Sometimes I despair. Sometimes I wonder if the inflation fallacy is at the root of all the US and Eurozone troubles. It's so easy to get popular support for the idea that printing money will cause inflation, and inflation means a fall in our real income. So it's much better to have high unemployment, low employment, low real output, and errrr, low real income, than to risk having low real income.
The inflation fallacy is an invalid argument about why inflation is bad. Now, an invalid argument can sometimes have a true conclusion. Maybe inflation is bad. Maybe inflation does reduce our real incomes. But it's still an invalid argument. It doesn't give any good reason for thinking that inflation is bad, or reduces our real incomes.
A lot of non-economists believe the inflation fallacy. I'm an expert on what non-economists think about economics. That's because I have spent the last 30 years trying to teach non-economists how to think about economics.
Sometime in February, I will ask my ECON1000 students: "So, why is inflation a bad thing?"
I can anticipate the look on their faces. Some will give me that look of sympathy, normally reserved for those who aren't too bright. Others will look like they know this must be a trick question, since I wouldn't ask anything that were really quite so obvious. Finally one will answer.
"Because if all prices rise 10% we will only be able to afford to buy 10% less stuff. Duh!" Except the "Duh!" is silent.
That's the inflation fallacy.
You could try to counter the inflation fallacy by talking about the neutrality of money. But that's the wrong approach. Sure, if money is neutral, and so has no effect on real variables like real income, then the conclusion of the inflation fallacy would be false. But that misses the point. The inflation fallacy is an invalid argument. It is logically, conceptually, confused. Even if the conclusion were true, it would still be an invalid argument. Even if inflation did cause falling real incomes, the inflation fallacy would not be a good argument for believing that inflation would cause falling real incomes.
Why is the inflation fallacy a fallacy?
Apples bought must equal apples sold. What is an expenditure to the buyer of apples is a source of income to the seller of apples. Every $1 rise in the price of an apple means the buyer is $1 poorer and the seller is $1 richer. That's true whether we buy and sell one apple or buy and sell one billion apples. It's true whether or not we add in bananas, carrots, dates, and eggs. It's true whether all prices go up by the same amount, or percentage, or if they all go up by different amounts. It's true whether we measure prices in money, in gold, or in venus dust.
It makes exactly as much sense to argue that a 10% rise in prices is a good thing because it means we earn 10% more income from selling things and so can afford to buy 10% more stuff. Let's call that the inflation fallacy mark 2. It's the exact opposite of the original inflation fallacy mark 1.
Why is the inflation fallacy mark 1 so common, but the inflation fallacy mark 2 so rarely heard? I don't know, but I'm going to make a couple of guesses.
1. We live in an economy with specialisation and the division of labour. We sell one good, and buy hundreds of goods. Naturally, we are much more knowledgeable about the one good we sell than about the hundreds of goods we buy. We understand the forces that proximately determine the price of the one good we sell. We don't understand the forces that determine the prices of the hundreds of goods we buy. So we put a name to our ignorance, and call it "inflation".
"Inflation" means an increase in the price of the goods we buy. The price of the good we sell is determined in a quite different way. So, if we think like that, we will think of inflation as making us worse off.
Inflation is when other people increase their prices, not when I increase my price.
2. Most of us earn our income from selling our labour. And we think that other people are like us. When we think of the representative person, we think of ourselves. We have a special name for the price of labour. We don't call it a "price"; we call it a "wage". And we think of inflation as price inflation, not wage inflation. Since there's no obvious one-to-one link between price inflation and wage inflation, and we know that sometimes wages rise faster and sometimes slower than prices, we think that inflation reduces real wages, and makes people worse off. Even if it did, we forget that capitalists are people too. They are "the other".
If we excluded apples from the CPI, and gave the price of apples a special name, then "inflation" would mean a rise in the price of bananas, carrots, and dates. So of course inflation makes us apple sellers worse off.
The inflation fallacy is a conceptual fallacy. It's a fallacy of composition. It fails to recognise that "inflation is someone else's price increase, not mine" doesn't work at the macro level, when we add up all the buyers and sellers. It's a fallacy of someone who hasn't come across the "income = expenditure" accounting identity. It's a fallacy of someone who doesn't recognise that production is the ultimate source of our aggregate income and expenditure, not how much we pay each other.
It's a fallacy I think we will never eradicate. "Ours the task eternal", once again.
I have sympathy with some Austrians, who define "inflation" as an increasing money supply, not rising prices. But it doesn't really work, because both the demand and supply of money can change. And people will still find another way to talk about rising prices, even if you forbid them to use the word "inflation". And I have sympathy with Scott Sumner's approach too, in trying to ban the use of the "i-word", and talk about NGDP instead.
Because the question "is inflation a good or bad thing?" is a really stupid question. It doesn't have an answer. Inflation is an endogenous variable. It depends what caused it. If inflation is caused by a harvest failure, then it will make us worse off. But it's not the inflation that makes us worse off, it's the harvest failure. With lower output of goods, our real income is lower too. Inflation is only a symptom. It's the way a bad harvest will manifest itself to us, if we weren't directly involved in the harvest itself.
The right way to ask the question is to talk about monetary policy. If the Bank of Canada had a 0% inflation target, or a 4% inflation target, would either of those make us better or worse off than the current 2% inflation target? That's when we can move beyond accounting identities, and start to argue about the neutrality or non-neutrality of money (strictly, super-neutrality of money).
And if we could talk about the effects of a falling value of money, rather than a rising price of goods, that would help clear people's minds too. Speaking about a falling value of money suggests both that we will get more money from the goods we sell, and give up more money from the goods we buy. It leads us to think about both versions of the inflation fallacy at the same time -- mark 1 and mark 2 -- and to see that they offset each other. Then, and only then, can we start to think about the real question.
Paradoxically, one of the strongest valid arguments against targeting too high an inflation rate may be the very existence of the inflation fallacy itself as a sociological phenomenon. The fact that many ordinary people are so confused about inflation does suggest that inflation may be a bad thing.