Home > Uncategorized > Maybe inflation should be welcomed

Maybe inflation should be welcomed

from Philip George

Until 1982 it was believed that stomach ulcers were caused by stress and lifestyle. That year,
two Australian scientists, Robin Warren and Barry Marshall, demonstrated that most gastric
and duodenal ulcers were caused by a bacterium, Heliobacter pylori. They cultivated the
bacteria which they discovered in biopsies of patients suffering from ulcers, after which
Marshall ingested the bacteria to prove that they caused gastric ulcers.

As this example shows, it is not uncommon even in science to try and explain real-world
phenomena using variables that cannot be measured, like stress. Such attempts inevitably turn
out to be incorrect.

In economics the most common of such fairy variables is “inflation expectations”; the other
popular one is of course “rational expectations”. Thus, when inflation falls short of the
targeted rate for a long time it is ascribed to the central bank’s failure to calibrate inflation
expectations high enough. That the cause could lie elsewhere is never considered.
An analogy would not be out of place. If someone fails to hit the top of a tree with his gun
you get him to aim higher, at the top of a skyscraper. If he still cannot hit the top of the tree
you get him to aim at the moon. When he still cannot hit his target you are forced to veer
around to the conclusion that his failure is because his gun is not powerful enough. With
inflation during the past few decades in the US, this has indeed been the case. But
economists are reluctant to accept this explanation.

Consumer price inflation in the US after the Great Recession fell below the targeted 2% for
long periods. The reason was said to be “low inflation expectations.” But a more sensible
explanation is simply that consumers did not have sufficient money to spend.
It is sometimes useful to think of the economy as a firm. If the price of a key input A
accounting for 5% of its total costs goes up by 20% then the firm has to raise the price of its
output by 1% to earn the same profit as before. If the price of the input increases by 20% each
year for five years, while the prices of other inputs remain the same, then A will eventually
account for a higher proportion of the firm’s input costs, a little less than 12%.
In a previous post (What caused the stagflation of the 1970s? Answer: Monetarism) we
showed that most of the changes in inflation since the early 1970s were due to changes in the
price of oil, ignoring second-order effects. Oil accounts for a small proportion of total costs in
the US economy but oil prices change by large amounts; in 1974, for instance, oil prices rose
by an average of 170% each month year-on-year. Since then, oil prices have fallen which
mainly explains why energy costs as a proportion of GDP have fallen from 13.1% in 1980 to
5.7% in 2019.

But there is one other important input that has contributed to the fall in inflation and that is
wages and salaries. Economists are right to worry about wage costs because they account for
about 45% of GDP at current prices (55% if supplements to wages and salaries are included
but those consist of contributions to pension plans and are not immediately spent). Since
wages constitute the largest component of GDP a small increase of 5% in labour
compensation will result in a 2.25% increase in prices. If the increase persists over several
years then labour compensation will eventually account for a larger proportion of GDP. In
reality, the opposite has happened. Labour compensation as a proportion of GDP has fallen
from about 52% in 1969 to 45% in 2020 though it used to be even lower after the Great
Recession.

George 1

Thus, if inflation has consistently fallen short of the target it is not because of “low inflation
expectations” but due to lower labour compensation combined with an increase in the saving
rate following the large loss of net worth in the aftermath of the Great Recession. Also, the
distribution within the labour compensation basket is skewed towards the high end with a
lower propensity to consume.

Low inflation has been achieved by squeezing wages. If higher labour compensation results
in a little higher inflation it is a welcome price to pay.

  1. bruceolsen
    September 13, 2021 at 9:37 pm

    “Low inflation has been achieved by squeezing wages.”

    I’m sure this result was entirely unforeseen by mainstream economists.

  2. September 14, 2021 at 1:40 pm

    With positive interest rates, debts grow because of interest, hence there appears to be a need for central banks to manage the problem of usury, for instance by reducing the value of money.

  3. Ken Zimmerman
    September 16, 2021 at 1:56 am

    Frankly, I don’t care much about inflation debates and percentages except as they relate to Americans’ quality of life. If the value of money impedes access of the non-rich to food, shelter, transportation, clothing, a well paying job, or anything else needed for a comfortable and dignified life, then it needs to be fixed immediately.

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