How inflation wrecked the middle class

Inequality is the defining political issue of our time. In fact, it has been at the core of policy making at most times for more than a century, but today, the policy prescription which are applauded by large parts of the electorate (on both sides of the Atlantic) are more severe than they have been since the 1960ies and 70ies, when marginal tax rates in the UK and the US approached 100%. Wealth taxes and steep increases in marginal income tax rates coupled with a vast expansion in public services are targeted at treating the symptoms of a broken system, which has seen the difference between the “haves” and “the have-nots” increase dramatically. But there is little political will to treat the underlying cause, because it is both hard to understand (and hence to sell to voters) and requires unpalatable medicine to be treated. That underlying cause is inflation.

Inflation used to mean an increase in the supply of money, and a s such, inflation would lead to higher prices, when more money was available to purchase an unchanged amount of goods. Today, however, the term has been twisted to mean a rise in prices – as subtle but important change. In the UK, the official inflation measure is the Consumer Price Index (CPI). This is a highly manipulated figure, which is artificially low by construction (as we explain in detail here), but if we were to take it at face value, cumulative inflation in the UK over the last two decades has been just under 50%. This contrasts with a growth in the supply of money (M1) of more than 250%. Wages, unfortunately, have not kept pace. Especially in the last ten years – the period which includes the financial crisis and the subsequent recession, but also the recovery which has led to historically low unemployment – wage growth has lagged even the artificially low CPI inflation: it is up by only 20%.

Conventional wisdom, which is the basis for central bank policy across the world, dictates that the relationship between inflation and unemployment is inverse: if unemployment decreases, the thesis is that upwards pressure on wages will cause inflation to rise. This is the famous Phillips curve which dates back to 1958 and has guided generations of central banks to a simple recipe for monetary policy: interest rates must be raised to dampen inflation when unemployment is low, or lowered to aide employment when inflation is low. The reason why central bank policy is so dovish today, despite very low unemployment both in the US and the UK, is that the inflationary pressure from labour markets has failed to materialise: wage growth is low. Central bankers have been saved from having to increase interest rates.

Those who are familiar with Austrian economics should not be surprised however: there is no obviously deterministic relationship between inflation and unemployment, and if there is, then in a central-bank controlled world it is the opposite of what the Phillips curve predicts: when people are productively employed, there will, given a certain money supply, tend to be downward pressure on prices, as the same quantity of money is used to buy an increasing amount of goods. On the other hand, when unemployment is high, as it was in the aftermath of the financial crisis, central banks react by lowering interest rates, but this only leads to higher consumer prices.

But if low interest rates and a flood of new money has not impacted labour markets in the form of rising wages, what happened? For one, of course, consumer prices have risen dramatically. But the real inflation is in asset markets: house prices have exploded over the preceding three decades and so have stock markets. And this is why the last decades have seen unprecedented growth in the wealth of the richest while people on low and middle incomes, who do not have significant assets, have seen living standards decrease as wage growth has failed to keep up with inflation. The rapidly rising house prices in particular have left whole generations feeling left behind.

This is the real headache for central bankers, and with them, politicians: no-one wants asset prices to fall. Send stock markets tumbling, and the rich will tighten their belts as they see their net worth go south. Ordinary people will have their pensions decimated. Recession will ensue. Even worse, cause a property crash and swathes of the population will see their limited wealth disappear, and the recession will be even worse. It is a political nightmare scenario. When UK house prices collapsed in the early 1990ies it contributed to making the governing Conservatives so unpopular that they didn’t gain power again for almost 15 years. Austrian business cycle theory perfectly explains the credit-fuelled boom which has sent asset prices skyrocketing, but it also tells us that bubbles must be allowed to deflate to permit misallocated capital to be diverted to more productive use. That is the only way for an economy to experience sustainable growth based on sound production, but the pain involved while the bust phase of the cycle persists is politically unacceptable. That’s why politicians will continue to applaud the economic performance of an overheated economy, like when Donald Trump cheers new all-time highs in the Dow Jones. But the fact is, unless they abandon the path we have been on for the last decades they will do nothing to help the poor or the middle classes – the very people they all purport to champion.

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