Here's who wins and loses in an inflationary time

If you took out a big loan on a house recently, you're in luck.
Here's who wins and loses in an inflationary time
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Inflation rose at 6.2 percent over the last year, the highest one-year increase since 1990, according to the latest release of the Consumer Price Index.

You might wonder who might be helped and harmed by high inflation—especially if high inflation rates continue beyond this year and throughout the economy. I’ll address that question in the second half of this piece, but before we get there it’s important to distinguish between different types of inflation.

Inflation has two basic causes. There are supply-side causes, where goods and services are getting scarcer or harder to produce. And there are demand-side causes, where people have more money to spend or are choosing to spend their money more rapidly. Who benefits or suffers from inflation depends on which kind of inflation is happening.

Supply-side inflation is just bad and everyone loses

Most of the inflation we’re experiencing now is supply-side inflation, created by real problems with the world economy, like COVID-19. There are essentially no beneficiaries here; stuff got more expensive because it’s harder to produce or deliver under current circumstances. Production can’t keep up, and higher prices are the natural market mechanism for rationing some people out. People end up worse off as a result.

You don’t need much economics training to grasp that this doesn’t have many winners, if any. This supply-side inflation is the best explanation for the relatively low marks that voters give the economy. Real wages per hour worked, in the aggregate, are falling.

There is perhaps one exception to the general rule that nobody likes supply-side inflation: occasionally the market will reward clever people who find a way to make expensive goods cheaper again: if you’re one of those people, good for you! And this is a reward mechanism that helps direct the private sector naturally towards fighting inflation. But it takes time.

Demand-side inflation is worth accepting in moderation

The far more interesting story is about the kind of inflation that policymakers have some kind of handle on: the demand side. Congress and the Federal Reserve can’t control inflation directly, but there is a mechanism available to them. They can accelerate spending throughout the economy by lowering interest rates, cutting taxes, or raising government spending. Or conversely, they can decelerate spending by raising interest rates, increasing taxes, and cutting government spending.

Decelerating spending can fight inflation, and sometimes that is a worthy goal⁠. So why don’t we do it all the time? Because that would crush people’s income. When “spending” collapses, that means revenues at your workplace collapse too, because other people’s spending is your revenue.

Yes, it would be nice if you didn’t have to outbid other buyers for a new car, and instead got the new car at a discount. But remember: if people can’t afford to bid for the new car, they also probably can’t afford whatever good or service you provide that helps pay your bills.

Often, much of a new dollar of spending goes towards hiring an additional worker and getting more stuff produced, not just bidding up the prices of stuff that would already be produced. This explains why policymakers⁠—including and especially the Biden administration⁠—choose to accelerate spending: not all of it goes to inflation, some of it goes to real output.

Currently, spending is about at normal levels, but tilting towards the high end. The Mercatus Center’s David Beckworth has a tracker of the “nominal GDP gap:” essentially, whether Americans are spending more or less than longer run expectations would suggest. Right now, they’re spending more, and that certainly accounts for some part of our inflationary moment.

Demand-side inflation has winners and losers

So what of the spending increases that really do go towards pure demand-side inflation? The spending that results only in higher prices throughout the economy, not new production? Who does this benefit or hurt?

At least in theory, you could imagine something economists call “neutrality of money.” It’s an idea that isn’t true, but it’s instructive. The idea is that basically every dollar-denominated value just goes up or down by the same factor, and nothing happens to the real world; the numbers are just multiplied by a constant. And note that this inflation doesn’t make people poorer, since their salaries or business revenues are rising too.

This is likely what happens in the long run; for example, many Japanese prices are effectively just American prices multiplied by one hundred. But obviously you can’t transition to new values with a snap of your fingers; some prices, some salaries, some dollar-denominated contracts are quicker or slower to adjust than others. And this creates an opportunity for inflation to benefit some people and harm others.

Many analyses fail at this point: they come up with an argument about how looser or tighter policy benefits “the rich” or “the poor.” There are a couple of problems with this: first, this is often a stalking horse for the author’s preferences: the author will claim their policy preferences help the poor more. But second, and more importantly, “rich” and “poor” is not the right dimension for thinking about this particular problem.

Here are some better dimensions:

Some firms use inflation to sneak in real wage cuts

Struggling firms like Dunder Mifflin might be likely to use inflation as a means to cut real wages. (Photo by ajay_suresh.)

For most people, their biggest asset is their job, not any financial account. So it is important to consider how demand-side inflation helps or harms people’s work prospects.

In an inflationary environment, workers worry less about job loss and more about real wage cuts: that is, raises that don’t keep up with inflation. Inflationary times are a seller's market, so many workers can and should be more aggressive in pay negotiations.

But some more precarious workers can't negotiate higher pay, even in a time of high demand. The workers that have to worry about this most are the ones who are paid relatively well for their output. Imagine a well-compensated worker in an industry that used to do well but has suffered in recent years. Someone like Michael Scott of the fictional Dunder Mifflin paper company.

Michael's considerable sales skills were valuable in the past when paper was more in demand, and he was promoted to manager of the Scranton branch. But the overall industry is in decline because of a dated business model, and he is no longer generating the revenue he used to. Nonetheless, he hangs onto the job at a salary no new firm would ever be able to justify for an obsolete role.

Dunder Mifflin might use an inflationary moment to effectively cut Michael’s real wages. In theory, businesses could just cut employees’ wages directly, but this rarely happens, perhaps because it would make employers feel awkward. It would likely be especially awkward if Michael Scott were involved.

Of course, cutting back economy-wide spending might be even worse for Michael; his firm is prone to layoffs, so real wage cuts through inflation may be preferable.

The real wage cuts mechanism is not so much a problem for workers in high demand; yes, they also have to deal with inflation as consumers. But the same high-demand environment that creates the inflation also puts them in higher demand at work. They aren't like beleaguered Scranton branch paper salesmen; their firms genuinely want to keep them around, and the negotiating power is in their hands. Customers are paying more and more and the job needs to get done.

This does not necessarily mean the highly-demanded workers are especially rich. For example, truck drivers today are in high demand, and aggressively pushing for raises, and receiving them frequently; one company has raised pay three times in under a year.

Aggressive balance sheets beat conservative balance sheets

From the perspective of businesses, net worth, and investing, there’s one more framework that is useful: I’ll call it conservative balance sheets and aggressive balance sheets.

A conservative balance sheet means you have little or no debt, and allocate much of your net worth to cash, or assets that are relatively likely to be convertible into cash at relatively guaranteed rates, regardless of broader economic performance. Things like bank deposits, treasury bonds, or high-grade corporate bonds. If you own stocks, or run a company, it’s in something with relatively steady demand like consumer staples.

An aggressive balance sheet is the opposite. You might have student debt for an MBA program and expect to earn that money back through a high salary at a consulting firm. You might have a large mortgage on a house valued at six times your income. You might have relatively little cash on hand, and expect to pay most of your expenses out of your next paycheck. You might put your savings, if you have them, mostly in stock.

Inflationary environments vastly favor aggressive balance sheets. The opportunities for earning more, or getting more profit, are up because everyone’s paying more for everything. And your liabilities⁠—like the mortgage on your house⁠—get smaller.

It’s not always easy to say what kind of people might have aggressive or conservative balance sheets, and it’s certainly not easy to stereotype broad categories like “rich” and “poor.”

Many people shift from one category to another at different times in life. For example, when preparing to purchase a house, my balance sheet was fairly conservative, so as to consolidate the down payment. But immediately after the purchase, I had an aggressive personal balance sheet with a lot of debt.

In a different demand-side environment, like 2007-2009, I might be quite unhappy with my purchase. But the aggressive balance sheet was the right call going into 2020. After several rounds of COVID-19 relief, money is a bit more plentiful than expected, and houses are more expensive than expected.

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