More than just inflation

by Philip Brewer on 20 January 2008 21 comments
Photo: Philip Brewer

With prices up, price statistics that look preposterous to anyone who shops, and the Fed trying to thread the needle of preventing a recession without letting inflation run out of control, I want to make sure everyone knows that we're seeing at least two other issues besides inflation.

Inflation is when the money becomes less valuable. The visible result is higher prices, but it's important to remember that the higher prices are the result, not the thing itself. In general, inflation is happening all the time--sometimes faster, sometimes slower--but it's worth keeping in mind that there are other processes that affect prices, because the best strategies are different in different situations.

Changes in relative prices

One other thing that can look like inflation (but isn't) is changes in relative prices. Relative prices change all the time, of course: the price of text messages goes up, the price of milk goes up more, the price of flash memory cards goes down. Sometimes you get into a situation where the prices of things that everyone buys (food, fuel) go up, while the prices of things that most people don't notice go down. For example, the price of wool just lately has been so low that (except for certain specialty types) it's not even worth the trouble of marketing it, even for farmers who raise lambs for meat and have to shear their sheep anyway.

Relative prices change for many different reasons. Tastes change, leading to higher prices for whatever the hot, new thing is. There are seasonal changes in relative prices both because of what's available and what people want to buy. The weather affects relative prices (seasonal weather, but also short-term changes like a hot day and long-term changes like global warming). Changes in technology are a huge factor in relative prices. Not only technological improvements driving the prices of high-tech goods relentlessly downward, but also new, cheap high-tech goods replacing old expensive alternatives (such as plastic buckets replacing galvanized metal ones).

Changes in standard of living

Sometimes price levels just go down as people overall get wealthier. That's been the dominant trend of the past three hundred years or so. The combination of cheap energy (coal and steam engines at the beginning of the industrial revolution, oil and internal combustion over the past hundred years or so), globalization (letting goods, labor, and capital move to wherever it could be most profitably employed), economic liberalization (letting markets work), and technology have simply made people vastly more wealthy than ever before.

Other times prices levels just go up as people overall get poorer. That has always happened for brief periods--when drought or war destroyed the capacity of people to produce the necessities of life, and when bad government or a lack of government made it impossible for productive people to prosper.

Over the past few hundred years, declines in the standard of living have generally been temporary--often even brief--but that's just happenstance and not a law of nature. Two of the great engines of prosperity (cheap energy and globalization) may be just about played out. That could well mean stable or even falling standards of living, and not the continual increases that we've all grown used to.

Different things, different strategies

All three of these things are going on all the time, but the strategies for dealing with the them are different, so it's worth thinking about which ones are dominant at any particular time.

I wrote a couple days ago on How to live with inflation, which is actually the easiest to deal with, because inflation doesn't really change prices, it just changes what they're called. That is, the price of something was called $1.00 last year and this year it's called $1.10, but the real cost (in terms of hours worked or what other items you could exchange it for) is about the same--wages, salaries, and other prices have all gone up by a similar amount, so you're really in about the same situation you were in before. Each individual circumstance is different, so some people will fare better and others worse, but as long as you're aware of the situation and adapt to the changes, you can live with inflation okay.

Dealing with changes in relative prices

Changes in relative prices can be good, of course, if the prices of things that you buy go down relative to prices of things you don't buy. (People generally don't even notice when that happens, which is why changes in relative prices are so easily confused with inflation.)

For adverse changes in relative prices, though, there are really only two answers. You can adapt by changing your spending choices to buy less of the more-expensive stuff and more of the less-expensive stuff. Or, you can let your standard of living fall.

Everybody does both of these things all the time anyway--you go to the store to buy a roasting chicken, find that the fryer are on sale, and just buy a big fryer and roast that instead. Of course, a frying chicken is a pretty good substitute for a roasting chicken. Often there isn't such a good substitute: Beef gets more expensive so you buy chicken. Chicken and pork get more expensive so you buy lentils. Lentils get more expensive so you buy less. Making do with less is lowering your standard of living. Buying something that you don't like as much is also lowering your standard of living, although perhaps not by as much.

In cases where there simply is no good substitute (whether in an absolute sense, or just because of your family's preferences), changes in relative prices amount to the same things as a reduced standard of living.

Dealing with changes in standard of living

Putting aside reducing saving and taking on debt (which let you live at a higher of standard of living now, but at the cost of a lower standard of living later), the only answer to a drop in your standard of living is . . . to lower your standard of living. This is true regardless of whether the cause is a change in relative prices or a drop in standard of living across the board.

For example, let's say that oil prices go up. At first, this leads to a change in relative prices--gasoline and fuel oil prices rise.

People with a choice don't just take that lying down, of course. They switch to cheaper fuels. The guy who heats with fuel oil but also has a wood-burning stove will track down some wood to burn. A company might cut a production line at a factory that uses fuel oil while another factory that uses natural gas might add a second shift. The result of these actions is to raise the price of substitutes.

Whether they're paying more for oil, gasoline, wood, or natural gas, companies are all going to try to pass these costs on to their customers. They'll also try to hold the line on other costs (such as wages). To the extent that they can't manage either of those things, they'll end up producing reduced profits for the owners. These changes ripple through the whole economy, making everybody less well off--a decline in the standard of living.

The key to dealing with a decline in the standard of living is not to confuse it with inflation. If what's going on is inflation, you can just go on living much as you had been, with some confidence that wages, salaries, and investment returns will all adjust to make things come out even. If you try that strategy when standards of living are declining, you find your savings dropping, your debt rising, and your job unexpectedly at risk. Don't do that.

It's always hard to tell the difference among these things at the time; it only becomes clear after the fact. Fortunately, you can keep yourself on the right track by making the most cautious choices. If prices go up, look for alternatives. When there are no alternatives, buy less. Look for choices outside the money economy, or at least around the edges--grow vegetables in your own garden, make friends with your neighbors who have gardens, join a local food co-op, sign up with local Community Supported Agriculture, learn about wild foods that grow in your region and start to use them. Keep your saving on track and avoid taking on more debt.

To the extent that what's going on is just inflation and changes in relative prices, these choices may result in an unnecessary drop in your standard of living, because wages, salary, and investment returns will end up balancing the rise in prices. But, if what you're seeing is a drop in standard of living, then these are the choices that protect your family. If it's just inflation, then you're ahead of the game--a bit more money to save and invest. If it's not, then you're in much better shape than people who just assumed that everything would be fine.

There are worse things out there than inflation. Be ready to deal with them.

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Guest's picture
Zannie

Dominant, not dominate.

Philip Brewer's picture

Thanks!

Linsey Knerl's picture

A very well-written, easy to understand article.  If only my college economy classes had been so clearly presented.  Thanks!

Guest's picture
professor

How can you state that inflation doesn't change prices? Those of us on fixed incomes tied to the govcorp annual CPI inflationary lie continue to lose buying power. Prices in this area are rising 15% per month over the last six months and that does not reflect gasoline. The reality is that prices are not rising but the value of the dollar is falling. The prices seen are merely indicative of the rate that the dollar value has collapsed. Your advice to eat wild foods is something out of a sixties hippie trip..it's -5F below right now, tough on dandelion greens. Sorry to be harsh Mr. Brewer but you need to get back into Fortran-77 or C++ and leave economics to those grounded in the real world.

Jabulani Leffall's picture

I liked you post and I want to comment on what I really think inflation is but I'll be labeled a pinko. Suffice it say, it's simply the law of diminishing returns and supply and demand. If we stopped buying gas cold and started taking the bus or bike riding or conserving, car pooling, whatever... Agribusiness, Big Pharma, OPEC and the oil cartels their in collusion with would be forced to come off their reserves and bring prices down in order to move inventory. As far as food and produce, there are always cheaper alternatives but brand loyalty and force of habit keeps people slaves to businesses, the bigger ones at least, who raise prices number one create demand number two as a cushion against shortfalls if business falls off or the price of doing business goes up there's your inflation. BTW, the professor makes a good point, the quote un-quote "inflation" people are sqawking about now is due to the falling dollar, which is down because of our trade deficits and the fact that we increasingly can no longer take advantage of a weak dollar and bring it back up because we export almost nothing -- other than culture -- that can't be made for cheap somewhere else.  The puppetmaster is at the Fed and it's pulling the strings and joshing with Wall Street as it is wont to do. I say on a fundamental level, fear, blind consumption and demand causes inflation. You made a great point about alternatives, choices, but unfortunately most people make the same choice over and over again and follow the crowd. More on this later folks......Tune in next week. Great job Phil.

 

Jabulani Leffall

Monetary Gadfly, Common Currency

00000 Broke Blvd. Kitchenette #68 & 1/2

Lowcash, CA 90000-0000

Guest's picture
Guest

Uhm, according to the Austrian school, inflation is an artificial expansion of the money supply. Rising prices are just a symptom.

Philip Brewer's picture

@Jabulani:

I think you're right about the key sources of rising prices just now: people in rich countries buying all the oil they want (even as the supply of oil has stopped growing), together with the attempt to turn food into fuel (ethanol and bio-diesel) so that we can keep to our motoring lifestyle.

Guest is right, though, that the rising money supply is what makes money less valuable. That's what's made the value of the dollar collapse.

The thing is, we're seeing all these forces active at once, which makes it really hard to tell how much of the rise in fuel and food costs is due to inflation (the money being less valuable) and how much is due to suppy and demand and lifestyle issues.

In a few years we'll be able to look back and figure out how much was one thing and how much was another. In the meantime, you've got the right prescription--walk, bicycle, and take the bus more; buy less.

Philip Brewer's picture

@professor:

I've actually coded in both Fortran-77 and C++. The former, though, was a very long time ago--thanks for bringing back some old memories!

It's certainly true that pensions indexed to the CPI aren't growing as fast as the actual cost of living--anybody who runs a household can see that. My point in this article, though, was that a good bit of those changes (especially in the cost of food and fuel) are not inflation, but rather are declines in standard of living. A perfect inflation index (if there could be such a thing) might actually be producing much the same result just now, because a big chunk of the problem is that everyone is poorer now than a year ago.

Indexing for inflation isn't supposed protect you when people are getting poorer, just when the money is getting less valuable. Clearly, both thing are going on just now, and it's hard to see how much of any particular price change is due to one versus the other.

rstlne's picture
rstlne

People whose wages can go up at least have a chance of dealing with inflation. What about retires, people living on fixed incomes, and pensioners whose pensions are not indexed to inflation? They're cornered. That's why inflation is bad.

Guest's picture
Worried

All I can say is that I am worried! I'm being laid off of my programming job this month (can't find another -- all of the jobs are going to India).

Housing prices are falling -- will I be able to sell my house so that I can move to find another job?

I'm a COBOL programmer so you can see that I'm facing age discrimination. I can't afford to retire.

I guess all of this makes me a typical American, huh.

Inflation or falling standard of living doesn't make a difference to me.

Philip Brewer's picture

Whether your standard of living is falling because you're on a fixed income that isn't keeping pace with inflation, because your job has departed and isn't coming back, or because oil prices are rising and aren't likely to get cheap again: The key to surviving a falling standard of living is to let your standard of living fall. Nobody wants their standard of living to go down, but it's better than imagining that it's higher than it is, and living as if it were.

Wise Bread is fairly bursting with ideas for living well on less money. Check 'em out.

Guest's picture
Guest

The demand for a fair standard of living is the basis of what we memorialize on MLK day. There are more and more rich people, making more money than ever in history... and at the same time, many in our country are seeing a decline in real wages, and in some ways a real decline in their standard of living. This is an immoral situation, and must be reversed.

Yes, if we're making less and can't afford the good cheese, definitely eat less cheese or cheaper cheese... yes, if our wine budget is too fat, slim it down. But there are people who need to see the doctor, need to pay for education, and need a safe place to live, who need to have their standard of living improved.

Philip Brewer's picture

On that, I'm with you 100%.

Guest's picture
Guest

"... who need to have their standard of living improved."

Did you mean have their standard of living improved by someone else, or for them to improve their standard of living.

We complain about the rich making more money even as we stick our hands deeper into their pockets asking for more. We complain about the cost of prescriptions even as we depend more and more on "Big Pharma" for extending our lives. "I need..." "I deserve..." "I want..."

This country was built on people working hard and sacrificing -- pretty much what this web site is all about. Tighten your belt, get off the couch and get a second or third job. No excuses. Then one day YOU'LL be in a position to give someone a helping hand.

Guest's picture
Guest

>>>This country was built on people working hard and sacrificing -- pretty much what this web site is all about. Tighten your belt, get off the couch and get a second or third job. No excuses. Then one day YOU'LL be in a position to give someone a helping hand.

This is an untenable non-solution.

The large numbers of low-wage jobs that earn so little money that people have to work two jobs is a social problem. It's okay, even good, to have some number of these jobs so people can enter the working world, but if there are too many of these jobs, it destabilizes the "floor" for middle class people. That is the direction we're headed.

For one, people who are very poor are not able to maintain a healthy standard of living, and can't create what we'd consider a "safe society" where parents are at home at night to raise their children. The "best" parents take second and third jobs, and have no time to improve their situation by going to school, and put their children at risk of neglect.

The existence of a "middle class" depends on huge masses of people with money to purchase things at relatively high prices. Poor people don't buy many things made in the USA. They don't pay for services - they get them from the welfare system. Most of their income goes toward rent and food.

The global dominance of our society depends, to some extent, on people being over-skilled. People acquire skills to climb the income ladder. To do this, they need "free" time after or before their job, to go to school, or apprentice themselves, or self-educate. If people are squeezed, and can't find time for self-improvement, they will be stuck, and inflexible. This is *difficult* when there are economic upheavals, or huge changes to laws that restructure jobs out of existence.

FYI, I *am* helping some people, and have helped others in the past. I don't want to see their economic situation replicated more. I want to see more decent jobs, with health care benefits. I want to see more situations where, maybe people aren't paid that much, but they have insurance benefits and a pension (or there's socialized medicine and a government pension), and the CEO and presidents are making a reasonable amount of money, not these millions of dollars (while their poorest workers get minimum wage and no bennies). I would like for small business owners figure out how to get health insurance for their workers, before they buy a $50K car and a $0.75MIL house.

Guest's picture
Guest

A non-solution? It is THE solution. Work hard, eliminate debt. Purchase a home and pay it off. Focus on education, apply your skills and get rewarded. There are so many people who have followed this path, to question it is ridiculous.

Again, no excuses. Demand more, give more and you'll get more. Is it hard? Yes. Is there sacrifice? Yes. Is there pain? Yes. But in the end, the price is worth it all.

I branched out on own, but didn't succeed. I have debt up to my eyeballs. Life is hard right now -- I have two jobs, my wife has three part-time jobs and we homeschool our kids. For the time being, family game night is a big night out. But that's the price we're willing to pay to right our ship. No complaining, no excuses, we're just going to get it done (with some great ideas from Wise Bread!)

I don't care if a CEO makes millions, or if a small businessman buys a Lexus. I have no class envy. Collectivism failed (see Soviet Union). This country rewards hard work. I look forward to succeeding again -- and then giving back to this great country I love.

Philip Brewer's picture

There are plenty of hard-working people willing to take risks who are willing to tough it out when those risks don't pay off. However, there are also plenty of hard-working people willing to take risks who want the government to step in and "protect" them when the risk doesn't pay off.

As long as you don't go too far, you can make either system work. What we've done just lately, though, is broken in two ways:

  1. We're socializing the risks, but just for rich people. Small businesses that go broke just go under. Big businesses that go broke "reorganize" in a way that wipes out the employees and the shareholders--but that gives huge rewards to the banks and to management.
  2. We're socializing the risks, but not the profits. All those businesses that "reorganize" in a way that wipes out pensions, devastate 401(k)s, and squash wages, turn around and complain bitterly about the taxes that they have to pay once their reorganized business (free of all its old obligations) starts making huge profits.

I wouldn't care about a CEO making millions when his business did well either--except I've seen what happens when the business does poorly. I'll give you a hint--what happens is not that the CEO pays back his last year's bonus and promises to live on $50,000 a year until the pension is fully funded and the stock price is back up to its previous high.

Guest's picture
Guest WG

I feel like I'm not really communicating. :-(

Since we got on the topic of CEO compensation... unions are using their equity in corporations to exert pressure on CEOs. The government is saying this is illegal. Is it right or wrong?

http://online.wsj.com/article/SB120105026345108353.html

Philip Brewer's picture

But as I understand the issue, the pension fund must be managed for the benefit of the retirees and the people who will eventually retire. If the trustees can be convinced that some policy (for example, better health benefits) will improve the long-term success of the company, then it would be entirely legal and proper for the pension fund to pressure the CEOs to institute that policy. The Wall Street Journal article seems to start by supposing that better health benefits would be a pure expense. If that's true, then the trustees would be violating their fiduciary duty by supporting it. (For example, if they supported a policy for the company to turn its profits into $100 bills and then burn them up.)

Sorry you don't feel like we were communicating before. I'm willing to take another stab at it if you are.

Basically, I agree with the philosphy (common here on Wise Bread), that people should live within their means and take responsiblity for their own success. That doesn't mean that I don't have compassion for people who aren't doing so well, though--especially when their situation is caused largely by forces outside their control. For every person who's in financial trouble because they waste their money buying crap they don't need there are at least as many people who are in trouble through simple bad luck such as an illness or accident. There are lots of people who made what seemed like prudent choices at the time that didn't turn out so well. And then there are a few people who were badly ill-used, some by actual criminals, others by people acting legally but behaving unethically. Dealing with those situations on a case-by-case basis is so expensive, that it's often cheaper (and sometimes fairer) to just soften the edges a little. Plus, we're all better off when money is spent on education, sanitation, public health, etc.

Guest's picture
peder

we will see how well the economic stimulus package helps us later in the year. while we are getting a boost in spending confidence now, what will happen later in the year when the stimulus money is all gone.

i have been blogging about this for the past month and i will continue my year long mission to blog about the economic stimulus package. 600 dollars divided by 365 days is a buck64aday.

i am the help the goverment never though they would get. I am spendning my stimulus a buck64aday.

read my story

www.buck64aday.blogspot.com

Guest's picture
Tracy

I am glad you are immune to the cost of living increases. I am not. I watched the cost of housing go up by 40% in Austin and I did not get a cost of living adjustment. As a matter of fact, our wages were frozen for over 3 years. I finally quit and moved back home at 34 years old. My raises did not keep up with the cost of inflation, let alone the cost of living. I have a BS and I am working on a MS. I received my BS in Dec 2007. I have yet to find a job. The gov't in Texas has been under a hiring freeze for well over a year now. I do not see what little money I have going very far. The cost of food has increased so much that my Mom who is on Social Security can hardly afford to buy food. We recently learned she will not be receiving a cost of living adjustment for 2010. She never earned more than what it cost to buy the basics in life. It was all she could do to keep a roof over our heads and food on the table. I am the first to go to college and get a degree. We expected me to pull us out of the poor house. Seems to me the poor house only increased in size.