In a post earlier this week I took reporter Jon Hilsenrath of the Wall Street Journal to task for asserting that the recent reduction in inflation was good news, because it meant that more money would be left in people’s pockets than if inflation hadn’t come down.
The real problem with that sentence is the unstated assumption that the number of dollars people have in their pockets has nothing to do with how much inflation there is. I do not expect Mr. Hilsenrath to accept my theoretical position that, under current conditions, inflation would contribute to a speedup in the rate of growth in real income, but it is inexcusable to ignore the truism that rising prices necessarily put more dollars in people’s pockets and simultaneously assert, as if it were a truism, that rising prices reduce real income.
Blogger Jonathan Catalan in turn took me to task in this post.
What Glasner seems to be arguing, though, is that because inflation amongst consumers’ goods necessarily requires rising nominal expenditure (by consumers) real wages remain the same. That is, prices rise proportionally to the increase in consumer spending. In order for Glasner’s proposition to be true all consumers’ nominal wages would have to increase proportionally, and the change in prices of individual goods would have to occur in such a way that the value of money in relation to all consumer goods remains the same. We can deduce right away that such a set of prerequisites is impossible to fulfill.
Actually Catalan is reading more into that quotation than I put into it. All I meant to say was that the existence of inflation is predicated on an increase in total spending compared to an alternative world in which there was no inflation. I am not saying that inflation raises all prices proportionally, I am just saying that if prices in general have risen, total spending, and therefore total income, must also have risen. This not a matter of diagnosing the cause or effects of inflation, it is just simple bookkeeping. Thus, Catalan is aiming at a strawman in his next paragraph, not at me.
Right away, we know that not all consumers’ have had their nominal incomes grow proportionally. A little over eight percent of the United States’ labor force is unemployed; to that, we can add a large quantity of discouraged workers. These are consumers who are not earning an income, besides any unemployment or welfare benefits they are receiving (benefits that follow inflation trends, if even that). The employed labor force are all working for wages set by their employers (based on the demand for specific/unspecific labor and supply of adequate laborers) — I do not think that anybody is assuming that all wages are rising proportionally and simultaneously. [DG: Just wondering, does Catalan think that wages rise only when employers feel like raising them?]
I didn’t say that all wages were rising proportionally. What I said was that with nominal income rising along with prices, the gains in nominal income as a result of those price increases had to accrue to someone. Thus, insofar as some people were made worse off by inflation, others were made better off. There are of course theories asserting that inflation has either good effects – and others asserting that inflation has bad effects — on the economy, but, for purposes of this discussion, I am not taking sides for or against those theories. In his next paragraph, Catalan repeats the same point, suggesting erroneously that I argued that no one can be made worse off by inflation. But at the most naïve level, i.e., not trying to figure out the indirect and long-term effects of inflation, the losses of some are offset by the gains of others.
Catalan continues, and here he gets himself into trouble.
But, if wages are not rising simultaneously and proportionally for all consumers, then some must suffer from a reduction of the real purchasing power of the dollar. Abstracting sufficiently, we can pool individuals into those who receive newly created dollars and those who do not. Those who receive money first will be able to bid new currency towards consumers’ goods at their prices of the immediate past, causing prices to increase. Those who do not receive this money will have to suffer from an increase in the prices of consumers’ goods.
What is wrong with this statement? Well, first, it’s not clear if new currency is injected into the economy in just one dose, or if injections are ongoing. If the injection is a one-time dose, then Catalan is correct that the sequence in which the new money reaches individuals has some transitory significance on the distribution of gains and losses from transitory inflation. People who get the money first may have some fleeting advantage over people who receive the money only after it has already gone through many hands before reaching them (although even this proposition is subject to any number of potential qualifications). However, if money is being injected continuously or periodically, Catalan’s statement is erroneous, because once the cycle of injection and dispersal is repeated, it is no longer meaningful to identify a particular point of entry as prior to any other point in a continuing cycle. What matters is not the temporal sequence in which the new funds are spent, but whether the injection of new money alters the overall distribution of spending.
Glasner’s mistake — unless I terribly misinterpreted his point — is an over-reliance on the mechanical quantity theory of money and prices. Yes, inflation is a monetary phenomenon. That does not mean that inflation actually takes place simultaneously and proportionally amongst the prices of all economic goods and wages. Instead, prices change relative to each other; some lose and some win. It was this lack of focus on relative prices that Friedrich Hayek warned about in Prices and Production (although, he was referring to relative prices amongst goods of different stages in the structure of production and this would lead him to his elucidation of intertemporal discoordination).
In a sense, Catalan and I are not that far apart. We agree that monetary expansion can raise prices, and that as it raises prices, newly injected money may also affect relative prices. However, I don’t think that it’s possible to say much about how injections of money affect relative prices unless the monetary authorities are deliberately aiming to put money into the pockets of specific groups of people. But that’s not really how new money is injected into the economy, so I don’t think that trying to find the relative-price effects associated with inflation is very useful way of analyzing the effects of inflation. And that is why Hayek was unable to make a positive contribution to the analysis of business cycles beyond articulating some very general (but nonetheless important) principles about the conditions necessary for intertemporal equilibrium, the importance of stabilizing nominal income over the business cycle, and the ineffectiveness (in most circumstances) of anticipated inflation in increasing employment.
So to come back to the specific point that Catalan took me to task for, although I did not argue that inflation does not affect real wages, I do think that it is far from obvious that inflation has reduced real wages, i.e., that inflation has caused prices to rise faster than wages. Surely some wages have risen less rapidly than prices, but some wages have gone up more rapidly than prices. And as a general proposition, we have little way of determining whether recent changes in relative prices (and wages) were caused by real forces affecting relative prices and wages or by the forces affecting inflation. Given our ignorance of what is causing individual prices to change, there is no obvious basis for suggesting that anyone’s real income has been affected by inflation. If you want to make that claim, be my guest. But there is no inherent property of inflation that justifies it. If you want to make the claim, it’s your burden to come up with an argument to make the claim credible. Good luck.
PS It looks like this will be my last post for 2011. Best wishes for 2012. May it be an improvement on 2011!