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

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 F**** ** relative prices.”

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 transaction 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 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 to, 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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