What's Wrong with Inflation?

The media try to sensationalize it. Inflation does cause serious economic damage, but in subtle ways.

Economists cringe when we see inflation discussed in the media. The typical story says that inflation makes you poorer because you can no longer afford stuff. That is not how inflation works.

I think of inflation as causing the following problems: it rewards the most alert and aggressive economic actors, and it punishes people who are passive and habitual; it interacts with the tax system to reduce productive investment; and it makes planning for the future difficult, particularly when it comes to buying a home.

Living in Neutralia

Why do economists reject the media narrative that inflation means that you can no longer afford stuff? We use a thought experiment in which everything is indexed to inflation, including labor contracts, financial instruments, government programs, and tax rules. Call this the imaginary country of Neutralia.

Suppose that Neutralia experiences steady inflation of 1 percent per month (12 percent per year, not including compounding). Every month, the price of everything you buy goes up 1 percent. But so does your salary. So does the principal on all of your savings. In Neutralia, even cash accrues a 1 percent increment each month.

There is no such thing as living on a fixed income in Neutralia. People’s pensions go up 1 percent a month. So do their government benefits. And you stay in the same tax bracket, even as your income goes up because of inflation.

If we lived in Neutralia, then we would not experience a 12 percent inflation rate any differently than a 0 percent inflation rate. Our work effort and our savings would enable us to obtain the same goods and services under either scenario.

But in reality. . .

Inflation is messier than in the imaginary world of Neutralia. Some people adapt better than others to high inflation. Many standard financial practices, such as the 30-year mortgage, become unsustainable when there is high inflation. And in order to keep the same level of after-tax income, we have to make different decisions about how we work, spend, and save.

Consider two workers, each earning a salary of $50K per year. Passive Patsy is not interested in looking around for other jobs or in negotiating a higher salary. Aggressive Augie is constantly checking the job market, and when he finds a position with higher pay he either takes it or uses it as leverage to negotiate a raise from his current employer.

With no inflation, Passive Patsy and Aggressive Augie do equally well. But with 12 percent inflation, Passive Patsy will allow her $50K salary to erode in value. But Augie will find that other employers are willing to pay more than $50K.

Employers will try to take advantage of their Passive Patsies for as long as they can. If the fair market salary is $56K, they will pay $56K to new hires, including Aggressive Augie, but they will leave Passive Patsy at $50K. Relative salaries will become very distorted by this behavior, creating both inequality and inefficiency.

Your savings get taxed away

Suppose that you have $100K in savings and you are in the 25 percent tax bracket. If there is no inflation and the interest rate is 2 percent, then you have $2000 in interest income and you pay $500 in taxes.

But what happens if there is 12 percent inflation? If the interest rate stayed at 2 percent, your purchasing power would erode. In order for your savings to increase your purchasing power by 2 percent, the interest rate needs to be 14 percent. But that gives you $14,000 in interest income, so that you have to pay $3500 in taxes. So your purchasing power has eroded after all!

When inflation is high, people’s financial decisions become dominated by tax considerations. Tax-favored investments, such as owner-occupied housing, retirement accounts, and municipal bonds, become even more valuable.

Ordinary financial instruments, including stocks, bonds, and savings accounts, lose value as the tax system interacts with inflation. People are punished for saving, and so they save less. What little they do save gets channeled into less productive investments as they focus on tax considerations rather than real returns.

The Mortgage Dilemma

Our standard mortgage instrument, the 30-year fixed-rate mortgage, is designed for a low-inflation environment, but it becomes onerous in a high-inflation environment. For example, if you have a $400,000 mortgage at a 4 percent interest rate with 0 inflation, your monthly payment is $1910. But if inflation is 12 percent and the rate goes up to 16 percent, your monthly payment is $5379!

In theory, there is no difference between a 4 percent mortgage with 0 percent inflation and a 16 percent mortgage with 12 percent inflation. If you can afford one, you can afford the other. But the timing of your mortgage burden differs enormously.

With 12 percent inflation, your income “tilts” upward: as the years pass, your income will get higher and higher, so that a fixed payment will be lower and lower as a percent of your income. That would make the 16 percent mortgage that you take out today easy to afford 10 years from now. But that does you no good today, when the mortgage is impossible to afford.

If you already own a home, and especially if you have financed it with a low-rate mortgage, inflation is very good to you. Your payment burden grows lighter and lighter. But when interest rates rise to cover inflation, young families cannot get a foothold in the housing market.

The “solution” to the “income tilt” problem is to adopt mortgage instruments that reduce your payment today in exchange for much higher payments in the future. But then what happens to you if inflation goes away? If that happens, then when those higher payments kick in, you won’t be able to afford them and you will lose your home.

The fixed-rate mortgage in a low-inflation environment allows you to face the future securely when you buy a home. High inflation takes away that security, and that makes it harder to plan for the future.

Conclusion

A high-inflation economy creates distortions. Relative salaries get out of whack. Savings no longer flow to their most productive uses. Fixed-rate mortgages create windfall gains for people who bought homes before inflation took off, while crushing the dreams of would-be first-time home buyers.

These distortions produce real costs. They are not the sensationalized costs that the media wrongly portray. But the costs are serious, and they cause long-term economic damage.