"We might entertain the hypothesis that, when ‘everybody’ complains of being worse off in the face of reportedly unchanged real per capita G.N.P., they may be right."
Axel Leijonhufvud, Information and Coordination, p. 257
"Everybody" seems to hate inflation. Yet modern economists often have a difficult time understanding why. According to most economic models, the cost of moderate inflation is not very great. Are non-economists merely confused? Or are economists missing something important?
As the quote above indicates, I tend to side with the ordinary people who intensely dislike inflation. I believe that many economists take too narrow a view of how inflation affects the economy and the people who work and trade in it. Thus, I have a whole laundry list of ways in which inflation imposes costs upon people.
We measure in prices. Businesspeople make decisions on the basis of money flows: revenue, cost of inputs, dollars of profit, and so on. To make good decisions, businesspeople must have accurate information. Inflation affects the price system the way static electricity affects AM radio signals. "Noise" or "static" makes the radio signal difficult to hear. Similarly, inflation causes prices to change more frequently than they would otherwise and in ways that inject "noise" into the market’s information system – the system of relative prices.
If business managers misread prices, then they are apt to misallocate resources and capital. Resource misallocation refers to producing too much or too little because of misreading the true relative price of the good being produced. It can also appear as mistakes in production: buying too much of one input and too little of another because one appears to be cheaper. Resource misallocation reduces the efficiency of production and the profits earned by firms.
Capital misallocation also occurs. Firms invest in new factories that later prove to be unprofitable. They are then forced to close the plants and write off losses. Huge amounts of savings are wasted during inflationary periods as firms enter into projects that they would recognize as unprofitable were price signals not obscured by inflation.
The text discusses two types of transaction costs: shoeleather costs and menu costs. Shoeleather costs refer to the costs of engaging in more financial transactions as the cost of holding less money. Since money loses value during inflation, people economize on their holdings of money. Instead they hold mutual fund shares, or equities, or bonds that offer higher rates of return than money. But to carry out transactions they need money. Thus, they must engage in an endless series of financial transactions, transferring funds from illiquid accounts to liquid accounts to make payments. This takes time and effort and often involves some monetary cost.
Menu costs refer to the costs of changing prices. Most businesses don’t change prices all that frequently. In a noninflationary period, most prices probably change once a year or less. Part of the reason for such stability is that changing prices involves some costs. New price stickers must be tacked on or, at the least, new prices must be entered into the computer. Perhaps new catalogues or new price lists must be printed. Changing prices more frequently adds to costs.
When prices change, some people win and others lose. We regard this as acceptable when individual prices change either because consumers change their valuations of goods (demand changes) or costs of production change (supply changes). But inflation does not reflect changes in consumer preferences or changes in production costs; inflation reflects a decline in the value of money. It serves no social purpose, but it redistributes income anyway.
We enter into all sorts of long-term contracts. As members of households, we save and borrow. If we buy certificates of deposit or bonds paying a nominal rate of interest, and the inflation rate rises, we end up earning less in real terms than we expected. The real interest rate is lower than we expected. As savers, we lose. On the other hand, if we are paying a fixed interest rate on our mortgages and inflation rises, the real interest rate also falls; we win and the lender loses.
Since the changes in individual prices during periods of inflation are not all equal, some people gain and others lose. The gains and losses are completely independent of whether the gainers or losers "deserve" the change in wealth. Thus, people are understandably unhappy when they lose in the redistribution game.
Another related issue is the effect inflation may have on worker behavior. During noninflationary times, workers work hard to earn merit raises, which add a percentage point or two to the increase in wages received by average workers. But what’s a percent or two if inflation is running 10 percent? Workers are more concerned with keeping up with the cost of living than with merit raises. Incentives suffer.
A likely result of general economic unhappiness is an increase in the number and intensity of demands for government to "do something" to rectify the situation. People who perceive themselves as being treated "unfairly" want the government to pass legislation to lessen their pain or to help them overcome it. Rather than supporting equality of opportunity, people begin to demand equality of outcomes. If the process is perceived as unfair, many voters will cast their ballots for candidates who promise to focus on results, rather than processes.
In this way, inflation can erode the rule of law that is so important to a productive, growing economy. Private contracts, which are subject to arbitrary losses (or gains) brought about by inflation give way to government actions designed to produce particular results. Never mind that the government is the source of the inflation problem, or that inflation-induced distortions of the tax system contribute to the pain. Many countries emerge from inflationary periods with more regulated, less efficient economies than they entered with. Perceptive people – if not theoretically inclined economists – recognize such a political transformation as a very costly effect of inflation. No wonder people want to avoid inflation, even if shoeleather costs are small.