Real inflation cycle theory

Noah Smith has a good post on what, from a certain perspective, is kind of a puzzle. Why do real wages usually decline during inflations?

In theory, some economists imagine, inflation should be neutral. The nominal price level is just an arbitrary unit. If tomorrow we redenominated cents as dollars, and passed a law that updated previously defined contracts and prices to the new unit and let people exchange old currency for new, we’d expect nothing much to change. Sure, in “dollar terms”, prices would have risen by 100 times! But so also would have wages, and bank account balances, and everything else, so who cares. If we think of the real economy as fundamental and inflation as just a slipping of the nominal price unit, we’d expect wages and prices to rise simultaneously. Absent formal redenomination, there are some rigidities. Unexpected inflation redistributes from creditors to debtors, as debt contracts made in nominal dollars fail to adjust. But as Smith points out, wages are not thought to be rigid (“sticky”) upwards. So why, in most durable inflations, don’t wages rise at the same pace as prices?

This is a puzzle if you think about inflation as basically arbitrary, a symptom of mismanagement by central banks of purely nominal units. But that’s entirely the wrong way to think about stubborn inflations. Demand mismanagement can lead to some inflation, but it’s rarely durable. When there are not fundamental reasons for the inflation, moderate monetary and fiscal tightening quickly ends it. That happens a fair amount. Team transitory wins.

Stubborn inflations occur when there are in fact deep reasons why the inflation, or else some alternative form of unpleasantness, is necessary. Generally, inflation is the answer to a question: What do we do if we are not as rich as we thought we would be? More precisely, what do we do when the expectations of the labor force, in real terms, cannot be satisfied by the output we are capable of producing? Then we have to cut real wages relative to prior expectations somehow. If the shortfall is large, given the reality of downward nominal wage rigidity, we must resort to some mix of inflation and unemployment.

Inflation bounces around. We have lots of little spikes, the central bank and the fisc fine-tune, over time wages usually do keep up with prices through all of it. But when we have a serious inflation, it almost always accompanies a mismatch between what the labor force expects and what the economy, on the “supply side”, is capable of delivering. The functions of serious inflations are to (1) reprice real wages downward; and (2) allow for redistributions within the labor force, via repricings of relative wages that downward nominal wage rigidities would otherwise prevent.

Until February of this year, team transitory was right. In 2022, the fiscal impulse of the COVID era was going to collapse as quickly as it had arisen (and it has). That, and some monetary tightening, and unsnarling some temporary supply-side SNAFUs, would have ended the inflation. Last winter, we were seeing some redistribution of real wages within the labor force (towards the lower end), but not a steep decline in real wages. Then shit happened. February and early Spring brought three big shocks: the Ukraine War, the impact of Omicron on COVID-Zero China, and, in response to the Ukraine War, accelerating mistrust and hostility between China and the West. As Wolfgang Munchau points out (ht E.E. Reed), the old factory we have relied upon is shutting down. Over the next few years, we may have to radically reorganize the global supply side. The global demand side will have to adjust, at best, to a pause in the growth we might have expected from iterative improvements to that once humming machine. More likely we will have to adjust to some impoverishment in real terms, as businesses try to build a new machine from parts of the old one while the old one is struggles to sputter on. Patterns of sustainable specialization and trade that we have long depended upon are likely to be, well, no longer sustainable.

Globally, real wage expectations are out of kilter with what the global supply-side will be able to deliver. Locally, there will be winners and losers from the changes, which will entail redistribution of real wages from prior patterns within the global labor force. We are enduring a global inflation now because we require one. We don’t like it, so we are countering it with fiscal and monetary tools. But those can’t restore real wages the economy is unable to deliver. What fiscal and monetary tightening will do is trade some of the inflation for unemployment. Instead of everyone’s real wages falling, if we destroy demand for some superfluities, we can cut some of the labor force out from a share of the impaired flow of core goods and services that the global machine is now able to produce. That leaves more for the rest of us, higher real wages. As long as the supply side of the economy is impaired, our choice is whether to share the burden more broadly (tolerate inflation) or concentrate it on subgroups of workers (accept unemployment).

We are likely to do a bit of both, and oscillate between the two, until expectations of the labor force are realigned with expected (and much less uncertainly expected) global output. We won’t solve our macroeconomic problem until we find patterns of specialization and trade that are, in this new era, actually sustainable, and then accommodate our expectations and arrangements (wages, rents, etc.) to the actual production those new patterns can manage. Our problems are real. Neither Jay Powell nor Janet Yellen can fix them. Governments can, by finding a durable peace and building politically sustainable foundations for international trade and migration (which, I think, will be quite different from the arrangements of the past few decades), or by spurring domestic production of core goods and services.

Besides wage earners, there is another group of claimants who can share the burden of the real product shortfall. People who receive capital income might also adjust their real consumption. Under inflation they do, to a degree. Inflation will cause people “on fixed incomes” to consume less, and that will “help” in the sense that their discomfort will contribute to the burden sharing. Crashing portfolio values, declining home equity, higher mortgage payments (for those not on 30-year fixed rate mortgages) will reduce expenditures of the global “upper middle class”, helping limit the inflation and the decline of real wages. But in dollar terms, the vast majority of capital income goes to the very wealthiest, who did not spend much of it in good times, but who won’t adjust their spending downward in bad times, absent near total collapse of their wealth. Perhaps the main privilege of being fabulously rich is, under almost all circumstances, you get to opt out of “adjusting”.

At a macro level, the problem with capital isn’t that firms raise prices to pad margins. Those funds get paid mostly to people whose spending is decoupled from their earnings, so who don’t put pressure on global production. The expanded profits are like a tax, directly inflationary but disinflationary going forward as wage earners will afford less and less. The problem is when capital has the ability to increase profit by raising prices, that displaces the alternative strategy of increasing profit by expanding production. Expanding production is the happiest way of addressing a shortfall of core goods and services relative labor force expectations, and reduces the need for inflation and unemployment. In economic (as opposed to political) terms, the problem with capital is not that it takes too much money, but that it takes all that money while delivering too few goods. Which is why antitrust, or, excess margins taxes, or public options, should be at the very top of our inflation reduction agenda.

Update History:

  • 7-Nov-2022, 4:10 p.m. EST: “Patterns of sustainable specialization and trade that we have long relied depended upon are likely to be, well, no longer sustainable.” [eliminate repetitive use of “relied upon”]
  • 7-Nov-2022, 7:15 p.m. EST: “We don’t like it, so we will are countering it with fiscal and monetary tools.”; “Crashing portfolio values, declining home values equity, higher mortgage payments…”
  • 9-Nov-2022, 11:00 a.m. EST: “Under inflation they do, to a degree. There are people whose marginal consumption is affected by capital income or wealth effects.

One Response to “Real inflation cycle theory”

  1. Detroit Dan writes:

    I enjoyed this post and referenced Noah Smith post. This is macroeconomics at its best — using common sense along with data and relevant theory and terminology to discuss issues which affect our daily lives. It’s probably not worthwhile trying to completely separate the politics from the economics, as they are too closely interrelated. But we need to recognize that Krugman and the mainstream Democratic consensus tends to obfuscate more than they connect to workers, and we could use more widespread economic communication along the Interfluidity lines of thought.