Paul Krugman and Inflation

Paul Krugman, who had been on “team transitory” about the current inflation, has become more pessimistic about the outlook. In an April 12, 2022 opinion piece for The New York Times (“Inflation Is About to Come Down — but Don’t Get Too Excited”), Krugman argues that inflation may be coming down in the next few months because supply chain problems will be less of a factor and oil prices may have overshot and will come down.

However, Krugman argues that there is still an inflation problem because wage increases are unsustainable. To show this, he reproduces a graph from the Federal Reserve Bank of Atlanta showing that in April 2022 wages had shot up by 6% over a year. This, he states, is an “unsustainable pace” and “won’t recede until the demand for workers falls back into line with the available supply, which probably — I hate to say this — means that we need to see unemployment tick up at least a bit.”

Krugman, though, fails to note that wages have not kept pace with inflation. The CPI in April rose 8.3% over the year. In other words, the current tight labor market shows the limit of workers’ bargaining power; their real wages have gone down. One could tell a story that the tight labor market has resulted in increased nominal wages, which led for consumer prices to increase even faster than wages. Krugman does not make that argument, and, while it might be correct, it would be hard to prove.

There are different reasons being given for the current inflation. Some blame a too expansive fiscal policy. Another reason, sometimes linked to fiscal largess, is that demand had been suppressed because of the pandemic, and now with the general impression that Covid is diminishing in seriousness, people are spending more.  Others put the blame on the Federal Reserve, which, the argument goes, kept interest rates too low for too long. And, as mentioned, supply chains and labor market tightness are also blamed. Of course, all these factors may be contributing to the current inflation; their relative importance is unclear as is the how long we will have to endure too high inflation.

The Federal Reserve is on course to raise interest rates substantially. The Fed can of course stop the inflation; the question is at what price. Paul Volcker’s judgement in the early 80s was to do whatever it takes given the high inflation of the time. The price was high; but his judgement was that leaving inflation unchecked was worse for the economy and, I am not sure he explicitly said this, the future of our liberal democracy. Most economists and others agree he made the right call, painful as it was.

As the Fed raises interest rates, economic activity will slow down, and unemployment will increase. Krugman is right about that. He seems disconcerted that workers are effectively put on the front line to fight inflation, but the Fed has no choice. The real, long-term problem for the U.S. and other developed economies is the increasing inequality in income distribution. As an IMF annual meeting a few years ago demonstrated, economists are unsure why this is happening and what to do about it. It is a pressing issue. While I cannot prove this, the appeal of the siren call of authoritarianism in the West may be linked to this growing inequality and the anger it causes, though there are likely other reasons too. In the U.S., Democratic Administrations have failed to address the income inequality issue in a meaningful way, and, while those on the right flirt with such questionable measures as protectionism, their policies have usually benefitted those with high incomes.