It is fashionable these days to reminisce about the days when a penny could buy a fancy candy. I have no recollection of such times and I strongly suspect they are but a myth, especially when the not so old retell a story that should only be in the vague memory of the dead. I cannot help but roll my eyes whenever a conversation which touches on once-upon-a-time-a-penny-could-buy-a-fancy-candy slowly turns into a lament against inflation. Talk of inflation in the public sphere almost always takes a pessimistic tone but the inflation that we suffer is really misunderstood possibly due the lag that exists while wages and prices chase each other.
It is typical for many modern economies to see a rise in the general level of prices over time since the 1970s. There were some cases of deflation but we mostly live in an inflationary world. In Malaysia where inflation has been around for the longest time, many in the public complain about how inflation reduces individual purchasing power.
What many do not realize is that the general rise of price levels is as much as about the general rise of wage levels. As both factors try to catch up with each other, inflation really matters little in the long run.
Due to this, it really does not matter if a penny could buy a fancy candy in a time long forgotten but not now. We can still afford to consume that candy anyway. In fact, it is very likely that with all the real improvements we have seen in our standards of living, we can afford to buy more candies than we ever could when candy was priced at only a penny.
But however many candies we can afford nowadays, what makes inflation hurt in the short run is the lag between price increases and upward adjustments to wages. This lag is usually associated with a phenomenon known as price stickiness: individuals and entities take time to change prices. Sometimes, the act of changing prices itself incurs cost and further forces prices and wages to be inflexible.
For instance, one transportation company that I am familiar with took two weeks to revise its prices upwards after the June 5 price hike. Why two weeks? Internal approvals, negotiations with customers, costing modeling, simulation, etc. The company was adversely affected by the lag but after that, higher fuel expenditure is met with higher service prices while the service level remains the same.
This is the actual meaning of inflation. It is not about erosion of a person’s real purchasing power per se but rather, it is about erosion of purchasing power of a unit of a currency.
It is important to note that the phenomenon does not exclusively happen to businesses. Individuals too undergo the same path. In the long run, the wages and prices tend to approximately equalize each other. And just like what happened to the transportation company, it is the lag of wages vis-Ã -vis prices that hurts individuals. Inflation adversely affect real wages by depressing temporarily, until nominal wages catch up with higher level of nominal prices.
So, how do we reduce the pain?
There are a number of things but my favorite revolves around management of expectation.
The idea is that if individuals or entities successfully anticipate a rise in prices, wages would quickly match the other. That would come close to eliminating any lag that might exist otherwise.
To do that, wages have to be defined in real terms, i.e. having wages adjusted to inflation. In employment contracts especially, an escalator clause is a must if preservation of real wages is a goal. At the moment, too many people out there have their wages defined in nominal terms, i.e. unadjusted to inflation. For businesses, well, they could just increase their prices and pay their own wages.
If we manage to considerably eliminate this lag, then perhaps it would finally dawn on many that inflation really does not matter as much as many make it out to. More importantly, the story of a penny candy would finally be buried and forgotten.
A version of this article was first published in The Malaysian Insider.
8 replies on “[1732] Of inflation is not really that bad, if there is no lag”
Re: specie-fiat currency, I don’t personally think fiat currency is at all bad or worse than specie-currency. The issue with fiat is when the currency is centrally controlled. It is possible to have individually or non-state entity to issue currency. Case in point: Scotland. Banks (not central bank) issue their own currency.
On the other hand, the biggest problem with specie-currency is that is linked to deflation. Money supply wouldn’t readily catch-up with the economy and threatens the neutrality of money. At least with fiat currency, the neutrality of money is easier to achieve.
More importantly, fiat currency is credit-based, allows deficit spending and provides greater flexibility. This ensures liquidity which specie currency typically unable to provide.
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Maybe I made it unclear but the adjustment was done by the market, not by the state. Wages/prices adjustment is typical in a free market.
Central banking predates the Keynesian doctrine, true – but it has always been part of the Keynesian dream to have a one-world fiat currency (or at least a regime of fixed exchange rates of various national currencies) issued by a one-world central bank. Economic world government, in short – so you’d find a good part of libertarians (e.g. Ron Paul) who want central banking to be abolished, even if on libertarian grounds alone.
Youtube has some videos of Ron Paul in Congress, some of which he briefly talks about the Austrian POV on business cycles and inflation.
Personally, I’d like to think of Friedman as a compromised Austrian – ‘compromised’ by accepting/resigning to the existence of central banking, and thus came up with his monetarist theories and wrote about what should be done if central banks were to exist.
Of course, this is a romanticized view of Friedman which I hold to (and is probably wrong). For the record, his enthusiasm for the gold standard took a U-turn in later years, but he had the good judgment to realize that issuing more paper money is bad for real economic growth in the long-run.
Austrians e.g. Mises, Rothbard, Hayek are usually reluctant to compromise (which probably explains why they never had good academic positions), and Friedman definitely had far greater influence on both government policy and public debate (re: deregulation, free market etc). Friedman reserved much respect for the Austrian school, and later in life apparently revered Mises as “the greatest economist who ever lived” – so perhaps there’s some common ground between the Chicago and Austrian school even if the methodologies are entirely different. My opinion is that the Austrian school provides a more comprehensive worldview and makes the most economic sense (so far).
Central banking is a tenet of Keynesianism? Neo-Keynesianism maybe, but I believe it was the libertarian Milton Friedman who started the monetarist school.
Article on the purported links between Austrian Economics and Classical Liberalism:
http://mises.org/journals/aen/Aen_sp96.asp
> Aren’t wages adjustment vs inflation against the
> spirit of liberalism?
In fact, the true libertarians want to do away with central banking altogether and reinstitute a sound, ‘hard’ monetary system. You cannot have full economic freedom and a truly free society if the power to control and direct monetary inflation is invested in a few undemocratically elected Keynesian masters. They make claims to ‘omniscence’ (something which all central planners do), but as we all know Keynesians are idiots.
The way central banks currently operate (e.g. controlling interest rates, focusing on CPI, ‘open market’ operations, determining the amount of ‘credit’ available, injecting ‘liquidity’) is actually CENTRAL PLANNING if you think about it.
Some economists, e.g. those belonging to the Austrian school, distinguish between fluctuations in the prices of goods due to supply-and-demand (which is indicative of a healthy market economy), and price increases due to monetary inflation. So they DEFINE inflation purely as the direct result of the inflation of the money supply. The erosion of the purchasing power of the local currency is but a corollary seen from this perspective.
Inflation of the money supply, as Hafiz suggested, is not a problem if it is evenly distributed according to the amount of money that people hold (in which case, why inflate the money supply at all). However, this new money is NEVER distributed in such a manner (nor can this ever be the net result even if the money is allowed to be circulated thoroughly through the system), but is concentrated in the hands of government, banks and those closely connected to it. This is just the old Keynesian smoke-and-mirrors trick.
Wages are always the last thing to increase, and since these revisions occur usually on an annual basis – and when that happens who knows how many times the government has already further inflated the supply of currency. If you’re lucky the lag (for wages to increase to keep up with inflation) is only several years. So you lose in purchasing power re: wages – but a far more insidious consequence is that your SAVINGS erode in value.
Inflation is a TAX. Unlike ordinary taxes however, the same amount of money can be TAXED an INFINITE number of times – against your volition.
Does this make central banks the biggest taxing agents? Heh.
The best way to reduce the pain is to stop the banking system and reserve banks from inflating the money supply. And people should stop throwing stones at the ‘speculators’, ‘capitalism’, ‘free markets’, ‘foreign coutries’ when the problem was fundamentally wrought by central bank mismanagement.
Aren’t wages adjustment vs inflation against the spirit of liberalism?