Why do people care so much about inflation?

Economists are fond of asking this question. Why do people care so much about inflation? Nick Rowe does it here, Noah Smith does it here. From Nick Rowe:

A lot of non-economists believe the inflation fallacy. I’m an expert on what non-economists think about economics. That’s because I have spent the last 30 years trying to teach non-economists how to think about economics.

Sometime in February, I will ask my ECON1000 students: “So, why is inflation a bad thing?”

I can anticipate the look on their faces. Some will give me that look of sympathy, normally reserved for those who aren’t too bright. Others will look like they know this must be a trick question, since I wouldn’t ask anything that were really quite so obvious. Finally one will answer.

“Because if all prices rise 10% we will only be able to afford to buy 10% less stuff. Duh!” Except the “Duh!” is silent.

That’s the inflation fallacy.

Why is the inflation fallacy a fallacy?

Apples bought must equal apples sold. What is an expenditure to the buyer of apples is a source of income to the seller of apples. Every $1 rise in the price of an apple means the buyer is $1 poorer and the seller is $1 richer.

But there’s a problem with Rowe’s argument; in fact, it’s a problem that crops up again and again in economics: wilful obtuseness on matters of politics. Economists want so much to be an a-political ‘scientific’ discipline that they’d rather sit around being smart-arses and saying stuff like: “if all prices double, and all wages double, that would have no effect on the quantity of labour demanded,” than actually addressing what actually concerns people about inflation.

When people say they are “worried about inflation” what they actually mean is that they are “worried that their real wage will be eroded because commodity prices rise faster than their wages.” Inflation is a worry because it represents one (very effective) way of bosses reducing workers’ wages and increasing profits without the workers being in a position to do anything about it.

If unemployment is high and unions are weak – as is currently the case in the UK – then workers are not in a position to demand rises in their real wage, so commodity inflation represents a threat. 

Now, as Smith argues, there are good reasons to think that the ‘best’ situation is one of moderate, positive inflation; but that necessary upward price adjustment cannot occur simultaneously across all sectors of the economy. Someone has to move first. So the question arises: who shall bear the short term burden of differential price rises, workers or firms?

There has been a great deal of opposition to fiscal stimulus because it is claimed that fiscal stimulus will lead to inflation. This is obviously wrong in the present situation of high-unemployment, because if there is excess capacity in the economy (and what is unemployment but excess capacity?) then using some of that extra capacity will not necessarily result in inflation.

But warnings of inflation are a very effective tool for cowing the masses into doing what the ruling class wants. The ruling class want weak trade unions, low inflation, and a high profit share out of total income. The masses ought to want a high wage share out of total income, strong trade unions, and moderate inflation. Insofar as a trade-off exists between unemployment and inflation the masses ought to prefer a situation of full employment and moderate inflation, over a situation of high unemployment and low inflation.

But there are many cognitive biases that exist to prevent the masses from expressing a rational preference. Although people fear unemployment, even in the worst economic situation, the majority of people remain employed. Unemployment is awful for the people experiencing it, but those people are only ever one small fraction of the total working population. But inflation is experienced by everyone in the working population.

The salience effect leads people to overweight the importance of things that are in front of them. People spend more time shopping and looking at rising commodity prices (especially of big-ticket items like petrol) than they do looking at unemployment figures. The just world fallacy and fundamental attribution error leads people to blame individual unemployed people for being unemployed, rather than blame the impersonal economic forces that are actually its cause. As George Orwell writes in The Road to Wigan Pier, this can even lead people to blame themselves:

When a quarter of a million miners are unemployed, it is part of the order of things that Alf Smith, a miner living in the back streets of Newcastle, should be out of work. Alf Smith is merely one of the quarter million, a statistical unit. But no human being finds it easy to regard himself as a statistical unit. So long as Bert Jones across the street is still at work, Alf Smith is bound to feel himself dishonoured and a failure.

On the other hand, if the supermarket jacks up the price of petrol, I – and many others – are far more likely to demand that Something Must Be Done; and we are more likely to be listened to, because petrol prices affect more people, and their impact is more immediate and obvious than that of unemployment.

In summary: anti-inflation policy is a wedge issue that enables the rich to persuade the poor to vote against their own interests. I have no idea what to do about this.

Some distinct arguments in favour of free markets

What follows is a list of arguments in favour of free markets. I have made no attempt to critically analyse each argument, as my intention is merely to present and label various arguments so that I can refer to them at a later date.

It should be noted that many arguments in favour of free markets present markets in opposition to some alternative, usually something called ‘central planning’.  This opposition strikes me as a false dichotomy, as it is entirely possible to imagine a system that incorporates some elements of central planning with some elements of markets. In fact, we don’t have to imagine such a system because we actually live in one; the real world of economic activity is characterised by an intermingling of central planning (e.g. within firms and governments) and market systems (e.g. between firms, households, and sole traders).

Anyway, without further rambling, I present the arguments…

Markets as disciplined pluralism

In The Truth About Markets John Kay argues that what makes markets really useful is that they allow for what he calls ‘disciplined pluralism.’ Markets are pluralistic because they allow people to ‘propose’ different projects, usually in the form of business ventures. Markets are disciplined because if these business ventures provide goods or services that are not in demand then the business will fail, and the resources used by that business will be allocated elsewhere.

Kay distinguishes the disciplined pluralism of the markets with the lack of discipline and pluralism one often finds in government-controlled enterprises. Because governments wield a monopoly on the legitimate use of violence, government-supported projects can survive long after they have been shown to be inadequate or wasteful. Kay illustrates this point with examples like Concorde and the British AGR nuclear power stations. Both of these ‘white elephant’ projects cost billions of pounds and survived long after a private company would have gone bankrupt.

Furthermore, Kay argues, governments tend not to be pluralistic; they encourage industries to speak in ‘one voice’, or simply ignore alternative viewpoints altogether, with the result that potentially good ideas are not given a fair hearing.

Disciplined pluralism means markets act as filters, allowing good ideas to pass through and spread, whilst suppressing bad ones. This pro-market argument explains how markets provide for dynamic efficiency in the form of innovation, invention, and technological progress. Good innovations are rewarded with increasing market share, and bad innovations are allowed to fail.

Markets as aggregators of tacit knowledge

‘Tacit knowledge’ or ‘tacit knowing’ is a theory introduced by the polymath Michael Polanyi. It denotes the idea that a great deal of our day-to-day knowledge is deeply personal, intuitive, and cannot be reduced to a set of written or spoken propositions. Friedrich Hayek applied this concept to economics, and argued that much economic activity relied on this kind of in-expressible knowledge; and for so no central planner could ever hope to co-ordinate economic activity, because the central planner could not express the commands necessary to instruct people to do what they needed to do.

Markets provide a solution to this problem. Individuals no longer have to communicate explicit instructions for everything every other individual has to do. Instead, individuals use the price mechanism of the markets to transmit information between themselves.

Markets as systems of co-operation

In The Market System Charles Lindblom characterises the market system as a tool that enables co-operation. This notion has something in common with the idea that markets aggregate tacit knowledge. I discussed Lindblom and his book in more detail in this post.

I suspect that this argument in favour of the market system can be collapsed into one of the other arguments, possibly the tact-knowledge aggregation argument or the decentralised optimisation argument.

In fact, this isn’t so much an argument in favour of markets as a description of what markets are for, without necessarily demonstrating that markets are superior to alternative means of co-operation. Lindblom is very clear that markets have both positive and negative characteristics.

Markets as decentralised optimisation systems

It is possible to show that, under certain highly restrictive conditions, market systems can achieve something called ‘static efficiency’, whereby scarce resources are, in some sense, allocated in an optimal fashion. The most complete expression of this view is to be found in Gerard Debreu’s Theory of Value.

I have yet to read Theory of Value, but I am reliably informed that it contains some elegant and beautiful mathematics; however it is not clear that the theories that Debreu presents has and relevance to the actually-existing economic world. Indeed, it seems that Debreu himself was at pains to point out that his theory had no real-world implications. In fact, it could be said that Theory of Value constitutes a negative result, essentially demonstrating that the conditions required for markets to achieve optimal results are so restrictive that they will never be met in practice.

Markets as revelation of democratic preference

I am vaguely aware that certain people argue that markets are tools for revealing the collective ‘will’ of diverse groups of people. Without wishing to burden this notion with more credence than it can support, I shall include this in the list, if only to ease future referral.