Inflation: a political problem

Why is inflation a problem? I ask because the common sense answer is wrong, whilst a standard answer among economists is out-of-date.

You might think the answer is obvious: inflation is making us poorer. Not so. Of course, wages haven't kept pace with prices, especially of food and fuel. But this, strictly speaking, isn't inflation. It is a change in relative prices. If utility bills were rising 17 percentage points faster than wages and food prices 12 percentage points we'd have a problem even if other components of the CPI were falling so that overall inflation were low.

Nor are higher mortgage rates a cost of inflation. They are a cost of bringing inflation down. And this is a policy decision in two senses: first to want to cut inflation; and secondly to do so through higher interest rates rather than through other means such as higher taxes or price controls.

We define inflation as a rise in the general price level, in which prices and wages rise at the same rates. What's so wrong with that?

For years, the standard view among economists was: not much, unless the inflation is unexpected. As Milton Friedman wrote (pdf):

Anticipated inflations or deflations produce no transfers from debtors to creditors which raise questions of equity; the interest rate on claims valued in nominal terms adjusts to allow for the anticipated rate of inflation. Anticipated inflations or deflations need involve no frictions in adjusting to changing prices. Every individual can take the anticipated change in the price level into account in setting prices for future trades. Finally, anticipated inflations or deflations involve no trade-offs between inflation and employment.

And in 1995 Robert Barro found that it was only high inflation - above 15% - that had a statistically significant impact in reducing economic growth.

Why, then, worry about inflation?

One answer is that it can raise taxes. If our wages rise by, say, 10% at a time when prices are rising 10% we are no better off. But that 10% rise will make us pay more tax, and push many of us into a higher tax bracket. Which is happening now. HMRC says that the number of people paying the higher rate of income tax rose by over 40% from 2020-21 to 2023-24.

I don't think this is a cost of inflation, though. It is a cost of the government's conscious decision not to index tax allowances to the rate of inflation - something which, thanks to the Rooker-Wise amendment of 1977, used to be the case.

Instead, Friedman's beef with anticipated inflation was different. Higher inflation and higher interest rates, he said, caused us to economize on holding cash; because it pays no interest it is more expensive the higher are interest rates. That in turn means that, rather than carry lots of cash on the hip, we have to make more trips to the bank which means we waste more time walking there and standing in queues. Economists called these "shoe-leather costs". In the late 90s, Bank of England economists estimated these to be significant - equivalent to £60bn at the time, which is almost £120bn in today's money.

But obviously, this is out-of-date. Many of us rarely use cash today; the quantity of notes and coins in circulation has fallen in the last two years, and many of these I suspect are sitting in vaults and jars rather than changing hands rapidly.

If shoe-leather costs are no longer so significant, then, what is wrong with inflation?

Maybe not much. Good judges have for years advocated raising (pdf) the inflation target, on the grounds that the benefits of low inflation are small and outweighed by a cost - of the risk of low inflation becoming a deflation which drags us towards the zero bound wherein monetary loses its efficacy.
I suspect, though, that there are reasons why inflation is a bad thing.

For one thing, it creates uncertainty; this is perhaps one reason why the inflations of the 70s and late 80s were accompanied by rises in the households' saving ratio.

The uncertainty here isn't just our reaction of "how much?!" when being charged £13 for a pint of beer and glass of wine at the Hornblower. It's deeper than that. Inflation enriches some at the expense of others. And it does so not on the basis of contribution to society but upon factors such as: how real interest rates move; whether one has a nominal fixed income (such as an annuity or contract to deliver goods at a given price); or - of course - one's bargaining power. As Maynard Keynes wrote (pdf):

The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the existing distribution of wealth... and the process of wealth-getting degenerates into a gamble and a lottery. Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.

Right now, this "arbitrary rearrangement" is benefiting higher earners and larger capitalists who can exercise their greater bargaining power.

You might think this is welcome from a capitalist point of view.

Not necessarily. Capitalism requires not just favourable conditions for profit-making but also legitimacy. And inflation undermines this by reminding us that the notion that incomes depend upon marginal product is an ideologized fiction. Although discontent for now is manifesting itself only in lukewarm support for an unimaginative Labour party from mortgage-saddled former Tories, there's no assurance people will remain so passive if inflation persists. The inflation of the 70s, remember, fuelled sincere talk of a "crisis of democracy", and earlier hyperinflations in Europe had nastier effects.

From the point of view of rentiers and some larger capitalists (if nobody else!) British capitalism was working well in the low inflation era. Why risk rocking the boat?

Comments

[Graham Jones]

Inflation is a reduction in the value of money. It reduces our ability to ascribe a value to anything. Imagine that a foot ruler reduced in length by 10% but continued to show 12 inches. It would completely destroy our ability to measure distance.

[hdavies15]

Try selling the benefits of inflation to people on fixed incomes.

[rsm]

May I quote from NBER Working Paper #303 (in 1978), "Towards an Understanding of the Real Effects and Costs of Inflation", by Stanley Fischer and Franco Modigliani?

"The starting point for analysis is a fully indexed economy. All debt instruments are indexed, except currency, on which no interest is paid (because there is no convenient way to do so); wage and salary contracts are indexed; the exchange rate is freely flexible; tax brackets, fines, and other payments fixed by law are indexed; real rather than nominal returns on assets are taxed; there are no nominal interest rate ceilings; and so on."

Does that answer the objections of commenters Graham Jones and hdavies15, because in the first case, you would just supply more virtual rulers and an easily-automated conversion scheme; and in the second case, the fixed incomes (as Social Security today) rise at the same rate as inflation?

As Fischer and Modigliani explain:

"In principle, most prices in the indexed economy could be quoted in the unit of account, the cost of a commodity basket. In that case, the costs of changing nominal prices would be largely the costs of calculating the nominal amount to be handed over in each transaction, based on the stated indexed price of goods. There would be no
need to change marked prices in an indexed economy more often than in a non-inflationary environment."

Or, as Fischer Black says in "Noise":

"it is not clear what is gained by controlling the price level. If business cycles are caused by real factors rather than by things that are affected by the rate of inflation, then many of the reasons for controlling inflation vanish."

[Laban]

rsm - bur we don't have a fully indexed economy.

The last time inflation was like this (mid-70s) house prices were pretty static, as they were in the early 80s - or only increasing at a very low rate.

A combination of rock bottom interest rates, the energy price shock due to our Russian sanctions, and mass immigration has created a perfect storm where everything is going up. Mid-70s/early 80s inflation was only bad for those on fixed incomes, this is bad for everyone.

[rsm]

@Laban Why shouldn't we have a fully-indexed economy?

What if the Fed started selling cheap inflation swaps to manipulate breakevens to where they want them to be?

What if the Fed created individual deposit accounts for everyone who wanted one, and paid the inflation rate as interest on the contents of the account, thus providing a simple way to fully index private savings? (Is Erdogan approaching this policy by indexing lira savings in Turkiye?)

[Nick Drew]

@ Laban, "the energy price shock due to our Russian sanctions ..."

Can't let that snide little remark pass.

(1) From their extreme covid lows, energy (and metals) prices were clearly on the move, upwards, just as soon as every nation's post-covid economic recovery programmes kicked in, starting in the Far East, Jan-Feb 2021. Literally everyone in the know was hedging against this (or betting on it) from Feb-Mar 21 (which explains why so few energy suppliers of any substance went bust in 2022, and why so many commodities players made massive profits)

(2) This upward trend received a serious boost across the summer of 2021 (repeat, 2021), as Russia unilaterally ceased sales of non-forwarded-contracted gas into Europe (in order to force Europe into winter 21-22 with low gas inventories). That's Russia, pre-invasion, acting unilaterally, strategically, with hostile intent. Gottit?

(3) the recent 'energy crisis' dates from around Sept 21 (repeat, 2021) when this hugely significant price-trend became universally recognised. Memory failing you? Go back and look up news reports of the time.

(4) of course, Russia's (entirely uncalled for) invasion of Ukraine absolutely supercharged all this: but let's not have it framed as being caused by "our Russian sanctions". If anything, that final 2022 twist in the whole complex account should be stated as "our collective refusal to buy from an outright warmonger, even at high cost to ourselves".

[Jan Wiklund]

On the other hand, as Ha-Joon Chang reminds us, inflation was 42 percent a year in the 60s when it was one of the fastest economies in the world, and South Korea had an inflation of 20 percent a year with a growth of 7 percent a year. And on the other hand, who can argue that the inflation combatting policies of the post 1980 years has been good?

Perhaps inflation in itself is harmful, but it is not THE harmful thing. Perhaps one should not give it too much weight. There are things that are worse, and if to avoid them one has to permit some inflation, it should be done.

[Jan Wiklund]

Oh, I forgot to mention Brazil as the name of the fast-growing country above.

[Blissex]

«wages haven't kept pace with prices, especially of food and fuel. But this, strictly speaking, isn't inflation. It is a change in relative prices. If utility bills were rising 17 percentage points faster than wages and food prices 12 percentage points we'd have a problem even if other components of the CPI were falling so that overall inflation were low.»

Here our blogger repeats faithfully the right-wing friedmanite prevarication to define "inflation" not as common people understand it as a rise in the cost of living, but as a "rise in the general price level, in which prices and wages rise at the same rates", or in effect tautologically as a rise in the hallucinatory "quantity of money" (MV for friedmanites), so that "inflation" is a "always and only a monetary phenomenon".

Actually inflation, in the proper sense of rise in the cost of living, is always and only a political phenomenon, to achieve some form of redistribution, and so it is nowadays in the UK:

* UK inflation (and that in some other countries) is much higher than in many other countries, and some don't have inflation. Curious!
* UK inflation is supposed by the Bank of England to fall under 2% by the beginning of 2025. It's a plan!
* The BoE is keeping real interest rates way negative, at around 5% for the base rate and 6% for mortgages, while the RPI is at 12-14% (and the cost of living for many is rising rather faster).

«From the point of view of rentiers and some larger capitalists (if nobody else!) British capitalism was working well in the low inflation era. Why risk rocking the boat?»

For a very important goal, to help UK wage earners become "more competitive", which can be achieved in 3 ways:

#1 "external devaluation": a fall in the exchange rate and real wages become become "more competitive" in "strong currencies".
#2 "internal devaluation": a recession with much unemployment results in wage cuts, especially for those hired from unemployment, who are desperate to get a job, and wages become "more competitive" in the local currency.
#3 "internal inflation": most prices, except wages, increase, and wages become "more comepetive" in terms of purchasing power.

That real interest rates are way negative is the obvious sign that #3 is the policy choice of government and BoE, so 2-3 years of 12-18% cost-of-living inflation are intended to make wages "more competitive" by around 30-40%, and to enormously enrich those who can borrow at 5-6% when other prices are going up much faster.

[Blissex]

«[Brazil's] inflation was 42 percent a year in the 60s when it was one of the fastest economies in the world, and South Korea had an inflation of 20 percent a year with a growth of 7 percent a year.»

* Perhaps for a while high "inflation" has a positive effect on GDP, as it encourages spending as quickly as possible and "investing" in hoards of products and assets, but perhaps the longer term effects of that are not so good. :-)

* Perhaps when an economy is booming for other reasons, not even high "inflation" can stop that.

«And on the other hand, who can argue that the inflation combatting policies of the post 1980 years has been good?»

Those massive increases in the cost-of-living were not "inflation combatting policies", but political and redistributive policies to fight the labour unions, and relatedly to ensure that the cost of redistributing a chunk of GDI to oil producers fell mostly on wage earners.

«Perhaps inflation in itself is harmful, but it is not THE harmful thing.»

But it can be still quite harmful if it encourages speculation instead of production.

«There are things that are worse, and if to avoid them one has to permit some inflation, it should be done.»

My impression is that currently high cost of living inflation, especially related to assets, a policy with the purpose to redistribute immense (literally trillions at the rate of several hundred billions per year) amount of income and wealth upwards from wage earners to asset owners, mainly property, makes it much more profitable to speculate on continuing unproductive inflation than the engage in productive activities and in particular in investing in productive capital.

Especially now with real interest rates in -4% to -8% only morons would waste their liquidity in anything other than speculative inflation plays (e.g. massive BTL "investment").

That of course delights the 20-40% of the voters who have been massively benefiting from that, but as JM Keynes also wrote:

“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

[Blissex]

«#1 "external devaluation": a fall in the exchange rate [...]
#2 "internal devaluation": a recession with much unemployment [...]
#3 "internal inflation": most prices, except wages, increase [...]»

Perhaps #2 should be called "internal deflation" and it should be #3 that should be called "internal devaluation".

[rsm]

《“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”》

Is Keynes guilty of spinning a just-so yarn, since finance could just as easily have come before the "steady stream of enterprise" (see David Graeber, "Debt: the first 5000 years")?

Rather than violently trying to stuff the finance genie back in the bottle, would our time be better spent using virtual financial markets to distract selfish people into speculating on fictitious goods while real things are produced automatically, or self-provisioned in a dramatic rejection of Adam Smith's "specialisation is good" argument?

[Blissex]

«using virtual financial markets to distract selfish people into speculating on fictitious goods»

This has been happening on an ever larger scale for decades with options and other derivatives.

Those markets unfortunately don't use units of account with no purchasing power, but the same currency with purchasing power used in the real goods markets, so those who win bets about "fictitious goods" can use their winnings to buy lots and lots of real goods.