but *why* do they hate inflation

in which, weirdly, I ask for microfoundations

So … I asked a question to economists on social media the other day, as to whether there is some well-founded and orthodox explanation for why it is that voters, apparently, hate inflation so much.  Because in my view, it is the central puzzle of the vibescession – if real wages are rising (and they are, particularly for the lowest income segments), isn’t it strictly irrational to have money illusion?

I got a lot of answers, most of them[1], in my view basically inconsistent with a Good Old Chicago Price Theory model of a representative agent with perfect information and consistent preferences.  Which was what I was looking for – I wanted to be sure I hadn’t missed anything.  As always, the problem isn’t that macroeconomics doesn’t have fully rigorous microfoundations – it’s that without “ad hoc” assertions like “people attribute wage increases to their own efforts but blame price rises on the government”, fully rigorous microeconomics doesn’t have macroimplications. 

But … I’m still an economist, despite everything.  So some ad hoc stipulations about inflation seem considerably less appealing than others.  Although I can respect points of view like “people attribute wage increases to their own efforts but blame price rises on the government” or “the media screwed up by not explaining to people how the economy was doing”, in my gut I don’t like them.  Because they’re based on assumptions that people will not just be wrong, but stay wrong, systematically for a period of years.  And not just wrong about the aggregates – in most of these kinds of explanations, people have to be wrong about their own situation, their own preferences, or in general about things that you’d really expect them to be able to know.

Which suggests to me that another class of explanations might be more promising as a way to understand what’s going on.  (And as I also rather cheekily suggested, this is an important question, because the basis of the political economy argument for monetary policy independence is that governments have an incentive to create inflation[2], so if they don’t, this might need to be revisited)!

The two papers I’ve linked above share a theme with something I posted about earlier this year, not realising at the time that it was relevant to the vibecession.  In “Hayek’s Hamburger Hell”, I noted that one reason that most businesses don’t adopt dynamic pricing is that customers absolutely hate it, and are very resistant to economists ‘splaining why they shouldn’t.

And what’s inflation, but a kind of dynamic pricing? When the price index rises, it’s summarising a lot of different commodity price movements, some of which can be large in relative terms.  This is particularly true of food and fuel, which are excluded from the “core” measure not because they’re unimportant (they’re not!) but because they’re particularly volatile.  In undergraduate economics you’re taught that this is almost a good thing – the price level shift has an “income effect” (the same nominal income buys a smaller basket of goods), partly offset by a “substitution effect” (you can claw back some of that loss by rebalancing your own consumption bundle to consume more of the goods whose relative price has fallen).  So an identical percentage move in CPI and nominal wages ought to leave you better off – as I say, it’s an easy undergraduate exercise to prove it with curves and lines on a graph.

But of course, the “substitution effect” kind of sucks.  It’s a cognitive load, placed on people who, in my view, really aren’t in any shape to be bearing more cognitive load.  You have to find out what things have changed in relative price, potentially go through an extended trial-and-error period of changing your weekly shop, and so on[3].  If the only way to get your nominal wage increase is to either change jobs or have an awkward conversation with your boss about the cost of living, then that also really sucks.

So maybe the problem isn’t that the pervasive money illusion we’re seeing doesn’t have microfoundations, but rather that the microfoundations themselves need microfoundations.  “Preferences” aren’t just atomic properties of an individual, they are the outcome of the activity of choosing.  And choosing is not only a costly activity, but one which requires resources in limited supply.

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[1] It was also suggested to me that the problem is in the numbers themselves – that the tapering of pandemic-era benefits means that the real wages data didn’t actually describe real personal disposable income very well for a lot of households.  Someone suggested that “if you were only looking at your own pocketbook, the way you would have experienced that period would be that Trump introduced a Scandinavian welfare system and Biden cancelled it”.  I’m not realistically in a position to assess this on the numbers but thought it worth mentioning.

[2] Karl Whelan put me right on this to some extent, saying that the best formulation of the argument was that the government incentive was to run a deficit budget in the year before an election, on the basis that the output boost would be noticed immediately while the inflation took longer to arrive.  But even so – I think it very much affects the case if people really hate inflation these days.

[3] Straying a bit into “structurally incorrect beliefs”, I think it’s also possibly significant when the price index is made up of daily purchases combined with more infrequent consumer durables.  It’s a known phenomenon that people systematically under-report alcohol consumption, because if you ask someone “how much do you drink in a week on average?”, they will give the answer for a typical week, rather than including Christmas, birthdays and special occasions then dividing by 52.