Wednesday, October 03, 2012

Hard money and the gerontocracy

There is a huge divide between economists and the rest of the populace when it comes to inflation. Economists generally focus purely on the efficiency/growth effects of inflation - whether monetary easing can boost output, etc. Most normal people ignore this issue entirely, and mistakenly equate "inflation" with "falling real wages" (which is absurd, but 99% of people seem to make this mistake). But then there are lots of people who seem to care about the redistributive effects of inflation. These effects are real, and potentially big, and economists often ignore them.

Who loses from inflation? "Net nominal lenders". These are people who own a lot of non-inflation-adjusted bonds, and not a lot of stocks, and who get less of their income from wages. Who are these people? They are old people.

Owning lots of bonds, and not much stock, is the wise thing to do when you're old. Stocks are riskier than bonds, and old people can't afford to take as much risk - this is the core idea of "life-cycle investing". Also, obviously, old people have a lot of savings (and hence a lot of income from investments), and not much in the way of wage income. So old people tend to be hurt by unanticipated inflation, while young people are generally helped.

That is the basic idea behind this new paper by Jim Bullard, Carlos Garriga, and Christopher Waller of the St. Louis Fed. they make a model (basically, a variant on the simple old "overlapping generations" model) in which the government wants to please its citizens, but can't enact Social Security or other methods of income transfer. Instead, the government uses inflation to help whichever group has the heftiest demographic weight. If the country's population is tilted toward the elderly, deflation is used to maximize social welfare; if there's a baby boom on, inflation is the most utilitarian policy.

OK, so how does this toy model connect to the real world? In the real world, we are perfectly able to do things like Social Security, so we don't need to use inflation/deflation to redistribute between the young and the old. But in the real world, different age groups may use the political process to skew monetary policy anyway. Or as Bullard et al. put it:
When the old have more influence over this redistributive policy, the economy has...a lower or negative rate of inflation. By contrast, when the young have more influence...wages are relatively high and [there is] a relatively high inflation rate... 
In this paper, we have allowed [our math model] to “stand in ”for the political processes that society uses to make decisions concerning redistributional policy... 
[S]ociety could use other [policies] to achieve similar goals, so we interpret the …findings here as...taking the existing distortionary tax system as fixed and immutable.
Furthermore, they contend, the broad patterns of inflation and deflation seem to follow the age structures of developed countries. Consider the cases of the U.S. and Japan:

It certainly looks like there's a correlation.

Now, for this to be what's really going on, old people must exert some sort of control over the Fed. We typically think of the Fed as independent, apolitical, and technocratic - not the type of institution that would be swayed by the selfish desires of one cohort of the population to extract rents from its descendants. But who knows; maybe the legendary political strength of the elderly somehow filters through to the brain of the Fed chairman.

And if that's true, it means that elderly countries will have a much harder time fighting recessions. If old people's desire for the redistributive benefits of low inflation overwhelms the need for the Fed to boost growth, then we're going to have a much tougher time ending our current say nothing of Japan, where hard money is much more of a cult even than here in the States, and which has been mired in near-deflation for decades.

So next time you throw up your hands and wonder why the Fed isn't doing more to boost the economy, remember Jim Bullard's might be all Grandma and Grandpa's fault!


  1. argosyjones10:17 PM

    "Who benefits from inflation? "Net nominal lenders". "

    Well I think that's a typo?

  2. I have a solution. Teach old people about TIPS. There is no reason that bonds have to be nominal. In fact there are about $1 Trillion of US federal debt indexed to the CPI. There is no reason for people to be forced to choose between inflation risk and stock return risk. Indeed people in the USA and UK don't have to choose.

    As far as I know, there aren't inflation protected municipal bonds. This means that rich old people have to choose between inflation risk, stock market risk and actually paying income tax on their capital income plus expectable capital gains. Oops.

    But I think the real problem is that most old people don't know about TIPS. Now is not the best time to advertise them. A safe negative real interest rate is not very attractive.

    The figures sure are dramatic. I think there is another explanation. The Fed cares about full employment and price stability. In the 70s as the baby boomers and their moms were entering the labor force, this was really challenging. In the event, the Fed managed to avoid persistently high unemployment but not high inflation. Then Volker made the other choice and there was high unemployment for a long time, basically until the labor market had uh swallowed us boomers (even I got a job in 1989 and I was pretty sure I was unemployable).

    I don't have a clear idea how to distinguish. I think indexing public pensions to inflation should affect the politics but not the unemployment accelerating inflation tradeoff (hey did I just say I believe in a Phillips curve without a natural rate -- well yes I did -- I mean that's what the data say). Increased life expectancy at 65 has the opposite effect. The 70s saw a huge increase in US life expectancy at 65 as well as increased indexing (social security COLA introduced 1975). One increases electoral power of the elderly, the other (should have) made them hate inflation less. No test.

    1. I have a solution. Teach old people about TIPS.

      First can we teach them how to use the mouse? Snicker.

    2. In our book The Indebted Society, which was written just before TIPS were introduced, James Medoff and I argued that debt was deflationary because it created a large lender class (which, we sort of hinted, corresponds largely to old people, although we never came out and said it -- but we did note that a lot of lenders live in Florida, a state one of whose senators had proposed a tighter mandate for the Fed). Actually, the idea was suggested to us by John Kenneth Galbraith -- and IIRC he used the word "rentier" when he suggested it.

      We advocated issuing TIPS (though of course the acronym didn't exist yet) as way to get lenders to stop worrying about inflation. I guess it didn't work.

    3. OK, snark aside, yes, inflation-indexed bonds are obviously the way to go. But govt. bonds are the lowest-yielding bonds...why don't corporations issue inflation-indexed bonds? For that matter, why not issue inflation-protected asset-backed bonds?

    4. Anonymous5:09 PM

      these exist in the UK in the form of ground rents (effectively stream of income backed by residential property). Currently one can get around 4% real yield.
      Also a couple of companies have issued inflation protected bonds with slightly positive yields (unlike the government ones that have negative yields at the moment)

  3. "Who are these people? They are old people."

    I think even this overestimates the extent to which old people suffer from inflation. While old people may own more non-inflation adjusted bonds than most, the maturities on these bonds may not be that long-term. To the extent that the central bank avoids pro-growth policies because it is afraid of inflation, this is apt to hurt long-term interest rates, which will eventually come back to bite holders of bonds, when they attempt to roll their holdings over. This is hardly theoretical, there is already significant complaining about how depressed bonds yields have hurt those on fixed incomes.

    Second, old people, especially the poorer ones, still derive a significant portion of their income from social security, which is indexed to wage growth. If a depressed economy leads to low wage growth, this will more than offset any gains from low inflation.

    The people who are really hurt by inflation are banks and bank shareholders. Not only are home mortgages disproportionately long-term, but they rely heavily on short-term leverage. Thus, when inflation increases they lose out both because the real value of their loans increases, but also because their borrowing costs are also likely to increase. Higher inflation means higher nominal rates, assuming real rates stay the same - which can be ruinous if you've borrowed to finance assets with nominal returns.

    In contrast, if both real and nominal rates remain depressed because of a sluggish economy, this will tend to improve the profitability of a bank's outstanding loans, partially offsetting losses due to increased defaults, and a reduction of new lending. This is also what we've seen - bank profits today owe a significant amount to low borrowing costs, which have led to significant profits despite a dearth of new lending (it also helps that mortgage losses have already been accounted for). Thus to a certain extent, banks are partially hedged in the case of a prolonged economic slump that reduces to lending.

    How lucky for them that they also get a vote (five actually) on monetary policy.

    1. Also note how finance sector profits as a fraction of total corp profits has increased since the 80's, as inflation has declined.

      Plus, I don't see any reason to believe that the Fed takes it's dual mandate seriously. They have had no apparent concern for unemployment in decades.

    2. Anonymous5:21 PM

      I don't think that high inflation is bad for the banks, wrote the opposite, as it reduces drastically the amount of non performing loans, and therefore profitability. Especially when coupled with low nominal rates, ideally resulting in negative real rates.

  4. Noah tis whole post seems addressed mainly to people who have significant "investments" - in other words the affluent part of America.

    I understand that in textbook inflation the price of labor rises along with the price of everything else. But in the real world, employers take advantage of rising prices, high unemployment and low worker bargaining power to increase profits by resisting nominal wage increases, thus lowering real wages.

    I also remember quite clearly - although the guilty parties have conveniently forgotten it or buried it under the carpet - that many of the people who are now preaching a higher inflation target were just a couple of years ago frankly arguing that the best reason for such a policy was to lower real wages and production costs to boost exports. So forgive me if I'm not buying their new rationalizations and retreat to the idealized uniform price level phenomena of macroeconomic theory.

    1. So what sort of price path do you think would lead to the highest real wages? Flat prices? Deflation?

    2. The argument you are referring to in your last paragraph is that inflation will reduce real wages more quickly, given that they are above equilibrium already. The long-term path of real wages will be determined by the real economy; temporary shifts from unexpected inflation or disinflation are possible if wages are sticky as you suggest, but only temporary. The only lasting impact is if unexpected inflation or disinflation can move a real wage that's already off the equilibrium path back toward it.

      Further, while people regularly notice these ephemeral drops in real wage, they somehow fail to notice the positive swings on the other side. Perhaps you can make a loss aversion argument for that approach, but that's about it.

    3. I guess I don't buy that kind of equilibrium analysis of the economy, Norman and Noah. I see wages as determined in large part by power relations, not just by impersonal aggregate macroeconomic forces. In a weakly growing economy, wages for the bottom 75% could still rise if political and institutional power is shifting from top to bottom. In a strongly growing economy, wages for the bottom 75% could fall if political and institutional power are shifting from the bottom to the top.

      If prices are stable, the only way a boss can cut his workers' total wages is by instituting a pay cut or by firing some of them. If prices are rising, he can cut wages passive-aggressively or by stealth by simply keeping wage increases behind the rise in prices.

      It seems to me that what is most likely to happen as a result of price-level acceleration under prevailing social and political circumstances is that the income gap will widen even further, the top earners will continue to get large boosts in wages while everyone else falls behind, and the economists will tell us not to worry because wages in aggregate are rising along with prices.

      If there is an age gap in perceptions of the impact of inflation, perhaps one reason is that older people have more experience of how these things tend to play out in real workplaces?

    4. Wow, a labor guy for price stability!

      And I thought I'd seen everything...

    5. I have no firm feeling about price stability, Noah. If you economists can engineer a way to get prices to rise uniformly, with everyone's wages following suit including at the bottom of the pay scale, then I would be happy to see the inflation eating into debt burdens without any other pain inflicted - except on creditors. But it seems to me that when the economists start looking for aggregate inflation, in the real messy world, it is often a scam or tactic for engineering a reduction in real wages.

      Please note that Randall Wray's major 1998 MMT book Understanding Modern Money has the subtitle: "The Key to Full Employment and Price Stability".

    6. OK, but if all other things being equal, inflation is bad for workers (as you contend), and deflation is bad for workers (as most believe), then flat prices are the only option left by power of elimination.

    7. Actually I think Dan Kervick has a point. Of course Noah Smith has already conceded it.

      The left doesn't often frame things this way, but the aim of proper demand growth is to allow real wages to fall when they need to.

    8. Noah -

      You are insisting on some sort of a specific relationship between in/de/nil-flation and worker welfare.


      Ceteris paribus is not a common real world condition.

      Low inflation has resulted in a lot of pain for workers in the past decade because wages have not kept up. Contrast the late 70's when I got a bunch of COLA's in my pay check.


    9. Noah mentioned there was some guy arguing in this comment thread that inflation lowers workers' bargaining power, and hence labor's share of income (whereas I had just finished making the opposite case in another post). Lo and behold who do I find here but Dan Kervick.

      I'm sorry, but this is just utterly preposterous and counter to all the empirical evidence that we have.

      In particular, disinflation during the eighties and the nineties was accompanied by a significant rise in the profit share of national income in most OECD countries or, equivalently, by a reduction in the labor share. This suggests that changes in the rate of inflation are non-neutral with respect to the distribution of factor income. The consequences of disinflation upon inequality thus may largely be the indirect result of the effects of disinflation upon factor shares. The mechanism by which this comes about is fairly simple. Disinflation is correlated to rising unemployment rates, rising unemployment rates lead to lower labor bargaining power, and lower labor bargaining power is correlated with higher markups. Furthermore, lower inflation rates create lower price dispersion leading to less competition among producers to limit markups. This hypothesis was tested with a panel of 15 OECD countries over the period from 1960 to 2000 and a robust positive relationship between disinflation and the labor factor share of income was obtained:

      Furthermore labor has a long history of favoring inflation over deflation going at least as far back as the Populist Party in the late 19th century. You're clearly on the wrong side of the debate on this question.

      The Rentiers would just love to hear you deluding yourself.

    10. Excluded middle! That disinflation could accompany a falling labour share isn't a sufficient condition of inflation necessarily being good for workers. It's suggestion, but it could just be evidence that inflation or deflation as such don't explain changes in the labour share of national income and something else (like the institutions through which inflation and deflation are mediated) is necessary.

      I believe it may have been me that kicked off this particular row, by picking a war with Nick Rowe, and I should like to point out that I don't, in the least, support price stability as an abstract goal.

      I just suspect that trying to engineer inflation, without taking a view on wage bargaining, might have a pathological failure mode. If price inflation gets ahead of wage inflation, this is going to squash the consumer sector and therefore be self-defeating. I say "Wage-price spiral, bring it on!", but I suspect that the 30 years' war on inflation may have destroyed the institutions that made a wage-price spiral possible.

  5. What about the regressive effects of inflation, poor people have less means to cover them selves from inflation, no access to inflation linked financial assets (or no financial assets at all), and lower capacity to buy real assets as a way of saving. Think of an economy with high inequality and permanently high inflation, sophisticated agents will ultimately learn how to perfectly cover them selves from the losses of inflation, but poorer agents don't know how, or they simply don't have the purchasing power to do so, therefore their real wages are continuously falling and being discretely upgraded every couple of periods (once a year or every six months usually).

    1. Carlos, I think you and I may have a different idea of poor people - I'm guessing loads have no assets at all, whether financial, real, inflation protected or whatever. They might have some debts. So inflation either has no effect on their asset position (it's still nil) or helps to inflate away their debts. They depend on wages/social security, not their negligible or non-existent savings.

      If it's true inflation, their wages/social security tends go up. They still might not be able to buy houses/TIPS, but they couldn't before.

  6. Price inflation is actually driven by the age pyramid but not in the sense of old boys controlling it. The driving force is the change in the level of labor force. In Japan, the period of deflation is related to falling labor force and this period will extend into the second half of the 21st centure if no demographic improvements like migration occure any time soon. For the US, the growth in labor force comes to the threshold where deflation emerges. The rate of participation in labor force fell by 2% in 2010 ( This is a huge drop.
    On the surface, one sees old people dominating monetary policy and confuse deep economic/demographic processes with wishes and hopes.

  7. Ben Bernanke himself is quite old...

    I think the correlation is potentially explained by the shift of ideology that has occurred as the population has aged significantly. Furthermore, when this shift occurred the demographics were less tilted towards the elderly, so I don't think the demographics explain the change in ideology itself.

    Interesting paper, though.

  8. Scott Sumner's reply to this (which he hinted at when I alerted him to this argument in his comment section) would be that the tight money that produces sudden deflation/disinflation will tend to reduce real growth even more (as it has), which hurts savers and the older citizens more than the disinflation helps. The Fed's policies have made just about everyone worse off, says Scott, which is why he doesn't buy regulatory capture explanations of the Great Recession.

  9. Anonymous7:24 AM

    High rates of inflation would be useful in our current state to reset relative prices more rapidly.
    Economists, like generals are still fighting the last war, in this case the wage-price spiral of the late 1970s.

    Too many policy elites assume that lower inflation is better and that any step toward higher inflation is one step closer to the next wage-price spiral. This results from bad models produced in the 1980s that misunderstood the wage-price spiral and overlooked the role of fiscal and regulatory policy in ending wage-price inflation and creating the "Great Moderation".

    The question should be, "What is the correct inflation target? What inflation rate do we need to allow relative prices to reset more quickly in the wake of a housing bubble and bust?" A burst of wage inflation would go a long way toward correcting individual balance sheet, paying off loan sharks and allowing relative housing prices to reset. Old people who may wish to sell their home in order to retire have every bit as much at stake in getting relative housing prices and other prices to reset as anyone else.

    We simply do not have wage inflation because the wealthy elites have waged a successful Class Warfare against the Middle Class that has stagnated wages AND made wages less valuable by withdrawing Public Goods and services and replacing them with Privatized, For Fee Services that wealth special interest use to collect more than fair rents from the rest of us. The control over wage inflation is not done at the behest of the elderly, but at the behest of wealthy special interests who want cheap labor and to spend more of our economy on themselves and leave less for everyone else. The Financial sector, that holds assets for the elderly want to protect their profits from money management, and for the short term, wage inflation would see a decline in their profit.

    -jonny bakho

    1. We don't have wage inflation because of the global labor arbitrage. Sure that's something the upper class is exploiting for gains they somehow don't get around to sharing with the rest of their fellow-citizens. Labor used to be ensconced behind the high walls of "medieval castles" (national boundaries) and then the walls collapsed and the marauding Golden Horde of finance capital rushed in to make serfs of the workers. For the Golden boys, it's a sort of "class war of opportunity".

      But why did the castle walls collapse? I don't think this is well explained by a planned conspiracy of the upper class. It's partly to do with technological improvements in transportation and information technology and partly to do with "free trade" ideology which reduces an important insight about comparative advantage to an all-purpose cover-story for not-particularly-free trade practices.

  10. Noah - Mary Poppins clinches the argument as far as I'm concerned.

    1. I'm so glad someone always gets my little references... ;)


    2. I may have played a clip from this movie to introduce bank balance sheets in my Money and Banking course...

    3. "I'm so glad someone always gets my little references..."

      Some of your older readers may be concerned that you have just told them to "go fly a kite".

  11. Anonymous8:12 AM

    If you want to know about the redistributive effects of monetary policy in the U.S., there is actually some empirical evidence on the matter. See this recent paper by Yuriy Gorodnichenko:

    They find that contractionary monetary policy (i.e. that lowers inflation) increases consumption and income inequality, but that this is primarily driven by heterogeneous real wage effects rather than redistributive effects.

  12. I think Steve (Randy) Waldmann at interfluidity beat you to it.

  13. Hey, when Interfluidity posted on this, i though i should check some data and see if i got something, but never figured how I would go through this.

    I haven't yet, but i started with something. I did a linear regression, in all countries and country groups they have at the world bank. (note that this is probably bullshit, time series econometrics done right is kind of screwy, and I'm not doing it right).

    The medium correlation was -12%. The biggest was 93% in Poland.

    In 137/218 countries the relation is negative and in 81/218 the relation is positive. In 160/218 the relationship was statistically significant.

    The medium R^2 of the countries was 11,3% and the medium r^2 of statistically significant only was 12,8%.

    The biggest r^2 was of New Zealand with 63,68%. And the biggest effect was observed in Azerbaijan with a beta of -275.

    I'm still very skeptical of this thesis. There could be relations between age dependency and inflation in a lot of different ways.

    Here's my data, i didn't build it in a organized understandable way, but...Well, if you want to check:

    1. Ahh, I used the GDP deflator, and the dependency rate including only old people.

  14. Anonymous5:45 PM

    Inflation achieving generational distribution is a farse. The fed has not been able to generate inflation because there is no wage spiral, all they have managed to achieve was asset inflation (in both stocks, bonds and commodities) which is the worst of both worlds for the young. Not only can you not find a job, and if you do have one, have almost no bargaining power with employers, rent, food and living expenses keep going up.

    The rich boomers can easily divert their investments to hard assets and likely own property as well as stocks which have inflation passthrough. Meanwhile, I will be forced to pay more and more for necessities and my networth will shrink more and more and my retirement target and house downpayment savings will more and more unreachable. We've already identified that the flow into stocks will continue to be negative as more and more boomers retire, tell me why I should be the last sucker in this ponzi scheme.

  15. Okay, I'm sure I commenting without giving this enough consideration, but, as to that correlation: wouldn't we expect a younger population to more energetic and associated with faster general growth?

    And isn't faster growth associated with higher inflation?

    Do they deal with the possibility that you get anemic growth and thus low inflation or deflation when your population is disproportionately old?

    1. Anonymous3:27 PM

      I think there's something to this - developing countries seem to follow a path of much higher growth than developed countries (catching up) but they also always seem to have fairly high inflation.

      Perhaps growth is a process that overshoots and creates inflation? To some degree?

    2. No, don't be silly. It's much more reasonable to think that central banks adjust their inflation targets based on the percent of the population that's between 15-40 years old.

  16. The real problem is grandma and grandpa run the Fed - just like they run all of our major institutions....

  17. Anonymous11:14 AM

    I would like to see some correlations of inflation and demographcis applying to countires in the 1920s-1930s, where there were strong swings in the inflation and deflation.

    Also, applying these correlations to contemporary examples over the last two decades, like Australia, Israel, Sweden, and Canada would be useful exercises.

    If these correlations between price instability and demographics hold up in the examples above, you would make a believer out of me..