The Riddle of Inflation . . . Solved

As the stock market continues to climb, media pundits — many of whom ought to know better — continue to publicly scratch their heads and ask: “Why is such splendid economic growth accompanied neither by commensurate consumer spending nor — as a direct consequence — inflation?”

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May I suggest that the media take a moment to consult — oh, I don’t know — ANY TRAINED ECONOMIST AT ANY REPUTABLE INSTITUTION?

Let us say that I tell investors: look, you can put your money anywhere you like. But it gets better. Let’s also assume that I am not going to regulate your asset choice to see whether its underlying fundamentals are sound. But it gets even better. Let us also assume that I am not going to require that asset’s board to submit meaningful reports to the SEC.

In short, let us assume that I have entirely deregulated financial markets.

But it gets better. Let us say that I now enjoy a deregulated labor market where I have made it increasingly difficult and costly for working families to organize for higher wages, more secure employment, and better benefits for myself and for my family. Let us say that I have so stacked State and Federal courts as to make it virtually impossible for working families to win decisions in disputes with their employers.

The simple production function states that  productivity is a function of the cost of labor, given some quantity of capital, over the value of goods produced by that labor, over time. We can consider the production function from any one of these three sides: lower labor (or other factor) costs; greater efficiency of capital (say, by lowering the interest rate or increasing the quantity of money in circulation up to the margin); or improving the efficiency of production (say, by adopting a more efficient technology).

There are three conditions under which we might still see inflation. (1) if I win productivity increases at the expense of labor — by driving down labor costs — we still might see inflation if the decrease in labor costs are passed on to consumers in the form of marginally lower consumer prices; i.e., consumer prices lower than the decrease in wages such that the actually purchasing power of those nominally lower wages increases. Greater actual purchasing power, even if the nominal wage is lower, could give rise to inflation.

(2) the exact same results (for the exact same reason) would arise if investors determined that their capital would be more efficient — i.e., would yield higher returns — by shifting this capital from high risk/high return financial instruments to even higher return technological innovation and/or more efficient factors (i.e., labor), let us say by increasing the human capital of the labor force through superior training/education/health. In this case — again — labor would enjoy a relatively higher wage (even if its nominal wage dropped) which would stimulate higher consumer spending, which would, caeteris paribus, give rise to inflationary pressures.

Or (3) we could also imagine a new, highly efficient, widely available technological innovation — the automobile, the microchip, the steam engine — that sent ripples through the entire economy, driving down the costs of production, increasing spending and (again) irrespective of nominal wages, giving rise to inflationary pressures.

But none of these conditions is even possible in a deregulated and privatized market. Why would I plough money into manufacturing or into labor goods when these sectors consistently yield lower returns than deregulated financial markets? Why would I plough money into innovation — let us say in the energy sector — when regulatory agencies and elected officials are rewarding me handsomely to invest in fossil fuels? Why would I throw money away increasing the productivity of labor — through expanding support for public universities — when my capital is far more efficient in high risk/high return financial markets?

Yes. Some scraps will chance fall from the tables of speculators on the financial markets. Some will end up in the pockets of lucky consumers. And so some of these scraps will be spent on consumer goods. But some is a relative quantity. And we know from the facts themselves that this sum is so small as to never ever give rise to inflation.

But all of this is well known, surely by my first year students, but then why not by the financial analysts trotted out by CNN, MSNBC, and NPR, not to mention FOX. This is a no brainer, which suggests . . .

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