Wage-price inflation spiral - or - How to really "Eat the Rich"

From the basement of amusing theories, I would dearly like to present one fun way to play with the economy. Time to spark a wage-price spiral!

The basic idea behind a wage-price spiral is that workers will respond to an expectation of higher prices by demanding increased wages. This in turn drives up prices which again drives up wages,rinse and repeat. It's a bit of an esoteric theory which isn't exactly loved by economists because it's a bit of a beast with an incredible amount of moving numbers which is difficult to manage. To get any idea of how it works you have to think in "ceteris paribus", looking at what happens when one factor changes while holding all the other factors constant. Unfortunately, in the real world, this doesn't really happen.

A wage-price spiral is often blamed for being one of the major issues underpinning the stagflation seen in the 70ies, a decade which was plentiful of economic misery around the world. However, high rates of inflation does not seem to be the major issue in today's economic crisis'. In fact, deflation seems to be the real monster lurking around the corner. In addition, we have today floating exchange rates and independent central banks alleviates some of the risk associated with.

First up, it's a good idea to understand what inflation actually is: It's essentially how much a basket of goods costs today vs some point in the future, usually in one year. Let's say one weeks worth of groceries costs $100 today and $102 in one year. Et viola, 2% inflation achieved. If you get a 2% bump in your salary, you have what is usually referred to as inflation neutral wage increases. You have nominally been given a 2% raise, but in reality it's 0% since you can't buy anything more than you could last year.

Usually people demand (at least they should demand) a real wage growth.If inflation misses the downside of target rate, real wages tend to grow rather quickly. So why not just set a target inflation rate of 5%, have workers demand a 6% wage increase, and hope prices rise enough to hit the target rate..?

Here are some effects:

As explained above, real incomes would rise. Workers would be better compensated for the same amount of work. Unfortunately, since labor becomes more expensive, demand for labor would shrink, increasing unemployment further.

On the other hand.. The currency of the country undertaking a wage-price spiral would deflate assuming that the nominal interest rate is not increased. It would make imports more expensive, which leads to less demand for imported goods, and exports become more competitive which leads to higher exports. Demand would therefore shift to more internally produced goods, increasing employment rates, and exports would increase, again increasing employment.

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So those were the effects on the wage earners; Now for the "Eat the Rich" part. Inflation is your friend if you have debt and most people have lots of debt. Inflation is your enemy if you are wealthy as it eats away on wealth. For sake of argument, lets assume sparking this spiral leads to around 50% inflation over a 5 year period and a 60% increase in nominal wages. Lets say the housing crisis continues and house values only trickle slowly up by 25% in the same scenario.

At the beginning a regular Joe with a regular job and a regular house has an income of $50 and a mortgage of $250 on a house worth $300. At this point Joe has 5x income in mortgage and is 84% leveraged, which is an extremely precarious position. After 5 years this regular Joe will have an income of $80 and a loan (lets say it's interest-only) of still $250, which has been reduced to ~3x income, and a house worth $375, which is now only 67% leveraged. Joe is now in a quite healthy financials position. His $50k in 2011 equity has actually increased to $62.5 in 2011 equivalent dollars in 2016.

Now, think of poor rich Dick. Let's say he started off with an income of $1000 and lives in a $2000 mansion with 0 debt and $10000 in the bank. His income will rise to $1.6m and his house to $2500. However, his $12000 in 2011 assets has decreased to $6250 in 2011 equivalent dollars in 2016.

And that, ladies and gentlemen, is how you truly eat the rich. :)

Views: 62

Comment by Michael Klein on September 26, 2011 at 2:36pm

nice copy paste 50$ to 50k$...yup

 

also: interests from bank for the rich.

Comment by Arcus on September 26, 2011 at 2:47pm

Real interest income even in moderately high inflation periods tend to be near zero or even negative (especially when tax is added), and may be interpreted as part of his income. Also, the interest would not save his principal from depreciating in value.

Comment by Michael Klein on September 26, 2011 at 4:23pm

Those with money could lend to those in need at an interest higher than inflation. Downside is risk. Inflation only kills savings, and not investments, that's why it is generally accepted as good. It doesn't eat the rich.

 

Your expose is technically correct but practically wrong because there is always flight of the capital to profitable sources.

Comment by Arcus on September 26, 2011 at 5:42pm

1. Coulda, shoulda, woulda. It had to be combined with much stricter lending practices, otherwise it would lead to increased piling of debt on the appreciating assets (i.e. max 5x income/80% of market value). As homes are the asset class with the most widespread wealth distribution, and the major underlying reason the the current malaise, a bit of inflation would appreciate it and depreciate debt values at the same time.

2. Risk is not a "downside", it's just risk. For anything that yields a payoff there will be an associated risk.

3. Inflation reduce some of the marginal investments as the expected returns need to be higher than the risk free rate. Though with negative real interest on risk free assets, there is a counterbalance as long as the risk weighed payoff of the investment outweigh the risk free placement in risk less assets. Also, the term "risk less assets" is under heavy attack, which should spur investment further.

3. Inflation always eats the rich, ceteris paribus. However, it may offer bigger returns for those willing to take extra risk, and especially those who gear up and get double payoff.

4. If it's "always flight of capital to profitable sources", the how can it be wrong? If the underlying assumption doesn't change, the argument doesn't change. Also, the argument is self evident and devoid of any practical meaning, unless you proclaim that in certain instances capital chase unprofitable assets...

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