Tuesday, October 20, 2009

The Other Side Of The Real Wage Argument For Inflation

One of the few valid arguments for inflation is that if nominal wages are rigid downwards, or in other words cannot be lowered, then inflation can help bring about the needed real wage adjustment, something which will help create (or prevent the destruction of)jobs and therefore also help boost output. (Strangely though many of the economists that advances this argument contradicts themselves by saying in other contexts that wage cuts will not increase employment)

The most common counter-argument to that has been that workers, or unions or minimum wage setting governments won't be fooled by this and will demand higher nominal wages to compensate for inflation. This counter-argument is indeed to some extent true, as wage demands will indeed be higher if workers, unions and governments expects price inflation than if they expect price stability or deflation. This will limit the employment increasing effects of inflation.

However, because of the phenomena known as money illusion, nominal wage increases will likely not be fully as high as inflation.

Money illusion arises because people have difficulty linking their pay to general increases in prices. Their particular consumption portfolio might increase less or more than the consumer price index, making it difficult to link to monetary policy, as opposed to specific factors that might affect certain prices. Fuel price increases could be blamed on "speculators", "greedy oil companies" or whatever, food price increase could be blamed on bad weather and so on. But while non-monetary factors indeed affect the movements of specific prices, and even the consumer price index, the specific factors increasing the prices of some goods are usually cancelled out by specific factors decreasing the prices of other goods.

The point is that because of the difficulty in understanding the issue workers will have difficulty in demand compensation.

Moreover, some people fells psychologically better of with a 2% nominal wage increase combined with 2% inflation than a frozen nominal wage combined with 0.5% deflation, even though the rational choice is clearly the latter.

And so the conclusion is that inflation can in fact do some good by lowering the excessive real wages of some.

However, what is forgotten is that while this positive effect exists, inflation is associated with many negative side effects. That includes the fact that the same mechanism can make real wages too low.

Workers could perhaps because of money illusion be content with a 5% wage increase even though they could have negotiated a 6% increase.

It is not a law of economics that real wages should be as low as possible. They could be too high as well as too low. What damage do too low real wages create then?

Well, clearly the effect will first of all be redistribution from workers to corporations and their owners. That is of course something which many, particularly with a socialist leaning will find ethically wrong in itself. But from an economic point of view the main problem is instead that it will fuel malinvestments. While bubbles and inflationary booms are usually associated with too high P/E ratios for stocks, the problem is also that the boom makes the "E" (corporate earnings) in the P/E ratio artificially and unsustainably high, something which also helps contribute to make the "P" (stock prices) too high, and which helps fuel malinvestments. Eventually, when malinvestments becomes too great and/or the central bank has to contain its inflation, real wages rises back to normal levels, exposing the bubble.

In short, why there is no point in trying to deny that inflation can reduce excessive real wages, real wage manipulation could also create problems by making real wages too low.