Bad Explanations for Inflation
By: Alexander William Salter
While decomposing inflation into its constituent parts is empirically tricky, its essence is simple. Inflation results from too much money chasing too few goods. Milton Friedman popularized this rule of thumb. Its combination of intelligibility and explanatory power explains why it’s still widely used.
But not everyone got the memo. Politicians, bureaucrats, journalists, and Very Online™ academics are looking hard for other causes. Let’s consider some bad explanations for inflation.
The favorite of progressives in Congress, especially Senator Elizabeth Warren, this explanation is the worst of the lot. Corporations are always greedy. They want profits to be as large as possible. Yet inflation is rarely as high as it is now. The last time we saw the dollar depreciate this quickly was 40 years ago. You cannot explain a variable effect by a constant cause. Gravity does not cause one to trip and fall. Greed does not cause inflation.
In economics, “market power” means the ability of firms to charge prices in excess of marginal costs. Proponents of market-power explanations for inflation point to increased concentration in several industries over the last two years.
Assume for the sake of argument that industry concentration has increased. It still doesn’t explain inflation.
First, the link between concentration and market power is weak. Sometimes concentration is driven by structural economic factors—an efficient response to changing economic circumstances. When that happens, there’s no corresponding market power increase.
Second, the market power argument confuses the level of prices for the growth rate of prices. Inflation refers to the latter. Even if market power allowed firms to raise prices, it would be a one-time event. Inflation would temporarily spike, then return to trend. Instead, we’ve had a long period of above-trend inflation. It just doesn’t add up.
Some bad explanations never die. The wage-spiral view was a mainstay of Keynesian (pseudo-)theories of inflation from the mid- to late-20th century. It was bad then and it’s bad now.
Supposedly, rising prices cause workers to demand higher wages, which results in firms charging still higher prices to break even. It’s a positive feedback loop. But it has two grave defects. One is conceptual. The other is factual.
Conceptually, it doesn’t make sense for wages to outrun worker productivity. Firms can’t afford to pay workers more than the value those workers add to the firm’s bottom line. If you own a sandwich shop, and you think hiring a prospective worker would add $15 per hour in revenue, what’s the most you’d be willing to pay him to work? You will lose money if you pay him more than $15 per hour. The dollar figure of the worker’s output, what economists call the marginal revenue product of labor, is the upper bound on wages.
Factually, inflation has outpaced wage growth for months. The CPI increased 8.6 percent year-over-year, while nominal (dollar-valued) wages are only up 5 percent. That means workers have effectively taken a pay cut (i.e., after adjusting their wages for inflation). What wage-price spiral? If anything, firms are getting a deal!
I’ll take question-begging for $400, Alex! This theory of inflation says businesses pass on (“push”) higher costs to consumers in the form of higher prices. But this isn’t an explanation. It’s just repeating the thing to be explained. Why are costs going up? You’re right back where you started.
Improving public discourse
Hopefully, these lousy explanations will soon fade out of the public’s consciousness. We need to focus on what matters: a comparative abundance of money over goods. To be clear, this doesn’t mean inflation is 100 percent money supply-driven. I’m sure lingering supply-chain issues from the pandemic and the ongoing war in Ukraine are part of the problem. Furthermore, we should be careful in weighing monetary vs. non-monetary factors.
My Sound Money Project colleagues have done good work (here, here, here, here, and here most recently) demonstrating money matters a lot right now. It’s not the whole explanation, but it’s the largest part. Armed with this knowledge, and inoculated against some of the silly explanations prevalent today, we can work towards policy solutions to regain control over the dollar’s value.
About the Author: Alexander William Salter is the Georgie G. Snyder Associate Professor of Economics in the Rawls College of Business and the Comparative Economics Research Fellow with the Free Market Institute, both at Texas Tech University. He is a co-author of Money and the Rule of Law: Generality and Predictability in Monetary Institutions, published by Cambridge University Press. In addition to his numerous scholarly articles, he has published nearly 300 opinion pieces in leading national outlets such as the Wall Street Journal, National Review, Fox News Opinion, and The Hill. Salter earned his M.A. and Ph.D. in Economics at George Mason University and his B.A. in Economics at Occidental College. He was an AIER Summer Fellowship Program participant in 2011.
The Liberty Beacon Project is now expanding at a near exponential rate, and for this we are grateful and excited! But we must also be practical. For 7 years we have not asked for any donations, and have built this project with our own funds as we grew. We are now experiencing ever increasing growing pains due to the large number of websites and projects we represent. So we have just installed donation buttons on our websites and ask that you consider this when you visit them. Nothing is too small. We thank you for all your support and your considerations … (TLB)
Comment Policy: As a privately owned web site, we reserve the right to remove comments that contain spam, advertising, vulgarity, threats of violence, racism, or personal/abusive attacks on other users. This also applies to trolling, the use of more than one alias, or just intentional mischief. Enforcement of this policy is at the discretion of this websites administrators. Repeat offenders may be blocked or permanently banned without prior warning.
Disclaimer: TLB websites contain copyrighted material the use of which has not always been specifically authorized by the copyright owner. We are making such material available to our readers under the provisions of “fair use” in an effort to advance a better understanding of political, health, economic and social issues. The material on this site is distributed without profit to those who have expressed a prior interest in receiving it for research and educational purposes. If you wish to use copyrighted material for purposes other than “fair use” you must request permission from the copyright owner.
Disclaimer: The information and opinions shared are for informational purposes only including, but not limited to, text, graphics, images and other material are not intended as medical advice or instruction. Nothing mentioned is intended to be a substitute for professional medical advice, diagnosis or treatment.