three argues that the post is idiotic.

I posted here not at Angry Bear, because I thought it wasn't ready for prime time. I mean all economists know that non-economists have this crazy view about inflation.

Nick: Yes people assume nominal incomes are exogenous not just wages.

Anonymous: He died in 1923 about a week before the end of the hyperinflation. It wasn't a coincidence. I highly recommend "The Stabilization of the German Mark" by Hjalmar Horace Greeley Schacht (roughly "how I did it" and he did do it.

Havenstein may have been the worst central banker ever (with some tough competition) but he wasn't insane. Back then "inflation" meant expansion of the money supply not increase in the price level. He noted that the real money supply had shrunk. This is the shoe leather cost of inflation.

I think the Fed's problem is that it has to convince people that there will be inflation (to drive real interest rates down). They can't because people know they won't when unemployment is normal.

Frankly I think the only way Obama could have done better would be to appoint zombie Rudolf Havenstein Fed chairman. That would cause some expected inflation liquidity trap be damned.