Streetwise Professor

July 1, 2022

Get Ready: A Baleful Consequence of Inflation You’ve Heard Too Little About

Filed under: Commodities,Derivatives,Economics — cpirrong @ 6:37 pm

Going away the most entertaining–and in some ways educational–experience of my graduate school days was when the great Sherwin Rosen was lecturing to the 0830 Econ 301 Price Theory course at Chicago the last time that inflation was about where it is now. Sherwin was talking about how relative prices are what really matters, and then startled a somewhat dozy class by slamming his fist into his palm and shouting: “And that’s the problem with inflation! It FUCKS UP relative prices.”

Sherwin Rosen

Since we are entering a new inflationary age, you should pay heed to Sherwin’s wisdom.

The argument, in a nutshell, is that due to transactions costs (interpreted broadly) not all goods and services are traded in auction markets or auction-like markets in which prices respond immediately to shocks, including nominal shocks. Prices (including wages/salaries) are set by contracts, including implicit/informal ones. Different contracts have different degrees of flexibility. Prices (and other terms) in some respond quickly, others not so much.

So when there is a substantial nominal shock (e.g., a surge in the money supply) which in a frictionless, classical world would not affect relative prices, some prices adjust more rapidly than others. This leads to changes in relative prices that are artifacts of the nominal shock, and which distort resource allocation.

Cantillon wrote about this issue in the 18th century, and it is also a component of Austrian business cycle theory. (Interestingly, unlike most at Chicago, Sherwin treated Austrian theory sympathetically. I imagine that his emphatic statement in class so many years ago can be traced to Austrian economics in some way.)

Some practical implications.

First, I expect to see a substantial surge in labor disputes as real wages (i.e., the relative price of labor) fall when some more flexible prices rise and nominal wages don’t. We are already seeing some indications of that (keep an eye on potential strikes at US ports and railroads).

Second, arguing along Coasean lines, I expect that since inflation makes it costlier to rely on the price system, there will be a substitution towards non-price methods of resource allocation, including vertical integration (in lieu of long term contracts where misalignment of prices leads to costly disputes between the parties), and the rationing mechanisms that Dennis Carlton (another former thesis committee member of yours truly) wrote about in the JLE in 1991. (There might be some shifts in the other direction too. Goods that are somewhat commoditized but are currently exchanged under formal or informal contracts with relatively inflexible prices might be amenable to being traded on auction- or auction-like platforms with more flexible prices.) (Dennis wrote many interesting things about allocation mechanisms, price rigidity, and so in in the late-80s early-90s.)

Third, contracts will become shorter in duration, and incorporate various indexing clauses (which mitigate, but do not eliminate, relative price distortions).

Fourth, inflation and the associated relative price volatility can be a boon for futures/derivatives markets. It is not a coincidence, comrades, that a major burst of growth in derivatives markets (both in size and scope) occurred at the time of the last major inflationary period.

This list is not exhaustive by any means. It’s just some things that immediately come to mind.

Any adjustment in contracting practices, or increased cost of using contractual practices that work well when relative prices are not subject to inflation-driven variation, is a real cost of inflation. Misallocations of resources that result when nominal shocks distort relative prices are also a real cost of inflation. Inflation will drive more conflict, more battles over rents, more contract disputes, and on and on and on.

As Sherwin forcefully expressed, inflation is anything but economically benign, something that microeconomists (like Sherwin) are sensitive too, but which macroeconomists too often ignore. (Back in the day, macro types thought that the only real cost of inflation was “shoe leather cost” due to people having to walk to the bank more often.)

I tweeted about this some weeks ago. In the interim, I’ve only seen one article discuss it: this one based on an interview with Ross McKitrick. Definitely worth a read, to get you prepared for what’s coming.

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  1. SWP:

    Made my week to see a post from you prior to a long weekend.

    VP O/

    Comment by Vlad — July 1, 2022 @ 7:14 pm

  2. Well, gold clauses are enforceable again, even ones that had lain dormant after 1933.

    I had to chuckle at the penultimate paragraph, where the opinion notes how the tenant cries victim for a huge jump in rent, but also was expecting to pay below-market rent due to dollar figures not adjusted for inflation since 1912, for a lease renewable into the 22nd century!

    Comment by M. Rad. — July 1, 2022 @ 10:40 pm

  3. We all know the inflation is manufactured. What happens if the political wind changes? Is the inflation locked in? Or does recovery of sane policy restore order to the economy?

    Comment by Pat Frank — July 1, 2022 @ 11:36 pm

  4. Minor theoretical point:
    Cantillon was not about sticky prices, but large, uneven changes in relative incomes due to monetary shocks (in his days gold discovery or paper money) accruing to certain recipients thereby affecting relative (and absolute prices)…

    Comment by Viennacapitalist — July 2, 2022 @ 2:04 am

  5. We’re now seeing this start in the UK with silly money wage rises demanded by several unions and an actual strike by railway workers. The amusing effect currently is a spat between the Tesco supermarket chain and Heinz over the price of baked beans…
    Harbingers of worse to come, I think, with a dysfunctional government in charge 🙁

    Comment by Tractor Gent — July 2, 2022 @ 3:42 am

  6. “microeconomists … are sensitive to, but which macroeconomists too often ignore”

    Just more evidence for my belief that microeconomics is an actual discipline whereas macroeconomics is largely junk – a heap of identities, tautologies, political axe-grinding, and evidence deficiencies. If a genuinely clever bloke like Maynard Keynes couldn’t sort it out properly what chance that relative midgets will?

    Comment by dearieme — July 2, 2022 @ 5:53 am

  7. A particularly pernicious effect of inflation that I do not find generally appreciated is that it inflames envy. “They got an increase, we want an increase!” “They got more than we did!” or, in an absence of data, “I bet they got more than us!” The first to get the increase immediately feel short changed when they suspect that another group subsequently got more. I do not mean to diminish the real impact of depreciating fiat currency but the fundamental impact on inflaming envy has a terrible effect on society and the general goodness of humans to their fellow humans.

    Comment by Michael Cosgrove — July 2, 2022 @ 11:33 am

  8. So, buy stock in commodity exchanges and maybe commodity companies. Not sure how to play supply chain disruptions caused by strikes

    Comment by Jeff Carter (@pointsnfigures1) — July 2, 2022 @ 2:34 pm

  9. Read the linked article. Buy puts…..lots of them.

    Comment by Jeff Carter (@pointsnfigures1) — July 2, 2022 @ 2:38 pm

  10. “…real wages (i.e., the relative price of labor) fall when some more flexible prices rise and nominal wages don’t.”

    Bourgeois economics focuses on prices and wages, nominal vs real.
    There is another way of looking at the issue: from the viewpoint of allocations of real income between classes.
    The nominal price shock is the shadow on the cave wall reflecting the reality of real supply and demand shocks as geopolitical tectonic plates shift, grind and buckle (what an exciting time to be alive, eh?).
    When the price of food and energy rise, in economies which net import such inputs, there is an inflation shock which is the cave wall shadow of a real loss in national income.

    The issue then becomes: which class will bear the loss: the capitalists or the proles? You don’t need to read behavioral economists to know that loss aversion is a real thing in humans.

    People be bitchin’ over opportunistic price gouging by businesses. Yeah, which bit of predatory capitalism are you finding it hard to comprehend?
    The proles getting bolshie? Which bit of class warfare are you finding it hard to suss?

    Comment by Simple Simon — July 3, 2022 @ 10:35 am

  11. @10 in Socialism there are no price/inflation shocks because the money is intrinsically worthless.

    In the resulting allocation economy, the Party elites allocate themselves the luxuries because they’re working so hard for the people, donchaknow.

    There is no “bourgeois” in a socialist economy because everyone except the Party elites have been reduced to grinding poverty.

    It’s a little known fact that there’s no such thing as “Capitalism” rendered as a belief system. What is called ‘capitalism’ is only varying degrees of free trade.

    “Capitalism”-the-belief-system is an invention of socialists.

    Socialism is indeed a belief system — a utopian fantasy — and believers always need a demonized other to lend themselves a righteous unity. So they put an “-ism” gloss on people who have different views and then demonize them as a class.

    Hence the socialist invention and demonization of “capitalists.” It’s a crock of such long-standing as to have become accepted as normal. Time to recognize the the whole as the rhetoric of defamation. Falsehood as social theory.

    Socialism has failed at every turn. Its economics are a grift. Its elites have invariably engaged in mass murder to cover up their own failings and to retain power. The Soviet Union, Maoist China and Nazi Germany — Socialism’s Big 3 — managed to murder 170 million people in 60 years. It’s enough to make Genghis Khan jealous.

    Every single trendy socialist ‘war of national liberation’ that succeeded to power turned out to have been a war of national obliteration.

    Anyone who remains a socialist after the 20th century record of Socialist horror can only be a fool or a sadistic psychopath.

    Comment by Pat Frank — July 3, 2022 @ 12:39 pm

  12. Well Marxists are Social-Supremacists, they want and they did exterminate social classes of People instead of races classes that Racial-Supremacists do…

    Comment by AlexS — July 5, 2022 @ 6:24 am

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