The conflicting claims theory of inflation, and unemployment

The conflicting claims theory of inflation goes like this.

Suppose we start in equilibrium with 10 people in an economy each earning 10% of total income. Then all of a sudden each decides he deserves 11% of total income, and raises his price accordingly. The total claims add up to 110% of total income. In the new equilibrium, each still ends up earning the original 10% of total income, but there's 10% inflation to reconcile the conflicting claims.

IIRC, it used to be a popular theory of inflation back in the early 1970's, before Milton Friedman won his war. I never hear it spoken nowadays. But a quick Google tells me the theory lives on in the Post Keynesian underworld.

It had some problems as a theory. How could we test it? How could we measure the degree to which claims conflicted, to see whether inflation really does result from conflicting claims? What about periods of deflation? Is 10% deflation caused by people saying they only deserve 9% of total income rather than the 10% they are currently getting? What happens if the central bank doesn't print enough money to validate the inflation? And if the central bank did print enough money to validate the 10% inflation, wouldn't we get 10% inflation anyway, regardless of whether there were conflicting claims?

But what really killed the conflicting claims theory of inflation was rational expectations. Even a very very weak form of rational expectations, which says that people eventually figure out any consistently repeated simple pattern, is enough to eliminate a conflicting claims equilibrium rate of inflation. If each thinks he deserves an 11% share, and so raises his price accordingly, but finds everyone else has done the same, he still ends up with the original 10% share. So each will need to raise his price by more than he expects the others to raise their prices. So equilibrium means actual inflation must exceed expected inflation by 10%. But you can't have expected inflation less than actual inflation forever. People aren't that stupid.

Dinosaurs didn't go extinct; they morphed into birds. You could argue that the same is true of the conflicting claims theory of inflation. It morphed into New Keynesian macroeconomics. Or, if the DNA evidence rules out direct paternity, you could argue that the conflicting claims theory of inflation could morph into something very similar to New Keynesian macroeconomics.

Sure, New Keynesian macroeconomics looks very different from the conflicting claims theory of inflation. Birds also look very different from dinosaurs. But underneath the feathers, they have a similar structure.

Suppose you initially believed the conflicting claims theory of inflation. Then rational expectations theory hits you like a meteorite. You learn that there exists no equilibrium rate of inflation that could reconcile the conflicting claims. OK. If inflation is not the equilibrating variable that reconciles the conflicting claims, what is? The most obvious answer is unemployment. If the central bank refuses to validate the inflation created by conflicting claims, and eventually under rational expectations it must refuse to validate it or else see the price level explode, the result will be unemployment. Therefore the unemployment rate must rise to whatever level is necessary to suppress the conflicting claims so they add up to 100% of a smaller pie. That is the unemployment rate at which actual inflation will equal expected inflation.

The conflicting claims theory of inflation has morphed into the conflicting claims theory of the natural rate of unemployment.

At its simplest, as the unemployment rate rises, the fear of unemployment if you try to raise your relative price also rises. And eventually the unemployment rate is high enough to dissuade the average person from trying to raise his price above the average.

But that equilibrating process is fraught with difficulties:

1. As the unemployment rate rises, the total pie shrinks, so the absolute amount of pie claimed would need to shrink more than the relative amount claimed.

2. As the unemployment rate rises, some people may be shut out of the economy permanently. If those outsiders can't compete with the insiders, they might as well not exist, as far as the equilibrating process is concerned. The only fear that is relevant to the insiders is fear of becoming an outsider.

So the equilibrating forces may be weak. This means that small changes in the amount of conflicting claims may cause large changes in the natural rate of unemployment.

And there may be hysteresis, if being an outsider depends on how long one has been unemployed. This means that the natural rate of unemployment may depend on the past history of unemployment, and it may take a very long time, perhaps a generation or two, for the natural rate to forget history.

Even theories that look stupid may contain at least a grain of truth, if we can look beneath surface appearances, and translate their underlying vision. We shouldn't forget old theories. They may have something useful to say.

When I read about Greece and Spain especially, and how inflation seems stubborn in some European countries despite high and rising unemployment, my mind wanders back to the conflicting claims theory of inflation of the 1970's. Even if I can't fit it all into place quite yet.

Comments

[Determinant]

I tend to view expectations as a Bayesian process based on past experience. If people have a bias towards expecting higher inflation due to past history and act accordingly, it becomes a self-fulfilling prophecy. With Bayes Rule it's easy to see how to past clouds the present.

The corollary is that to change behaviour of such Bayesian actors you need to make a REALLY big splash to change their assumptions.

The conflicting claims theory looks much better with Bayesian actors than with actors evaluating expected utility.

[OGT]

Good post. I was completely unfamiliar with the Conflicting Claims theory (when I took Macro it was Quantity of Money, which also didn't quite work out). But, while I agree it doesn't make sense in a repeat game, looking at Spain in particular does lead one to grope for some sort of money illusion answer. It's hard to believe the NAIRU is 20% there.

[Min]

"But you can't have expected inflation less than actual inflation forever. People aren't that stupid."

Well, it seems that the people who fear hyperinflation seem to think that people are almost that stupid.

[reason]

Isn't this competing claims stuff just straight Keynesianism. People know what they are doing, but they don't know what other actors are doing. So their nominal actions may not have the real consequences that they anticipate. I think this uncertainty (about other actors) is the essence of Keynesianism.

[Frances Woolley]

Nick, great post. Now the competing claims theory is different from the friction reduction theory, isn't it, where inflation eases relative price adjustments (people are happier not getting a pay raise in an inflationary environment than they are getting a pay cut in an environment with stable prices). But if the relative price that's too high is the price of, skilled labour (or the wages of another large group of workers), would friction reduction theories start to look like competing claim theories?

[Nick Rowe]

Determinant: Maybe, but Bayesians will continue to update their beliefs if their past priors were wrong. And that means you cannot have an equilibrium in this model at any finite level of inflation.

OGT: Thanks! My guess is that most macroeconomists under 50 won't have heard of it. I think it was more popular in Latin America and Europe than in North America.

Min: Yes, but remember: the US needs people to fear inflation a bit, to offset those who fear deflation, and to increase aggregate demand!

reason: I'm not sure of the history of the theory, but I think it's more Kalecki than Keynes. In the 1970's, it drifted a bit into a sociological theory of inflation. But it did satisfy what the Keynesians needed at the time: how to explain why there was inflation even when output was below "full employment". And Post Keynesians do seem more favourable to the theory. But one of my main points is that the same theory can also be given a more "classical" interpretation, if you think of it as a theory of the natural rate of unemployment. Same curves, drawn in a different space, but homogenous in nominal variables.

Frances: Thanks! Yes, it is different from the inflation as a lubricant theory. But damn, that's a good point. There must be some relation between them. Must try to get my head around it. It has to tie in to the dynamics of inflation inertia somehow as well. Why inflation keeps on rolling for so long even after the fundamentals have changed. Because nobody wants to go first and cut their relative price.

[White Rabbit]

Greece and Spain is different from the US of the 1970s, because Greece and Spain does not print its own currency - the ECB does.

The ECB is following the interests of Germany and France: a tight monetary regime that fits those two growing economies.

That forces painful deflation down the throat of Spain and Greece, causing high unemployment and general economic stagnation - even contraction.

The ECB does what the Fed did in the US in the early stages of the Great Depression: nothing beyond ZIRP. That is fatal to Spain and Greece.

And now the ECB has announced to increase interest rates ...

[anon]

White Rabbit, interesting point. I guess it shows yet another drawback of inflation targeting: the ECB can target average European CPI and this works well in normal times, but if Greece and Spain are stuck with stable prices because of nominal rigidities, their reported CPI is "too high" and ECB policy reacts only slowly.

[jsalvatier]

@Determinant that sort of thinking assumes that Bayesians never consider the possibility that things change, which is obviously false.

[Nick Rowe]

White Rabbit: that's true and important, but I'm still puzzled by inflation rates in some Eurozone countries that have high unemployment.

[Determinant]

Nick wrote:

"Determinant: Maybe, but Bayesians will continue to update their beliefs if their past priors were wrong. And that means you cannot have an equilibrium in this model at any finite level of inflation."

Of course Bayesians will update their beliefs. Who says you can't have equilibrium? You just need the process to be convergent. As long as the reward of "guessing right" is higher than "guessing wrong" you'll get there, eventually. With high inflation expectations Bayes Rule indicates that that process may be slow.

When the variance drops below 5% of the original value I say you've reached a steady-state solution.

Certainly Bayesian actors may consider that things change, but departing drastically from past behaviour is "radical" and therefore unusual in reality among most people.

[pcle]

I don't think you're presenting this right. It's not that people "all of a sudden" decide they want more. It's because of a slowdown in the trend rate of gdp growth, the "aspirations theory". Something happens to cause the wealth distribution to change, Interest groups then react to maintain their standing in the distribution and the central bank gets drawn in to the competing claims over the diminished pie.

I think the great Canadian economist Reuven Brenner has written about this in one of his books (maybe "Betting on Ideas")

[Determinant]

On further thought, this may be a generational difference showing through. I have no problems with recursive methods or models relying on them as I will simply use my handy computer to solve them; it exists for such problems and hums along happily to solve them. There's no failure in this, recursion is innately computer-friendly and blackboard-unfriendly.

[Nick Rowe]

Determinant: "Of course Bayesians will update their beliefs. Who says you can't have equilibrium? You just need the process to be convergent. As long as the reward of "guessing right" is higher than "guessing wrong" you'll get there, eventually."

Agreed. But in *this particular model* it *cannot* converge to any finite rate of inflation, because the model says that actual inflation is always 10% more than expected inflation, and Bayes says that expected inflation converges to actual inflation. So there's a contradiction.

pcle: yep. I just *assumed* that "something" caused the sum of claims to exceed 100%. I wanted to stay away from arguments about what that something might be, because I see that as a separate question.

[Sergei]

"but I'm still puzzled by inflation rates in some Eurozone countries that have high unemployment"

Well, when economy collapsing like it does there and everybody wants to survive another day, then you just raise prices and hope. Very simple and very rational: default today or make to tomorrow.

What about such practice? I can see it all around the place.

[Robert]

This is not Nick Rowe's first post that is little more than him parading his ignorance of the literature. For example, he is clearly ignorant of both the empirical work and the synthesis model towards the end of Stephen A. Marglin's Growth, Distribution, and Prices.

Notice that Nick Rowe does not say that there never is such a thing as cost-push pricing. I don't know if that's because he realizes because that would be silly or if he is afraid to actually address theories he pretends to criticize.

[Robert]

"cost-push pricing" should be "cost-push inflation"

[Nick Rowe]

Robert: Oooh, nasty! But did I make any claim to be knowledgeable about developments of this theory? Nope. Just the opposite. Simply giving my thoughts. If you want to add yours, and add constructively to this conversation, then go ahead. But if you came here just to snark, then piss off!

As to whether or not there can be "cost push" inflation, that depends so much on what you mean by it, and how you define the monetary policy reaction function. Unless you do that, I think the old debate between cost push and demand pull inflation was a sterile debate, with people arguing at cross purposes. That's why the cost push vs demand pull distinction disappeared from the mainstream 30 years ago.

[Nick Rowe]

What has replaced the cost push vs demand pull distinction is the supply shocks vs demand shocks distinction. But whether a supply shock can cause a change in inflation (and whether it's a temporary or permanent change in inflation) depends on what you mean by "holding demand constant".

At one extreme, you could define "holding demand constant" as a central bank doing whatever is necessary to keep inflation at all times at a fixed target at the shortest possible horizon, regardless of consequences. In that case, by assumption, a supply shock (or any shock) can only cause a very temporary inflation in the time it takes the central bank to react.

At the other extreme, if (say) the central bank tried to keep real output, employment, or unemployment fixed, in the face of a supply shock then inflation could rise without limit.

My reading of the old cost push vs demand pull debate was that demand pull theorists tended to lean towards the first definition, and cost push theorists tended to lean towards the second.

Put the inflation rate (or price level) on the vertical axis, and real output (say) on the horizontal axis.

The first extreme has a horizontal AD curve, the second extreme has a vertical AD curve. The effect of supply shocks on inflation will be very different in those two cases.