Monday, April 23, 2012

Of Course Inflation Reduces Real Wages

Dean Baker denies the obvious negative link between inflation and real wages pn both theoretical and empirical grounds.

Starting with the theoretical case. Baker asserts that "most wages follow in step with inflation" though he concedes that some don't. Actually very few do, at least in the short term. Few if any, can go to their employer and get a raise on the ground that the gasoline and food they buy have become more expensive. It just doesn't work that way.

It is true that if in the medium- to long term inflation raises the nominal value added created by each worker then this will push up wages, but that doesn't always happen and even when it does there is generally a time lag between when workers face higher cost of living and when their pay gets increased.

Baker then correct asserts that creditors lose from higher inflation but then goes on to incorrectly conclude that this means that most workers in their role as debtors must win, something that isn't entirely accurate for reasons I explained here. The big winners from inflation instead tend to be the mostly very wealthy stock holders who benefit as inflation both raises corporate profits relative to wages and raises valuations.

As for the empirical case, Baker produces a chart which he claims disproves the link. Anyone who can see a link must have better eyesight than him, he writes, a comment obviously meant to be sarcastic.
And it is indeed a bit difficult to see anything, but that is Baker's fault for creating such a small chart for such a long period of time.But if you look closely, you can in fact see that usually (but not always of course as there are other factors involved) when inflation , represented by the the red line, increases significantly, real compensation of labor falls significantly and vice versa, the two great increases in inflation in the the mid-1970s and in 1979-80 being the clearest examples of this, but far from the only ones. For example in early to mid 2008 when inflation increased sharply, we saw a significant drop in real labor compensation followed by a dramatic increase in real hourly compensation in the second half of 2008 when there was a temporary period of price deflation. And when recently QE2 raised inflation from about 1% to about 3.5% we saw a shift from rising to falling real hourly labor compensation.

So the empirical record does in fact confirm that particularly in the short term, inflation has a negative effect on real wages.