July 2nd, 2022


Inflation and broken windows

Jeff Jacoby

By Jeff Jacoby

Published July 13, 2021

Inflation and broken windows
During the 1988 presidential campaign between George H.W. Bush and Michael Dukakis, I was invited by a Boston-area senior citizens group to debate the pros and cons of the candidates. My interlocutor was the late Elsie Frank , the president of the Massachusetts Association for Older Americans. Frank was a very liberal Democrat with impressive political connections: Her son was Congressman Barney Frank and her daughter was Ann Lewis, the one-time political director of the Democratic National Committee (who later served as director of communications for President Bill Clinton).

After all this time, I don't remember too much about that forum. But one exchange has stuck with me.

In the course of making my case for electing Bush, I praised the economic record of the Reagan administration (in which, of course, Bush had been vice president). I noted that on the Reagan-Bush watch, inflation had been tamed and out-of-control interest rates had been brought back to earth. The prime rate, which had soared during the Jimmy Carter years and peaked at 20.5 percent in 1981, had fallen to just 4.1 percent by the time of the 1988 campaign.

This was good news, I said, for anyone who needed to borrow money. It meant that more young couples in the market for their first house would be able to get a mortgage, and that hopeful entrepreneurs could afford a business loan to finance their new venture.

My argument was perfectly sound, but Frank had a better handle on what our audience wanted to hear.

"You think low interest rates are good news?" she demanded with great — possibly feigned — indignation. (I'm working from memory, so this isn't verbatim.) "Ask anybody in this room who is on a fixed income about low interest rates. Ask them if they like how little they're earning on their savings." By the time she was done, she had turned Bush into practically the worst economic foe America's elderly retirees had ever faced. It was a good lesson for me in the importance of reading the room, and of being able to talk about economic policy in terms that acknowledge voters' self-interest.

I thought about that long-ago encounter last Thursday, when I saw a tweet from CNBC celebrating higher wages as the "silver lining" of surging inflation.

"Although consumers may pay more for everyday items, it's not all bad news as far as household income and spending goes," wrote Jessica Dickler, CNBC's personal finance reporter.

Companies facing a labor shortage are also paying more to get workers to walk in the door. . . . Workers already saw a bump in their paychecks for June. As of the latest tally, average hourly earnings rose 0.3 percent month over month and 3.6 percent year over year, according to the Labor Department.

To be sure, wages tend to rise when inflation climbs. But rarely do they rise faster than prices. By definition, inflation erodes the purchasing power of every dollar earned or saved, invariably leaving most households worse off. As Ottawa University economist Peter Jacobsen explains in a cogent new essay, the "silver lining" analysis is a fallacy because it makes no difference between nominal wages — the number of dollars in a worker's paycheck — and real wages, which is what that worker can afford to buy after taking account of changing prices.

"Consider a hardware store," Jacobson observes.

As spending begins to pick up after the end of COVID lockdowns and restrictions, hardware store shelves that were full of building materials begin to empty out. In fact . . . the new money created by the Federal Reserve spurs even more spending than usual as the economy returns to normal.

In order to deal with goods flying off the shelves, stores . . . need to raise the prices of their building materials to avoid having a shortage of materials for sale. This contributes to inflation. Second, the stores need to hire (or re-hire) laborers to restock shelves and deal with selling the higher-priced goods.

But hiring may be tough. Let's say the business already had a few job openings which offered $8 an hour. Now the store needs even more laborers to restock the recently depleted shelves. How can they entice workers to apply for their jobs? Easy: The store can raise wages to some higher rate — say, $10 dollars an hour.

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At first blush, a 25 percent increase in hourly pay sounds great. Who making $8 an hour wouldn't rather make $10? But if prices are going up as fast as wages, a bigger paycheck won't buy any more goods or services than the previous paycheck did. Suppose the hardware store worker, pre-COVID, was spending $200 per month for groceries. In order to cover the grocery bill, he or she would have had to work 25 hours per month.

Now the hardware store is paying $10 an hour. But inflation has driven up the price of food and other staples, so the worker's monthly grocery bill is $250. How many hours of work, asks Jacobson, does it take to earn enough to pay that bill?

That's right, the exact same amount of time. In this example, your nominal wage has increased from $8 to $10, but your real wage is the same.

Anyone who thinks the worker is better off is suffering from the money illusion. They're confusing dollars for well-being.

Actually, the worker is probably worse off, since rising wages tend to lag rising prices. That is, prices generally go up before paychecks do, so for at least some period of time, the hardware store employee was forced to work more than 25 hours a month to be able to afford the same groceries. And if the employee had managed to put aside some money into a savings account or emergency fund? That stash is now worth less. In Jacobsen's example, $1,000 in savings would have paid for five months' worth of groceries before inflation started climbing ($1,000÷$200=5). Now those dollars will cover over only four grocery runs $1000÷$250=4).

Adding insult to injury, the employee's taxes will go up, too. Federal and state income tax rates are applied to nominal earnings, so as pay increases, more money is withheld from each paycheck. The tax collector doesn't care that your purchasing power is the same or less as it was before. That's yet another reason that inflation tends to leave most people worse off.

Inflation destroys value, and there is no "silver lining" in useless destruction. CNBC's error is a reflection of one of the most persistent economic myths — the idea that the loss of wealth can actually be a good thing, since some people will benefit from the rebuilding or recovery. The trillions of new "stimulus" dollars injected by the government into the economy push up prices and wages, so that on paper, vendors and workers seem to be earning more money. But inflation doesn't create new wealth, it wipes out existing wealth, and that can never be a good thing.

Yet there are always experts ready to insist that economic loss will prove to be a net gain, since the money spent on recovery stimulates new jobs and construction — or, in this case, the "silver lining" of higher salaries.

Back in 2011, I wrote a column rounding up examples of this enduring delusion. An excerpt:

Consider the massive earthquake and tsunami that devastated Japan earlier this year — a catastrophe that killed more than 22,000 people, caused the worst nuclear crisis since Chernobyl, and pitched the already sagging Japanese economy into recession. Three days after disaster struck, the Huffington Post published Nathan Gardels's essay celebrating "The Silver Lining of Japan's Quake.'' Urging his readers to "look past the devastation,'' he rejoiced that "Mother Nature has accomplished what fiscal policy and the central bank could not.'' Now the Japanese would have lots of bridges to build, "entire cities and regions'' to reconstruct, and information networks to revamp.

"The result of all the new wealth creation,'' Gardels concluded, "will be money in the pockets of Japanese.''

Japanese who survived, that is. The tens of thousands who died won't be pocketing any new wealth. And all the money in the world won't make whole the countless Japanese whose minds, bodies, or careers were permanently broken by the mayhem. True, trillions of yen will be spent to repair, rebuild, and restore. But equally true is that all those trillions will no longer be available for everything they would otherwise have been spent on. Whatever Japan may gain from the resources committed to reconstruction will never outweigh the value of everything lost through wanton destruction.

Yet the conviction that devastation is really a boon never seems to go out of fashion.

"It seems almost in bad taste to talk about dollars and cents after an act of mass murder,'' wrote Paul Krugman in The New York Times less than 72 hours after the atrocities of 9/11, but the terrorist attacks could "do some economic good.'' After all, Manhattan would "need some new office buildings'' and "rebuilding will generate at least some increase in business spending.''

The same was said of Hurricane Katrina, one of the severest calamities in US history. Barely had the storm subsided when J.P. Morgan economist Anthony Chan was assuring CNN/Money that hurricanes tend to stimulate growth. Granted, New Orleans had been shattered, said Chan, but "over the next 12 months, there will be lots of job creation, which is good for the economy.''

In 2007, immense wildfires in southern California consumed more than 1,600 homes, burned 500,000 acres and forced the largest evacuation in state history. A senseless tragedy? No, a blessing! "This will probably be a stimulus,'' University of San Diego economist Alan Gin told the Los Angeles Times, since "there will be a huge amount of rebuilding . . . financed by insurance payments.''

More than 170 years ago, the French political economist Frederic Bastiat skewered such attitudes in a now-famous parable : A boy breaks a shopkeeper's window, and everyone who sees it deplores the pointless destruction. Then someone insists that the damage is actually for the good: The six francs it will cost the shopkeeper to replace his window will benefit the glazier, who will then have more money to spend on something else. Those six francs will circulate, and the economy will grow.

The fatal flaw in that thinking, Bastiat wrote , is that it concentrates only on "what is seen'' — the glazier being paid to make a new window. What it ignores is "what is not seen'' — that the shopkeeper, forced to spend six francs on repairs, has lost the opportunity to spend them on better shoes, a new book, or some other addition to his standard of living. The glazier may be better off, but the shopkeeper isn't, nor society as a whole.

Broken windows are not economic stimulus. Neither are hurricanes, terrorist attacks, tsunamis — or government-induced inflation. There is no silver lining in useless destruction. Not even if CNBC says otherwise.