You just can’t keep a bad idea down. The New York Times, reporting on Europe’s economic angst here and here, wallows in money illusion. Let’s survey the scene of the crime and speculate on the motives.
The way I teach it in introductory macro, there are two types of money illusion. In Type I you are aware of wage increases but not price increases; you think you have more purchasing power than you really do. In Type II you are aware of price increases but not wage increases; you think that if only prices would stop going up you would have more purchasing power than you do. Both are fallacies, since wages are prices, or to put it differently, the money you spend for the things you buy all ends up as someone’s income. It is a logical impossibility for Europeans as a whole to suffer loss of real income as a result of inflation. (And, just to provide context, recall that the rate of price increases over there is in the 3-4% range, not good but certainly sub-ferocious.)
So what are the real problems? The biggest one is income distribution, which is becoming more unequal across the continent as moderating institutions are eroded under the pressure of global competitiveness. This has the most immediate effect on workers who produce goods and services for export or which compete with imports, and it spills over into other labor markets as the wages of the most vulnerable workers slip backward. Firms are also adjusting their organizational strategies to the new world of global competition, relying progressively less on long-term relationships with employees shielded from market forces.
Another possibility, hinted at in these articles, is an adverse shift in the terms of trade, as oil and gas imports become more expensive relative to manufactured exports. Food is less clear, however, since Europe exports vigorously (and controversially) in agricultural products, which leads one to wonder where are the farmers, and those who sell to them, in these tales of Euro-woe.
By blaming the deterioration in living standards on the wrong culprit, these stories detract attention from the true causes. The ECB can crank its rates as high as it wants in order to snuff out inflation, but this won’t restore real income to the average European—quite the contrary, actually, since high rates will produce more unemployment while further elevating the already too-high euro. Wrong diagnosis, wrong treatment.
The question that comes to my mind is why this nonsense about inflation lowering real incomes still has traction after all these years. The disproof is no more complex than the old, familiar circular flow diagram. My suspicion is that it can be attributed to the fundamental political economy fact about inflation: that unanticipated increases in inflation reduce the wealth of net creditors, who map more or less perfectly on the rich as a whole. There will always be a need to find a reason to make inflation the scapegoat for whatever ails the general public, and simple logical error will not constitute a disqualification.
I was hoping you would point out that there are other forms of money illusion. It is frequently seen in environmental cost/benefit analyses, where it compares $x going to some person here, with $y dollars coming from some other person there. It forgets that the marginal utility of money is not constant.
ReplyDeleteThere is also the illusion that comes from ignoring relative price changes, for thinking for instance that you if you have enough money you can compensate for a shortage of food or water for instance. Sorry the price of necessities goes to infinity as they become short.
Am I understanding the point you are making regarding the culprit being disproportionate income distribution? During an inflationary period prices of goods tend to rise across the board with some goods out pacing others,ie gasoline and food grains for example. During that same period wage increases are inconsistent with some being non-existent, others being negative, while some very few increase. I take it that the increasing disparity of income distribution is the primary culprit in the loss of purchasing power of the many, with inflation increasing the severity of the loss. Is this correct?
ReplyDeleteSo, IOW. while falling aggregate real income can drive inflation, inflation as such cannot generate falling aggregate real income.
ReplyDeleteLike bloodletting to address a fever, leading to a much larger number of people with fevers dying, and therefore having a fever being such a serious thing that you have to do something, like bloodletting, to address the problem ...
... its the prescribed cure for inflation that causes the fall in aggregate real income.
While Peter's analysis makes perfect sense to me, so far I cannot get my head around Bruce's reply. Given non-inflationary times, full reproduction takes place because economy-wide costs and profits are resolved at the retail level by cost and profit income earners. A fall in aggregate real income means a lower level of reproduction than previously, IOW the market failed to clear; I cannot see this in any way driving inflation. Only when higher prices, due to raised interest costs, are yet resolved because the receivers of interest income increase their purchase of retail output, does inflation _not_ generate a fall in aggregate real income. Fat chance of that happening. And so I yet fully agree that in general, The NC prescribed cure for inflation causes a fall in aggregate real income.
ReplyDeleteIn addition to that, it could be said to be the cause of asset inflation; such spending being the only other existing outlet for interest income earners.
A fall in aggregate real income means a lower level of reproduction than previously, IOW the market failed to clear; I cannot see this in any way driving inflation.
ReplyDeleteDeclining terms of trade are most often realized as imported inflation. Consider, for example, the experiences of Indonesia and Thailand in the Asian financial crisis.
As far as the idea that there is a mechanical relationship:
Given non-inflationary times, full reproduction takes place because economy-wide costs and profits are resolved at the retail level by cost and profit income earners.
... the economy is at an equilibrium of effective demand because total effective demand is at the level where leakages from the income expenditure loop are equal to expenditures financed from outside the income-expenditure loop. Whether that is a level of full reproduction is interesting for the long term evolution of the economic system, but it has no causal impact on the level of current level of economic activity.
Declining terms of trade are most often realized as imported inflation. Consider, for example, the experiences of Indonesia and Thailand in the Asian financial crisis.
ReplyDeleteBringing in FX to explain sticky economic problems is one of the oldest tactics in the book. Ricardo already got away with it in his polemics with Sismondi... but did it make him right? I put my faith in Occam's Razor.
... the economy is at an equilibrium of effective demand because total effective demand is at the level where leakages from the income expenditure loop are equal to expenditures financed from outside the income-expenditure loop.
The problem with this Keynesian model as I see it, is that it doesn't depict an equilibrium, or at least is woefully incomplete; for where is does the finances repayment schedule fit into the whole? Such leakages are expressed in asset inflation and repayments ultimately have to come from within the income-expenditure loop, don't you agree?
Whether that is a level of full reproduction is interesting for the long term evolution of the economic system, but it has no causal impact on the level of current level of economic activity.
Producers reproduce at minimally the previous level when they find that their markets are clearing. Calling this mechanistic, since they are clueless as to what determinants are involved, is a fair enough assessment; but I don't see it as taking anything away from its causality.
Am I to understand you that oil-price driven inflation increases wages? It is my understanding that oil price inflation benefits oil producing governments, and oil and gas companies, who are not even inceasing production, hiring more employees, or granting wage increases. Am I missing something here?
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