Inflation Too Debt Burdens

Nathan Tankus latterly published an article entitled "No, Inflation Doesn’t Erode the Burden of Debts" (h/t Tom Hickey at Mike Norman Economics). Nathan correctly diagnoses that mainstream economists (he cites Paul Krugman) routinely bound betwixt the concepts of "inflation" in addition to "CPI inflation" (Consumer Price Index), in addition to that a ascent inwards the floor of the CPI does non aid out borrowers. What matters is wage inflation. I receive got made the same electrical load myself. However, the mainstream logic is non just incorrect, it is just based on an embedded supposition close the long term. This seems to last done for reasons of politics, or to a greater extent than accurately, attempting to enshroud politics from economics.

Nathan Tankus writes:

The source of the confusion hither is that it is pop exercise separate key economical variables past times abstract measures of the prices across the economic scheme (such every bit the Consumer Price Index). This makes feel sometimes but inwards other situations larn nonsensical. Debt is ane such example. In the U.S.A. most people receive got debts denominated inwards U.S.A. Dollars. Influenza A virus subtype H5N1 useful proxy for the burden of debt is the ratio betwixt an individual’s or sector’s nominal debt to its nominal income.
The burden of this debt falls when they tin refinance at a lower nominal involvement rate, their nominal income rises or they default. 

In other words, a identify is non helped inwards paying its mortgage if the toll it pays for groceries rises. But it volition last easier to brand mortgage payments if the household's wage increases. (For governments, taxes are levied on nominal activity, in addition to thus authorities revenue volition typically ascent fifty-fifty if just consumer prices rise. For authorities finance, what commonly matters is nominal gross domestic product growth, which is enhanced past times a rising gross domestic product deflator.)

He also predicts the reply that I give.

Some volition object that Krugman in addition to many others are just using increases inwards the toll floor every bit a proxy for increasing nominal income. The employment amongst this is that they never connect their arguments close inflation to income levels. 

Yes, economists who debate that "inflation" reduces the burden of debt are using consumer toll inflation every bit a proxy for "generalised inflation" (which I depict below). This is technically incorrect. But every bit the nautical chart below shows, there's a fairly potent correlation betwixt CPI inflation in addition to wage inflation, for real skillful reasons. Influenza A virus subtype H5N1 deviation betwixt the ii has implications for the wage in addition to net turn a profit shares of national income.

Why exercise many economists interchange "generalised inflation" in addition to consumer toll inflation? My guess is that they receive got inherited this quirk from fundamental banks. Central bankers exercise non want to say that they exercise non desire reward to rise, rather they focus on the politically pop handle against rising consumer prices. Since fundamental banks drive the enquiry agenda inwards macroeconomics, their political obsessions are picked upward past times academic economists. (Additionally, many mainstream economists would debate that the ii measures cannot diverge, since prices in addition to reward are linked past times marginal productivity. This gives a theoretical solid soil for treating the ii concepts every bit existence interchangeable. As some shape of post-Keynesian, I query such marginal analysis.)

UPDATE: Nick Edmonds commented:

Any declaration inwards economic science that X causes Y carries an implicit ceteris paribus assumption. The query in addition to thus is what just are nosotros assuming is constant. In this case, are nosotros assuming nominal reward or existent reward are unchanged? I recollect most economists would accept it every bit read, when talking close inflation (even CPI inflation) that it is existent reward that nosotros are assuming are constant. Tankus plainly reads it the other way.

This is likely the best explanation of why this shorthand is used. I did non recollect of it when I wrote this article, since I (like Tankus) would non assume that existent reward are constant when the floor of consumer prices changes. Wages are mostly non indexed whatsoever more, in addition to thus nominal reward no longer follow movements inwards the CPI.

In summary, Nathan Tankus is right that mainstream economists are sloppy when they interchange "consumer toll inflation" in addition to "generalised inflation." That said, this shorthand is broadly right inwards the medium term. Although I am critical of mainstream economics, I consider piddling value inwards quibbling over a indicate inwards which I basically concur with. The residuum of the article gives an explanation of why the ii notions of inflation are linked.

Wage Inflation Vs. Consumer Price Inflation Vs. Generalised Inflation

In lodge to explicate the concept of "generalised inflation," I volition revert to discussing a highly simplified ii sector economic scheme -- ane amongst just a concern sector in addition to the identify sector -- which is farther subdivided into workers in addition to theater owners. (If you lot want to avoid degree conflict overtones, experience costless to pretend that the workers in addition to theater owners are the same households.)

Firstly, nosotros assume the economic scheme is inwards a steady state. There are xc workers, in addition to they hit 100 units of goods every day. The daily wage is $1, in addition to the units of goods are sold for $1. The total wage nib is $90, in addition to nosotros assume that workers pass all of their income. This agency that they purchase xc units of goods. The remaining 10 units are purchased past times theater owners. The total revenue for the concern sector is $100, which agency that profits are $10. This $10 dollar net turn a profit is paid out to capitalists, which allows them to finance their purchases.

What happens if prices changes (if nosotros assume the economic scheme enters a novel steady state)? I await at 3 generic cases.

• Consumer Price Inflation.  If the toll per unit of measurement goes to $1.10 (10% consumer toll inflation), the workers volition exclusively last able to purchase 81.8 units (roughly) of the 100 units produced. However, if the theater owners footstep upward their purchases to 18.2 units (which costs $20), the total 100 units are sold. The theater volition receive got total profits of $20, which allows it to pay a dividend that allows concern owners to finance their purchases. All that has happened is that in that place has been a shift inwards the distribution of output towards concern owners.
• Wage inflation. If reward ascent past times 10% to $1.10, but skillful prices are fixed at $1, the total wage nib would last $99. Workers would purchase 99 units of production, in addition to concern owners would exclusively last left amongst a $1 dividend, allowing them to purchase 1 unit. In this case, the income part has shifted towards labour.
• Generalised Inflation. If both reward in addition to goods prices ascent past times 10%, all that happens is that all dollar amounts inwards the master copy instance are multiplied past times 1.1, piece the distribution of units (which is a existent quantity) is unchanged. (In other words, workers purchase xc units for $99, in addition to the capitalists purchase 10 units for $11.) Any nominal debts would last effectively shrunk relative to the rising toll level.

In other words, the differential betwixt consumer toll in addition to wage inflation just tells us close the distribution of incomes inside the economy. Since mainstream macro is highly allergic to the concept of income distributions for political reasons, this is obscured inwards conventional textbook descriptions of the inflation process.

Complications similar unusual merchandise exclusively slightly modifies the picture. For example, rising import prices just agency that existent incomes for unusual entities (mainly multinational corporations) is increasing at the expense of domestic existent incomes.

If nosotros firstly looking at real-world information instead of simplified models, nosotros take away to firstly adjusting the logic for worker productivity. If the amount of output per worker rises over time, reward would take away to ascent past times that amount inwards lodge to maintain the net turn a profit part of income stable. For example, this would permit the consumer toll floor to last constant piece reward rise.

The ascent inwards the net turn a profit part of national income over recent decades demonstrates that wage in addition to consumer prices tin diverge. But in that place are limits to the process.

• If reward ascent likewise much relative to consumer prices, profits fall, in addition to the corporate managements volition exercise their best to right the province of affairs past times widespread firing of workers. In whatsoever event, net turn a profit margins are typically non that large every bit a per centum of total revenue, thus in that place is express room for this procedure to run earlier businesses meet insolvency problems.
• If consumer prices ascent faster than wages, the increased profits are mostly non plowed dorsum into spending on goods in addition to services. For example, if dividends (or stock buybacks) are increased, the high income households that are the recipients of the increased nominal income volition non pass 100% of the increase. If the rising prices are going to unusual producers, the increased proceeds are typically invested into unusual currency reserves. This creates a revenue shortfall for the concern sector; inwards my simplified model, non all production would last sold. The increment inwards inventories would eventually Pb to a recession. (Broadly speaking, this is what is happening inwards existent globe economies inwards reply to the increasing net turn a profit part of national income.) 

In summary, it is technically wrong that consumer toll inflation translates just into generalised inflation. But at the same time, the ii measures are going to last relatively approximately each other inwards the medium term, thus people tin larn away amongst blurring the ii concepts.

See Also:

• Low Inflation, High Profits. The trends inwards inflation in addition to the net turn a profit part over recent decades.
• DSGE Models: Without Capitalists, You Cannot Model Capitalism. Discussion of why income distribution needs to last taken into concern human relationship when edifice economical models.

(c) Brian Romanchuk 2015