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.
Catalan concludes:
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!
Uneasy Money 
David:
If I’m the first person to get a new dollar from the fed, then I’m also the first person to hand over a dollar’s worth of my bonds to the fed. My net worth is not affected, and neither is the fed’s. Thus there is no reason to expect inflation, or any change in my wealth, or any change in relative prices of goods
LikeLike
David,
Thank you for responding to my post!
I think I agreed with the general point “that if prices in general have risen, total spending, and therefore total income, must also have risen.” But, you used this as a means of suggesting that because this is necessarily true, it cannot be true that real wages have fallen (since total income must have increased). My argument is that the conclusion doesn’t follow from the premise.
I think this is the main point against my argument,
To avoid me horribly misinterpreting this, could you explain your reasoning here?
Finally,
But, they are! The “monetary authorities” don’t increase total income by giving an equal amount of dollars to every consumer, they increase spending by lending to banks, which then lend these dollars through the loanable funds market or through credit cards. The method by which total money is increased deliberately targets specific people over others.
One last point. You argue,
We don’t need an empirical study of past movements of wages and prices to discern the effects of inflation on real wages (without taking into consideration the possibility that inflation might increase productivity — something I disagree with, but you agree with, and is not being argued here). I agree that it is very difficult to know whether relative prices and wages were caused by real forces or monetary forces, but I’m not proposing a historical study. We can deduce the effects of monetary injections by causal reasoning. How exactly increases in total spending will manifest, I agree, cannot be predicted a priori, but we can get a general theory of monetary injection, cantillon effects, and how prices and wages will be affected on the whole.
LikeLike
David,
Economics and common sense have a lot more to say on the subject of relative prices than you let on. In Latin countries, for instance, inflation gains accrued wealthy investors that could hedge in FX and commodities markets. While middle-class earners tried to hedge best as possible (by running to supermarkets to spend their paychecks), there clearly was a transfer of wealth from this group to the wealthy. Since the wealthy had a lower consumption propensity (and higher import propensity), their increased income did not benefit real domestic demand enough to offset middle class real wage declines. The result: stagnant growth, capital flight, income inequality, etc.
Moreover, we also know that inelastic supply/demand goods are more sensitive to inflation, as are tradeables vs. services. If the indebted population experiences a terms of trade “shock”, they will reduce their forecasts for future income growth and decide to spend less. The wealthy have a lower propensity to consume and so may not make up for that reduction in real spending. Further, with corporate profits already at peak, it is not clear that higher prices would lead to more real business investment. None of this should be controversial.
Economists seem to believe that laymen only think of partial equilibrium. In reality, they use a shorthand — heuristics — to simplify complex phenomena. One such short hand is, “the Fed is increasing the cost of living, causing people to spend less in real terms.” This leaves out, “and the beneficiaries of higher prices are not spending enough to make up for it,” but it is implied.
LikeLike
It is sometimes fruitless to engage people who say “inflation is cutting incomes (or wealth).”
Perhaps this will work: Suppose we converted to Decidollars tomorrow, and did a 10-for-one reverse split on the dollar. We would all be ten times as rich, right?
Of course not—-nominal indexes are only that, nominal. When you went shopping, a new modest car would cost $2,000—and you would be making $2 an hour.
There are some biased effects to inflation, and inflation does, in the short-run, tend to reduce steadily employed worker real incomes. This may actually be a good thing, as it will encourage employers to hire on (all other things being equal).
Yes, unexpected inflation is a minor irritant for the steadily employed, although it is a lot better than being unemployed. The latter is the key point.
Of course, the best solution is Market Monetarism, for steady growth and steady moderate inflation.
LikeLike
Benjamin,
First, you write,
This is true, but to me it is a ridiculous proposition. You could achieve the same by cutting wages, and you wouldn’t have the other potentially negative side effects of monetary inflation (“negative,” depending on who you ask).
I’m not sure what your point is with regards to the first three paragraphs. Nobody said that real wealth is increasing as a result of currency debasement — the argument is the exact opposite: for some, real wealth is decreasing.
Finally, you write,
This isn’t being argued — I don’t agree with it, but it’s not what is being argued. We are arguing the effects of inflation without having to argue whether or not monetary injections can increase productivity. That is, the argument is whether or not inflation can reduce real wages.
LikeLike
I think it’s fair to say income must rise if prices do. When total real output/consumption remain the same, anyway.
The problem is not income, but paper based assets. These lose purchasing power.
So do fixed incomes. And creditors, of course. Although not banks, since they simply create the credit and take it out of circulation when repaid.
Inflation would not be much of a problem, if the middle classes didn’t hoard paper assets.
Interest is much worse.
LikeLike
Catalan–
Okay, the desirability of inflation in a recession is due to a problem known as “sticky wages.” For social reasons, it is difficult to cut wages. Cutting someone’s salary or hourly wage is understood to be punitive. Less common, there may be contracts fixing wages.
So, a decrease in demand is translated into a reduction in the numbers hired, not in wages. Exactly the opposite of what we probably want. Inflation is grease on the skids, maintaining the necessary illusion that the employer has treated the employees fairly and not cut their wages. It moves “blame” for wage cuts to a third and inanimate party.
You misunderstood my first three paragraphs. I was stating that if by fiat, the government increased the value of a dollar by 10-fold—-that is to say we did a 10-to-1 reverse split. This happened in Israel once. So you buy a Coke for 15 cents, and you earn $1 an hour.
No one is either wealthier, or paid more, or less wealthy or paid less.
It is nominal! Nominal! It does not matter!!
The better question is, “Why are you so concerned about a nominal system?” Should you not be concerned with real output?
Does it matter so much if there is moderate inflation or deflation?
In the case of deflation, we know there are serious detrimental effects—-especially for real estate investors, who have borrowed in nominal dollars. This leads to bank failures, and shrunken investment activity—see Japan, where they have had 15 percent deflation in the last 20 years, industrial production has fallen by 20 percent, and stock and property markets have fallen by 80 percent. The yen is very strong.
It is extremely difficult to be an investor in deflation, Banks do not want to lend, as they know everything will be worth less in nominal terms in a few years. Buyers do not want to buy for the same reason.
Moderate inflation seems to have few negative side effects (I can think of none, and even in theory the damage is exceedingly minor) and many positive attributes (good for banks and real estate, helps the nation deleverage, and solves he wage stickiness issue).
Catalan, I enjoyed your comment, but I would even more enjoy you joining the Market Monetarism movement!
LikeLike
Benjamin,
I just don’t think that there is evidence that supports the existence of “sticky wages” in the way you envision them. I agree that there are frictions in the movements of prices (including the price of labor), but I disagree on the causal reasoning as to why they exist (see my discussion of price stickiness here). E.g. In the case of wages, contracts can be broken and redrawn (and they are) and employers rather cut wages than fire employees (or, they rather fire employees and re-hire new employees at lower wages — this is something that can be empirically verified). I think that any super-rigidity in the labor market is due to government intervention — i.e. unfair enforcement of contracts, wage minima, et cetera.
With regards to your “10-to-1 reverse split,” that’s not what we’re discussing here. We’re not discussing taking off or adding a zero to a bill; what we’re talking about is injecting money into the market through specific points of entry. We’re talking about changes in certain prices, not in all prices — the inflation is not taking place neither simultaneously or porportionally; it is uneven, so how it impacts different people is also uneven. Here the effects are both nominal and real, since people are bidding these new dollars towards real goods.
I am concerned about real output, I just disagree that monetary injections can lead to increases in real output. I also disagree that there are “serious detrimental effects” to deflation (see the post I linked to earlier) [what’s funny here is that you don’t care about “nominal” decreases in the value of the dollar, but you do care about “nominal” increases in the value of the dollar — all, I guess, because of whatever training you’ve received]. Also,I would point at the period between 1873 and 1894 as an excellent example of a healthy, growing economy during a long period of deflation — see my article here. There is a difference that this is an increase in productivity v. a decrease in the supply of money, and I concede that (and whether or not decreases in the supply of money are bad is up for debate — see the first article I linked to above).
In any case, what we’re discussing is that inflation can have real effects on the economy, and that these real effects will have real consequences on the distribution of wealth.
LikeLike
Mike, Suppose, we were operating on a gold standard, and the Fed just happened to have a secret formula allowing it to take lead and convert it into gold at no cost. And whenever, the Fed felt like it could take some lead, costlessly convert it into gold and use the gold to buy a bond. Would the Fed’s open market purchases using gold have any effect on the price level?
Jonathan, You’re welcome. I thought you did a nice job of commenting on my post and posed an interesting question that brought out a point that I had had in the back of my mind, so thank you for your comment. I actually tried to avoid implying the proposition you attribute to me. I was trying to operate at an atheoretical level about the effects of inflation and just focus on the logical inconsistency involved in saying that inflation, as a matter of logical necessity, involves a reduction in anyone’s real wages. Inflation could have that effect in general or in particular cases, but any such proposition requires a theoretical argument or an empirical study to support. It is not a truism, as the quotation I was citing was suggesting.
My reasoning in the passage you cited is the following. If the Fed is injecting money into the economy at a more or less steady rate 24/7, it does not seem that there is any meaningful distinction between the initial recipients and the final recipients of the new money, because new money is constantly flowing into the stream of income and expenditures. Those effects are continuously working their way through the system, so why should we assume that the fact that the money is injected at a particular point every time has any significance for the overall steady state corresponding to a steady stream of injections? If you could isolate a particular group that always received injections of money and whose incomes increased as a result you could say that the new equilibrium corresponding to injections of money would reflect the increased demand of that particular group, but I don’t think that it’s possible to identify such groups as a general matter. My point is that there is no general theory of Cantillon effects, and there is certainly no theory of Cantillon effects that tells us that wages must lag behind prices, though I do not deny that wages may lag behind prices in some situations. But when wages do lag behind prices, it is at least as plausible to say that they do so because inflation is allowing real wages to gravitate toward a reduced equilibrium value than because Cantillon effects are causing real wages to deviate from their equilibrium value.
David, As usual, you have a very insightful take on inflation and its effects, and you make a plausible argument for why inflation could be reducing the real income of some vulnerable groups in society. I don’t agree that when laymen, or reporters for the Wall Street Journal, talk about inflation reducing their real income they are using a shorthand way of expressing your insights. I think that it is more likely that they are expressing their own resentments about what is being done to them by those terrible people who are in charge or repeating the talking points being drilled into them on talk radio.
Benjamin, As you know, I am uncomfortable with general statements about inflation. I think inflation now would be a good thing, but I don’t necessarily think that inflation is always and everywhere a good thing or a bad thing. It all depends. At least with regard to inflation, I endorse situational ethics.
Anthony, I am afraid that our views on paper-based assets, whatever that means, are very far apart, but thanks anyway for your comment.
Jonathan, Have you ever considered that there are actually good economic reasons why workers might refuse to accept nominal wage cuts even though they would be willing to accept a reduced real wage achieved through rising prices rather than a cut in nominal wages?
LikeLike
David:
Yes on the lead into gold question, assuming gold is money. But if the Fed took lumps of lead and stamped them into dollar coins and sold them for bonds, then there would be no inflation.
LikeLike
Mike, I guess I don’t understand why there is any difference between gold and paper (or lead) in your analysis.
LikeLike
David:
Your lead into gold process increases the amount of physical gold, which reduces its value. Assuming gold is used as money, this means inflation. But stamping lead into coins has no effect on the amount of gold that exists and therefore has no effect on the value of gold. (It might cause a small increase in the demand for lead, but that’s beside the point.)
There’s no important difference between producing token lead dollars or token paper dollars, so in either case an increase in the amount of dollars, backed by new assets of adequate value, leaves the issuer’s net worth unchanged, and therefore leaves the value of the dollar unchanged. We’ve only moved from a situation where the issuer held assets worth 100 oz as backing for $100, to a situation where the issuer now has assets worth 200 oz as backing for $200. Each dollar is worth 1 oz in either case.
LikeLike
Mike, You need to go really slow, so I can keep up with you. When the Fed exchanges a newly printed dollar for a bond, you say it’s net worth doesn’t change. But there is one more dollar out there, so why is the value of each dollar not correspondingly reduced?
LikeLike
David:
I presume you don’t have a problem with my statement that the fed’s net worth is not changed. So I’ll focus on your “one more dollar out there” question.
Start with the simplest case. A bank takes in silver on deposit and issues paper receipts (dollars) in exchange. It should be clear that whether the bank holds 100 oz and issues $100, or holds 200 oz. and issues $200, a dollar is worth 1 oz. either way. There are an extra 100 dollars out there, but in this case the bank locked up 1 oz every time it issued a dollar, so the total quantity of money out there is unchanged. A quantity theorist would say that the dollar held its value because the total quantity of money (silver+paper) was unchanged, while a backing theorist would say that the dollar held its value because each dollar was always backed by 1 oz. of bank assets. Both sides would expect no inflation, just for different reasons. But the quantity theory implies that the bank, having issued $200, could just throw away all 200 oz. of its assets and its dollars would hold their value, while the backing theory would say that this would reduce the value of the 200 dollars to zero. I favor the backing theory because if the bank really could throw away its silver, then other banks would be eager to issue their own dollars to get a piece of that free lunch, and the competition from rival dollars would reduce the value of the original dollars to zero.
Now, repeat the above story, except that some or all of the bank’s assets are in the form of land, bonds, metals other than silver, etc. This time, as the bank increases its issuance of dollars from 100 to 200, the bank probably won’t lock up an additional 100 oz. of silver (It will hold an additional 100 oz. worth of land, bonds, etc.), so it seems that there really are more dollars out there. In this case, the quantity theorist expects inflation because the total quantity of dollars out there has increased, while the backing theorist expects no inflation, since the bank has just gone from having assets worth 100 oz. backing $100, to having assets worth 200 oz. backing $200.
So how to resolve the quantity theory claim that there are more dollars out there with the backing theory claim that each dollar is backed by assets worth 1 oz and therefore is worth 1 oz.? The answer is the law of reflux, which I know you don’t need explained. As new dollars (adequately backed) are issued, somewhere out there some other kind of money will reflux to its issuer. Or maybe people were conducting a lot of trades using barter, and they start using dollars instead.
But what if the amount of newly-issued dollars was so large as to overwhelm any reflux of other moneys? Two answers: Either (1) That assumes the impossible. People who are glutted with dollars will not willingly bring a dollar’s worth of assets to their bank in order to get one of the bank’s paper dollars, so those new dollars would never be issued in the first place. or (2) The bank is refusing to allow its dollars to reflux (to itself). That, however, is equivalent to the bank refusing to back its own dollars, and in this case even the backing theory says that the implied loss of backing will cause inflation.
I don’t want to make this post any longer, and of course I have a lot of stuff on the web that gives further explanation (e.g., the wikipedia article on the real bills doctrine), but Rome wasn’t built in a day, and coming to understand the backing theory is a long, slow process.
LikeLike
Mike, I agree that the law of reflux is an essential element in your argument. However, it seems to me that the operation of the law of reflux is not as smooth and automatic as you assume if there is not a clear convertibility requirement or commitment that anchors the value of the bank’s liabilities. I think that is probably where most of our disagreement is centered. But let me ask you a slightly different question. If people cannot really figure out how much the assets of the Fed/Treasury/Federal Government are really worth, how does that uncertainty affect your analysis of the value of US currency?
LikeLike
David:
Reflux and convertibility are practically the same thing. If the dollar is physically convertible into 1 oz. of gold, then we could say that there is a channel of reflux called the gold channel. As long as that channel is open and unrestricted, and as long as the issuing bank has enough assets to buy back every outstanding dollar for 1 oz, then I don’t think anyone would doubt that the dollar will trade in the market for 1 oz., so our disagreement disappears in this case. But there are other possible reflux channels. For example, the bank can use bonds or used furniture to buy back its dollars instead of gold. Either of these reflux channels could serve in place of gold convertibility, though as you say, the reflux would be less smooth and automatic.
Another thing to keep in mind is that gold convertibility can take different forms. The bank might offer instant convertibility, or it might delay convertibility by a year or a century. As long as other reflux channels stay open, delayed gold convertibility might not even matter. Of course if enough reflux channels get obstructed so as to put 10% of the bank’s assets permanently out of reach of the bank’s customers, then that would cause the bank’s money to lose 10% of its value, just as if the bank had explicitly defaulted on 10% of its debts.
If people can’t figure out what the backing assets are really worth, then the currency would be valued in the same way as stocks, bonds, or any other liability that lays claim to assets of uncertain value.
LikeLike
That money has to go to someone… but that “someone” could be a bank, or an overseas firm. Yes, technically, the money went “somewhere” but for all practical purposes–and certainly for Hilsenrath’s purpose–it just as well could have been sucked up into space.
LikeLike
Mike, If there is not a formal convertibility commitment, doesn’t reflux depend on the cooperation of the issuing bank, so that it can choose whether it wants to allow reflux to operate and keep its currency at a stable value or prevent reflux from operating and allow the currency to depreciate?
Greg, If the money is going into space, then what is causing prices to rise?
LikeLike
David.:
That’s correct. If the bank is good about reflux then its currency will have high value, while if a bank is bad about reflux its currency will have low value.
I’ve over-used this example, but it’s pertinent: A landlord collects rent of 50 oz/ year (in silver). The market rate of interest is 5% and his property is worth 1000 oz. He sometimes buys groceries by writing an IOU, which says “This note is legal tender for 1 oz. rent on my property”. He could, in principle, write up 1000 of those notes, since they are adequately backed by his 1000 oz property.
These notes will normally reflux to him in payment of rent, but he could also stand ready to redeem them on demand for 1 oz. of actual silver, or he could hold bonds and use them to periodically buy back some of his 1 oz. IOU’s, or if there are people who owe him money, he could accept the IOU’s as loan payments. Each of these things could be called a channel of reflux, and they can each be considered a form of convertibility. If the landlord closed one channel (stops paying out silver) but keeps the other channels open, the value of the notes would not change (assuming he’s still wealthy enough to buy back all his IOU’s at par).
On the other hand, the landlord might start misbehaving, only accepting IOU’s in rent or loan payments at half their value, never using his bonds to buy up excess notes, etc. This behavior is equivalent to a loss of backing, so the IOU’s will lose value.
LikeLike
Mike, Good example, Thanks.
LikeLike