Inflating Our Minds
The hot topic on financial sites for the past few months has been the recent spike in consumer inflation. Last month, we saw inflation jump 4.2% between April 2020 and April 2021, compared to the 1-2% increase in consumer price inflation annually throughout the past decade. Inflation is generally a broad rise in prices for consumers resulting in decreased purchasing power. Every $100 spent in April of 2020 is essentially worth about $104 spent in April 2021. Debates on the value of inflation for an economy have been persistent. Many opponents of inflation point out that it hurts the value of both savers and those who share the largest comparative cost of living, the poor. The Federal Reserve has a goal of 2% inflation annually, a target we have largely missed for the past decade so current inflationary fears are probably a bit over pronounced. Most of the current inflationary effects are considered transitory by many economists because of the slight deflationary period from the beginning of the coronavirus pandemic in March and April of 2020. Essentially, that this is just getting the economy back on track. That, combined with the fact that the Federal Reserve has failed to meet its inflationary target of 2% for many years gives our economy plenty of room to run a bit hot.
But, that said, why do we even want the economy to be inflationary? Why would the Federal Reserve set an inflationary goal? As inflation hurts savers, it also helps those with debt. For every $100 of debt purchased in April 2020 is now worth approximately $96 today. Over a year, this is not much of a hit. But if you were to extrapolate a $100 debt from 1970, it is now has the purchasing power of $15 in 1970. For savers, your $100 bill from 1970 in your wallet may look and function like cash, but has the comparative purchasing power today of $14 in 1970 dollars. This is obviously troublesome news for savers. Now, they have to seek other areas to grow their wealth. Yes, investments are risky, but saving is worse - it is a guaranteed decline in purchasing power. The rich and middle class now have to invest in new businesses and the stock market to grow their wealth, something the middle class relies on in order to retire. If you had invested your $100 bill in the S&P 500 Index instead, you would have $2620 in 1970 dollars today (adjusted for inflation obviously).
Inflation is neither inherently good or bad, but is easily the better of the alternative solutions for our current economy -- deflation or a stagnant economy. Prior to the 1900’s there was very little inflation other than transitory spikes during war times due to increases in military spending. There was little growth in the economy, and the rich in Europe in the 1700s could live off inheritance. When looking at economic data for as far back as the beginning of the industrial revolution, we usually look to the European countries as they have the longest history of economic record keeping. France in particular has the greatest breadth of historical data on their economy.
Due to democratic pressure around WW1, France and many other developed countries followed a similar trend of increasing social spending to strengthen the safety net for their citizens and to provide public housing and jobs. This social spending, in addition to increasing taxes, led to the only large period of redistributive wealth seen in modern economies (since the 1700s). Figure 2 shows the share of wealth of the richest 10% in Europe from 1300-2000.
The only two instances of declining capital share by the top 10% of individuals by wealth were caused by incredible shocks. The first economic shock, in 1347, was immediately after the Black Death. The Black Death was the worst epidemic in human history, killing 30-60% of Europe’s population. After the plague we saw the richest 10% lose 15-20% of overall wealth share of the US economy. Not that the workers prevailed in the immediate aftermath, as between 1348-1350 real wages decreased by 20% for laborers (Fig. 3). Combined with inflation of 27% it is the poor that would face the most harm. It turns out when you lose 30-60% of your population you run into supply shocks, and money circulation had to increase to cope with the large population losses. The wealthy lost more money in absolute terms though, as the poor only had so much money to lose. The poor lucky enough to live through the Black Death didn’t pay for the subsequent depression with money, they paid with starvation and suffering.
After a few years of wage decreases we do see evidence of large real wage increases in many European countries, as well as more modest increases in real per capita GDP for many years. The wage increases eventually stopped rising (even as productivity rose) 50-100 years after the Black Death in many European countries. Looking again at the percentage of wealth owned over time by the top 10% (Fig. 2) we see the shock lasted until about 1700, when the top 10% regained their prior levels of control of capital. The wealthy lost their capital share for those 350 years due to heavy loss in purchasing power due to inflation and having a long period of wage increases for laborers. This combination gave way to a sustained period of low estimated returns of capital. The rich could no longer expect to make 10% annual returns and had to settle for capital returning a rate of 4-6% for over 500 years after the Black Death. The below figure shows the estimated returns of capital in England following the Black Death.
By around 1915, after over 560 years post the Black Death, we witness an even greater loss of capital by the richest 10%. Almost 300 years of constant wealth accumulation and we see the wealthy holding approximately 90% of all capital in Europe (Fig. 2)! Wages no longer rose in line with productivity and the return on capital outpaced the return on labor. Then a sharp decline of wealth held by the top 10%, from 90% of all wealth to 60% from 1914 to 1950, due to the two World Wars. After two global wars, across the United States and Europe, labor made a comeback. The working poor paid an immediate price in lives and starvation during the great depression while the wealthy lost a large portion of their money, thus resetting the concentration of wealth among classes.
The bottom 90% use to be much more poor than they are now. The rich had little reason to treat the working class well and paid very little taxes for social good (Fig.5). There was no middle class as we know it today, merely a class that wasn't quite as bad as the bottom 50%, but still destitute. After World Wars 1 and 2, a middle class emerged in developed society due to inflation and declining return on capital due to increased wages and increased taxation. Taxes on the wealthy were increased to pay for the wars, the recoveries, and the social spending that laborers bargained for such as those proclaimed by the New Deal. Figure 6 shows France, with a bottom 50%, middle 40%, and top 10%. The middle class went from 10-15% of all wealth held in France to 20%, 30%, and then 40% of all wealth. The truly poor, the bottom 50% made slight gains of about 5-10% of wealth concentration.
The emergence of a middle class and the slight, but significant, gains in wealth concentration by the bottom 50% is tied to the decline of rentiers in developed countries, or rather the decline of individuals whose capital income dwarfs their labor income. The low-growth, low tax environment prior to the 1900s gave way to rentiers who relied on inheritance. Capital returns were high enough that, along with low taxes, allowed rentiers to maintain their consumption forever, passing on an inheritance that could maintain the rich lifestyle for their heirs. By the 1950s, rich rentiers earned about 10% of the capital income as their 19thcentury predecessors due to higher taxes, inflation, and the declining nominal return of capital due to increased labor wages repairing shocks from the two World Wars.
The shift of wealth concentration from 1915-1950 in Europe and the United States represented the first large shift in hundreds of years. A middle class emerged and accumulated the largest share of wealth concentration the middle 40% ever had in a developed country. The bottom 10% made out worse than the middle 40% in the shift, but still managed a significant increase in wealth. The middle class is far from the upper class, but it is important to note there is more competition than ever between the classes as well. The difference of capital between the middle and bottom classes led to stratification of the working class and has hurt the progression of labor and unions in the past few decades. Part of that is understandable, money might not be zero sum in the sense that the United States can always print more. But additional money in circulation within the economy does correlate with increased inflation, as the figure 7 below shows.
So after 200 years without hardly any inflation, developed countries around the world were met with the most significant inflation ever seen in modern economies, at the same time, albeit to varying degrees. France and Germany both suffered the largest economic damages from the World Wars and had to print the most money for repairing their damaged countries. A fairly young country, the United States had almost zero inflation for its entire existence. France, Germany, and Britain avoided it except in wartimes. Then, two World Wars happened, and reset the equilibrium of wealth inequality across all four countries as seen below (Fig. 8).
A clear trend of decline in both the top 10% and 1% wealth share is witnessed after 1910 and lasting until around 1970 for both Europe and the United States. Inflation is both a cause and an effect of shifting wealth from the rich to the middle and working class. Inflation causes wealth concentration to decrease in the wealthy, due to them having the most absolute dollars. Inflation is an effect of wealth concentration increasing in the working class, because the working class needs to spend that additional money on essential material needed to live, thus spurring demand and inflating prices.
Inflation is not always preferable, in fact most current consumers are rightly worried of the long-term impacts leaving them worse off in life. Hyperinflation, like the rate of 15% seen in Germany and France after World War 2 could wipe out the retirement savings of much of an entire generation of individuals. At the same time, the suffering of inflation by the working class during the Great Depression is something that gave way to a more egalitarian society. Without inflation, our economy would be much more unequal than today.
Note: You should also notice the United States being a much more egalitarian economy throughout history than France, Germany, or Britain. The United States is a much younger country and never had the time to concentrate wealth upwards to the manner witnessed in the European countries. America represented a resetting of the European economy, with a much more level playing field for the settlers.