Monday, April 21, 2014

A Reply to "Does Inflation Make You Poorer?"

Noah Smith channels Robert Shiller circa 1997 in his recent post, "Does Inflation Make you Poorer?" While Noah asks this question rhetorically, Shiller actually asked a series of related questions in a questionnaire of 677 people. His sample included both economists and non-economists from the U.S., Brazil, and Germany. He found:
"Among non-economists in all countries, the largest concern with inflation appears to be that it lowers people’s standard of living. Non-economists appear often to believe in a sort of sticky-wage model, by which wages do not respond to inflationary shocks, shocks which are themselves perceived as caused by certain people or institutions acting badly. This standard of living effect is not the only perceived cost of inflation among non-economists: other perceived costs are tied up with issues of exploitation, political instability, loss of morale, and damage to national prestige."
The first concern is the subject of Noah's mockery. True, some people think in partial equilibrium, neglecting the effects that inflation might have on their nominal income. But it is not an unreasonable concern in some contexts. Nominal wage stagnancy is a reality for many workers. In a 2008 Pew Survey, 57% of respondents believed that their income was rising slower than the cost of living.

In the figure below, the CPI, average hourly earnings for all private sector workers, and average hourly earnings for retail trade employees are all plotted. All are normalized to 100 in 2006. While average hourly earnings for all workers have grown faster than the CPI, the opposite is true for workers in retail. Since 2006, the price level is about 21% higher, but hourly wages in retail are less than 11% higher. They feel poorer and they are poorer.

Did inflation "make them poorer?" Not directly. But the political economy of inflation certainly contributed. Prices and wages do not simply rise or fall on their own. People choose to raise or lower them--this is why prices and wages are in the domain of economics, after all. Who chooses, and how do they choose? That's where things get more complicated. Decision-makers at firms set prices subject to an almost innumerable set of constraints and considerations imposed by the institutional and policy environment they face. Wages are not simply set by some abstract market-clearing condition; they involve bargaining between firms and individual employees or labor unions. Regulations, policy, and social norms also affect the bargaining powers of the relevant groups, with palpable effects on the wage structure.


In Japan, for example, deflation has plagued the economy for years. When Shinzo Abe ushered in a return to positive inflation, most Japanese consumers described rising prices as "rather unfavorable." These consumers were not being unreasonable. They were getting poorer! When prices started rising, wages did not. Since the 1950s, Japanese salaries have been determined by coordinated negotiations between unions and large employers. Only very recently, with the backing of Abe, have the unions had sufficient bargaining power to raise salaries in these negotiations. Japan also has a growing informal sector, where already-low nominal wages are unlikely to rise with the price level. Maybe eventually the overall Japanese economy will grow so much that even the low-wage informal workers will be better off. But no one knows how long that could take. Noah says it himself: "Whenever you buy something, the money you spend is someone else's income." But we don't know whose income it will be.

This is not to say that Japanese deflation was a good thing or made people richer. Quite the opposite. But it is to say that people should complain when their cost of living is rising faster than their earnings. Inflation has distributional effects, which will tend to benefit the politically powerful. The people getting the short end of the deal are perfectly rational to be upset about it, especially if their dissatisfaction can be harnessed into political action.

Not only inflation itself, but also inflation risk, has costs and distributional effects. The unpredictability of inflation is part of its cost. Hedging against inflation is theoretically possible but difficult. Inflation risk is costly for its bearers. Our political and economic institutions determine who the bearers will be. When social security and pensions are indexed to the price level, inflation risk to pensioners is reduced, while inflation risk to pension funds increases. When private debt contracts are primarily nominal, an unexpected increase in inflation will be costly for creditors. Indexing sovereign debt to the price level also redistributes inflation risk between countries and their creditors.

The other perceived costs of inflation that Shiller lists--exploitation, political instability, loss of morale, and damage to national prestige--all have historical precedents and are also related to the political economy of inflation. A government that "inflates away its debts" risks imposing any or all of these costs.  These costs of inflation are less relevant in the low inflation environments of the United States and much of Europe today. An increase in inflation from, say, 1% to 3% is unlikely to foster political instability or erode national prestige.

In the U.S. today, I think a little more inflation would be a good thing. But I think we also should take seriously the concerns of people whose real income is falling for one reason or another. This boils down to another call for economists to keep worrying about inequality-- even when thinking about issues like inflation.


  1. "Wages are not simply set by some abstract market-clearing condition; they involve bargaining between firms and individual employees or labor unions."

    Sure, such bargaining happens here and there all the time. But any gain to the winners of the bargain is a loss to someone else.

    I think that if you want to understand long-run economy wide average wages, market-clearing analysis is a much better way to think about things.

  2. Carola, a very nice post ... here's an interesting paper by Burke and Ozdagli at the Boston Fed: using household survey data. Contrary to economic theory they do not find that higher inflation expectations boost current spending. The disconnect between people's views about inflation (and wages) and economists' views may be quite important for policy.

  3. Ed, the key to what you said is long-run and average. If we only cared about average wages, then the fact that one person's gain is another's loss would net out. But if we care about the distribution as well as the average, then the consequences of wage negotiations matter. Losses matter, even if there are equal gains to other parties.

    To the above poster, thanks, and here is a similar paper I had read by Bachman, Berg, and Sims.

  4. Two questions:

    1. If inflation lowers real wages, does deflation raise them?

    2. Can you explain why real wages historically have risen during times of medium inflation in the U.S. and Japan, and yet have fallen in Japan and stagnated in the U.S. during times of deflation or low inflation?

  5. Hi Noah,
    1. No. I didn't argue that inflation lowers real wages or that deflation raises them. Just that inflation can accompany a decline in real wages for those people whose nominal wages do not increase.

    I know that it's a fallacy to argue causality from an accounting identity. The accounting identity here is that growth in real wages equals growth in nominal wages minus inflation. But that doesn't mean that inflation causes lower real wages or that deflation raises them. The same forces that cause deflation can also cause lower nominal wages. The forces that cause inflation can also cause higher nominal wages-- which they generally do, but not for everyone, that's why this is an issue of distribution.

    2. Not thoroughly in a few sentences, but part of it is this. Deflation and ultra-low inflation often have occured when the economy is at or near the ZLB and so policy is constrained to be less expansionary than it otherwise would be, growth stagnates, often with financial crisis, employers can justify nominal wage cuts or flat nominal wages. Medium inflation can be an indicator that things are well with the economy. Just to point out, though, US real wages fell from about 1985-1995 in the US when inflation was "medium" so this is not a hard and fast rule.

  6. Carola:

    1. If you're not arguing that inflation has a causal effect on real wages, then I'm afraid I don't see the point of the paragraphs in which you discuss falling real wages. The question is: "Does inflation make you poorer?" And if inflation doesn't exert a causal effect that lowers real wages, I'm afraid I don't see how falling real wages during a time of inflation constitutes evidence that inflation "makes you poorer".

    2. I agree with your reading of history, except for the period of 1985-1995. Here is the data from that period. I don't think I see what you see!

  7. The criticism of higher inflation is not that it does not work. But that it works only in the short term. This has been understood for a while. Yet the Fed and the BOJ are trying to permanently raise inflation. What can one make of that?

    Moreover, the Fed can only effect a rise in commodity and import prices - both of which hit living standards. That is NOT in dispute. So when they do it year after year, it ceases to make sense.

  8. Noah, here's what I was looking at for 1985-95:

    I am not arguing that inflation makes people poorer. I am arguing that some workers' real income is falling-- not directly caused by inflation, but because their nominal wages are not keeping up with inflation-- and that their concern about their falling purchasing power is something we should take seriously. Taking it seriously does not mean we need lower inflation. It does mean that if wage increases are very unequal we need to figure out what policies and institutions are contributing to that.

  9. It seems to me that Noah is being slightly obtuse here. People really care about wage cuts, and people may see inflation as providing cover for wage cuts. Because of my experience as a union rep during a few rounds of contract negotiations, I think they are right. My colleagues seemed to be outraged by the idea of nominal wage cuts, fairly resistant to the idea of 0% nominal wage increases, and somewhat resigned to the idea of nominal wage increases that did not keep up with inflation, that is, to cuts in real wages. I argued loudly that we should be mainly worried about real wages, especially because over the ten year periods before two contracts we negotiatied in the first half of the aughts our real wages had actually gone down, but my arguments never gained much traction, perhaps because adding another level of complexity to the negotiations was too much for my already distracted and overworked colleagues, or because of a quirk of the human brain, or whatever. The point is, my experience convinced me that it would probably be easier for my employers to negotiate real wage cuts in years when inflation was a bit higher than in years when inflation was quite low. There, if you like, is the "causal effect" Noah is asking for. It may be an artifact of quirky human psychology, but it may be a real effect. And certainly the falling real income that Carola cites is a real concern, and I am very happy to see her writing about it. It is incredible to me that in the US median real wages have been stagnant or falling for over 40 years, and nobody is outraged. I am pretty sure that there would be more outrage if somehow everything were the same but inflation didn't exist, and it were easier to how real incomes had changed.

  10. last sentence edit: ... easier to see how real incomes had changed.

  11. I think inflation tends to redistribute progressively from inframarginal workers to marginal ones. (This is largely why I like it and probably also largely why it is unpopular.) It's clear that this is true in the short run if there are sticky nominal wages, some real-wage elasticity to labor demand, and shocks that sometimes reduce equilibrium real wages: inflation means marginal workers can keep their jobs in the face of such shocks (or get jobs they otherwise wouldn't have gotten), while inframarginal workers have their real pay reduced. I think it is true more generally: for reasons of the ZLB and "greasing the wheels," there is a long-run Phillips curve tradeoff, and real wages are above equilibrium at the low end of the Phillips curve. On the other hand, the equilibrium real wage is also lower at the low end of the Phillips curve, so inframarginal workers don't necessarily benefit, but I"m fairly confident that at least some of them do have higher real wages when the inflation rate is lower. I agree with Noah that there's a lot of irrationality in the common dislike of inflation, but I think the rational component is largely the middle fighting against the bottom (though part of what's irrational is that they don't realize this).

    I would also say that nominal wages are much more sticky downward than upward, so inflation rarely reduces real wages much below equilibrium. Essentially, low inflation rates produce random subsidies to people with secure jobs, at the expense of those with insecure jobs or no jobs. The number of people who benefit from those subsidies typically exceeds the number who are harmed, so the political economy is such that median voters, even rational ones, will oppose inflation even though it it would increase a reasonable social welfare function.

  12. EC, thanks for your account. I've wondered what it's really like in these wage negotiations, so it's fascinating to hear from an insider!

  13. Yes - the confusion isn't really a misunderstanding, just talking about two different things.
    Inflation does have distributional effects. And therefore, by definition does make some people poorer or richer, depending on the scenario.
    However, in total, obviously the nominal price means nothing. What determines wealth or changes in wealth in the aggregate is change in the real amounts of goods and services etc. (regardless of the price those real things are denominated in, and how that price changes).

  14. Carola:

    1. I trust FRED.

    2. We agree on goals. But suppose the economy is being held back by lack of AD. And suppose that is holding down wages. And suppose that Fed easing could boost the economy, thus raising real wages. But suppose that poor and middle-class people who incorrectly believe that inflation makes them poorer oppose having the Fed do this. That would be bad, right?

    3. Try "threaded comments" for your blog!

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