# Constant real wages can hide a lot of pain

A thing that puzzles economistic types is why the public gets so mad about inflation even when, according to the stats, wages keep up with, or even more than keep up with, prices.

Some explanations are basically psychology. People anchor on certain prices as reasonable, and it takes a while to overcome a kind of instinctive sticker-shock revulsion. Can that box of cereal really cost $8?

There's what one might describe as the fundamental inflation-attribution error: People interpret wage increases as just desserts of their own efforts, but price increases as exogenous phenomona, beyond their control and unfair. As I wrote a while back:

> If a worker earns a constant nominal salary at a constant price level, she just never got a raise. But if a person gets a 4% raise and the price level rises by 4%, her experience is she earned a 4% raise through sweat and skill and staying late, ginning up the nerve to ask, demanding, holding firm. But then Joe Biden came along and took it away from her with his inflation.

There are also explanations that are more objective, less psychological.

When inflation is high, the dispersion of prices and wages is also high. Under zero inflation and constant wages, forward-looking economic calculation is easy. You can think about what you'll need a few years from now, observe how much those things cost, and try to save what you need.

Your plans won't be perfect. Maybe the price of cereal goes up while the price of bacon goes down. In aggregate, there's no inflation, but if you were planning a lot of cereal purchases you'll come up short. Relative prices shift regardless of changes in the overall price level. However, under no or low inflation, only changes due to supply and demand fundamentals provoke changes in prices.

But when the price level changes quickly, the dispersion of price changes tends to increase. Some prices are sticky and increase only sluggishly. Others spike easily. If the overall inflation rate jumps to 8%, but housing increases only 4%, then some substantial fraction of other prices are likely to rise by more than 10%.

Quite directly, this means economic calculation is harder when inflation is 8% than when it is 2%. It's not enough merely to take into account that, a year from now, you'll need 8% more cash to buy the same stuff. Even if you are confident the inflation rate will remain 8%, you face more uncertainty due shifting relative prices of the things you need. If what you'll need next year is very close to something like the CPI "average" bundle, then sure, figure on an extra 8%. But relatively few consumers actually purchase the average bundle. If what you'll need deviates substantially, maybe planning for 6% higher costs will cover you. But maybe planning for 10% higher costs won't.

Even if your wage increases will exactly match the inflation rate, the risk you face of suffering shortfalls increases as the inflation rate grows.

What is true of prices is also true of wages. When inflation increases, the dispersion of wages also tends to grow. Employees with lower bargaining power see their wages grow more slowly than the rate of inflation. They end up taking real wage cuts. Employees who are in demand capture real gains, flitting jobs or negotiating raises to ensure their pay increases more than enough to cover rising prices.

Suppose that, in aggregate or at the median, wage gains exactly match inflation. Let's say roughly 50% see wages grow faster than inflation, and roughly 50% see wages grow more slowly.

When inflation is low, the dispersion of these changes is low, so these differences aren't a huge deal. If inflation is 2%, and a substantial fraction are experiencing 2.5% nominal wage growth while their less fortunate twins experience 1.5% wage growth, the worst anyone experiences is real wages declining by 0.5%. That's not great, but perhaps it's not a crisis, if a given worker experiences that for a year or two. Losers fall behind their more fortunate neighbors by 1% a year. Again, not great, but not a catastrophe.

But when inflation is high, it's a different story. If inflation is 8%, and a substantial fraction experience 10% nominal wage growth while their doppelgängers experience only 6%, then the less fortunate see real wage declines of 2%. That's more than enough to really hurt, a loss of more than $1500 for a typical household. In relative terms, losers fall behind winners at a conspicuous 4% per year. Ouch.

In aggregate, of course, winners exactly match losers. If Joe is suffering 2% real wage cuts and Jane is enjoying 2% real wage gains, shouldn't we just score that a wash?

No, we shouldn't. We know, as a matter of descriptive economics, and presume, as a matter of normative economics, that utility or welfare are marginally diminishing in wealth. Holding the average wage constant and all else equal, the greater the wage dispersion, the lower the welfare. Starting from the same wage, it hurts us more to lose 2% than it benefits us to gain the same 2%. A typical household will not consent to betting $1500 on a flip of a coin.

That's basic, old-school, conventional economics. If we add more psychological, "behavioral-economic" phenomena, like habit formation, endowment effects, and aversion to loss of relative status, the cost of real wage dispersal grows even more.

8% inflation matched, in aggregate or even at the median, by 8% wage growth is much worse than 2% inflation matched by 2% wage growth. Some of that pain is psychological. But higher inflation means higher relative price dispersion and therefore higher risk for nearly all consumers. It means costly wage dispersion not matched to differences in productivity.

When you combine these effects, a substantial fraction of the public ends up losing both gambles. They experience prices growing faster than then headline inflation rate, and wages growing more slowly. The welfare loss this group experiences overwhelms the benefits enjoyed by those who win the same gambles. Everyone faces more risk. Adding zero-sum noise to economic outcomes is not a wash. It's a loss.

← When is the economy good or bad?
↑↑↑
Where am I? →

Subscribe to this blog (`drafts.interfluidity.com`)

E‑mail:
Display Name:
😎