Sunday, March 27, 2011

Not Inflation

I’m sick of hearing people complain about inflation. Unless your income comes from long-duration fixed-income investments, inflation has nothing to do with how much groceries and gasoline you can afford. Inflation is a pattern of increase in the general price level. What matters for affording stuff is a relative price, not the general price level. Specifically in this case it is the price of groceries and gasoline relative to the price of labor. And whether or not you like to eat iPads, the broader problem (for people with jobs) is not that the nominal price of groceries and gasoline is going up but that the real price of labor is going down.

In fact, when measured in terms of how much that labor can produce, even the nominal price of labor is going down, as illustrated by the last part of this chart from the Bureau of Labor Statistics:

Look at the last two years compared to the rest of the chart. As someone who thinks people are more important than gasoline, I’d say this looks a heck of a lot more like deflation than inflation.

And people are more important than gasoline – not just in the ethical sense implied by my snide suggestion, but in a cold, economic sense: labor is more important than energy as an input to the goods and services that get produced. Therefore if the price of labor is falling while the price of energy is rising, the pressure on the prices of goods and services is likely to be downward rather than upward.

Not that I’m expecting the prices of goods and services to start moving dramatically downward in the immediate future. After all, the price of energy has been rising faster than the price of labor has been falling. And the value of the dollar has been falling, while many of the goods Americans consume are produced abroad. And the price of labor is not necessarily going to continue falling. I will say, though, that I think the price of labor provides a strong anchor for the general price level: just as the gold standard provided assurances against runaway inflation, so the “labor standard” provides such assurances. In fact, the labor standard provides better assurances, because labor is the most important input into the production of many useful things, whereas gold is – well, just gold.

(You might object that we really aren’t on a labor standard, because unit labor costs could start rising at any time, and there is no guarantee that policymakers would resist such increases. All I can say is, if you think the gold standard provides a guarantee against changes in the whims of policymakers, you need to read about what happened in 1933 and 1971.)

I’m going to go further and say that I think the falling real price of labor is a good thing, at least in the short run. I’ll even say that rising food and energy prices, while not good in themselves, are symptomatic of something good that is happening and that I would like to see accelerate rather than decelerate.

The flip side of falling real wages is rising profit margins. In a simplified closed economy this would be trivially true: the profit margin for businesses in aggregate would be the difference between the prices they charge and the wages they pay, i.e., the inverse of the real wage. It’s also true to a lesser extent in the real world, although the situation is more complicated because there are imports and exports, and labor and capital are not the only inputs.

What we experienced in 2008 and 2009 can be seen as a dramatic decline in the willingness of aggregate business to produce more for any given level of the aggregate profit margin. (Obviously, the phrase “aggregate business” hides a lot of critical details: part of the problem was with banks’ willingness to lend; part was with hoarding of cash by large corporations; part was with investors’ preferences over public vs. private sector assets; and so on.) What we need to do to fix this problem (and what we are doing, to some extent) is to make profit margins so high that businesses are willing to expand despite their newfound conservatism.

And it should be noted that there is a continuum of price flexibility. At one end, wages are perhaps the least flexible; at the other end, commodity prices are the most flexible. But there is a whole range in-between. When demand picks up, commodity prices rise first, product prices rise more sluggishly (with varying degrees of sluggishness), and wages rise most sluggishly. If the objective is to raise profit margins, then product prices have to rise more quickly than wages, and an inevitable side effect is that commodity prices will rise even faster than product prices. To the (limited) extent that rising commodity prices represent domestic US demand, they are a sign of a process that needs to be encouraged, not discouraged.

In the intermediate run, the evidence is clear that real wages are procyclial. When a recovery really gets going, real wages eventually rise, presumably because the economy as a whole becomes more efficient and “a rising tide lifts all boats.” In the short run, though, we need to get the recovery going before this can happen, and the way to get the recovery going is to let real wages fall – or at least rise more slowly than productivity. Say what you like, I’m cheering for rising prices.

DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.


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