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Can Unions Cause Price Inflation?

Mises Daily: Thursday, January 10, 2008 by

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Central banks around the world have painted themselves into a corner as of late, as their plans for injecting hundreds of billions of dollars worth of credit into the financial markets butts up against their desire to avoid massive price increases. Rather than take the blame for this predicament, the financial central planners have characteristically started pointing fingers elsewhere. In the January 5–6 weekend edition of the Wall Street Journal, we learn that it is apparently unions who are now at fault:

European trade unions are preparing aggressive pay demands for 2008…. This is sure to grate on [European Central Bank] President Jean-Claude Trichet, who has been escalating his warnings that a wage-driven boost in euro-zone inflation would provoke an increase in official interest rates. The ECB calls it "second-round" inflation effect, which essentially doubles existing inflation as workers demand higher wages and companies pass on higher costs to customers. ["Europe Unions' Wage Agenda Likely to Vex Central Bankers," A4]

In the present article we'll try to sort these complicated issues out, but first we need a quick primer on monetary theory. Now I warn you, the following section will be more difficult to digest than an episode of the Colbert Report, but we'll make it as painless as possible. On the bright side, the reader's thinking on inflation will be much clearer when it's done.

THE PRICE OF MONEY

The "price" of money is how many units of goods and services a person needs to give up, in order to acquire a unit of money. It is the reciprocal of what we normally think of as prices (quoted in money). For example, if a car is $5,000, then one dollar has a "price" of 1/5,000 of a car. Or, if a gumball is 25 cents, then one dollar has a price of four gumballs.

It sounds funny to talk like this, but the oddity reflects the great service that money performs: by always constituting one side of every transaction, the money good allows us to think of "the" price of everything else merely in terms of its money exchange rate. If there were no single item that everyone traded against — in other words, if every seller didn't first acquire money before seeking out the things he or she ultimately desired — then there would be no single exchange rate that everyone would agree on, when quoting prices. People who really cared about gumballs might go around, thinking, "That item's worth 42 gumballs. That massage would cost me 3000 gumballs" and so forth, while somebody else might view the economy in terms of cars.

Unfortunately, we can't use the convenience of a single number for the "price" of money, simply because this is the one good it would be silly to price in terms of money. We learn something about the state of the economy when we know that a car has a price of $5,000, while a gumball has a price of 25 cents (i.e., 0.25 dollars). But it doesn't really tell us anything if we say that one dollar has a price of one dollar, even though that's a true statement.

The price of money, therefore, can be quoted as any of the millions of possible exchange rates with other items in the economy. Generally speaking, the price of money is its purchasing power, which is the inverse of what people mean by "the price level," although that's a very sloppy term. It would be less misleading to speak of the price array or price constellation. The popular term price level is misleading because we can express the purchasing power of money only by listing the millions of exchange rates it has against every good and service in the economy, and there is no reason for this list of numbers to change uniformly over time.

So we see that money has a price, just like other goods, but that expressing the price is a bit uncomfortable, precisely because it is money that makes it a snap to express the price of every other good (and service) in the economy. To put it in other words, it's not that it's difficult to express the price of money — rather it's that money itself makes it easy to express the prices of all nonmoney items.

PRICE SET BY SUPPLY AND DEMAND

As with everything else, the price of money is determined by supply and demand. The supply side is easy enough; at any moment, there is a definite amount of dollars — both in people's wallets and also their checking account balances — in the world. (A note to gold bugs: I am going to speak of dollar bills, rather than ounces of gold, so as not to confuse the modern reader. Naturally I am not endorsing fiat currency over commodity money.)

But what of the demand side? Can economists analyze the "demand for money" the same way they look at the demand for plasma screen TVs?

"As with everything else, the price of money is determined by supply and demand."

The answer is yes, but we first need to be clear about a common confusion. When it comes to money, the beginner should think in terms of stocks, not flows. At any point in time, every single dollar bill is owned by someone, and is part of someone's cash balance. There is no such thing as money "in circulation," to be contrasted with "hoarded" money. All money is being hoarded, in the sense that every last dollar bill is always being held by someone who — at that precise moment — considers it more advantageous to hold the marginal unit of money, rather than to exchange it for something else. (Of course, many dollar bills are being held in the cash balances of the owners of grocery stores and banks, and are sitting in the tills of their establishments. But this money too is part of cash balances; it's not "in circulation.")

In theory, there are all sorts of reasons that people might desire to hold cash balances. There might be people who adore the US presidency, for example, and can't believe how little they have to work in order to acquire yet another wallet-sized portrait of those handsome gents.

However, the main element constituting the demand for cash balances is the expectation of its purchasing power in the future. Strange as it seems, the cash sitting in your wallet or purse performs a service just by sitting there. It reassures you, in the same way that having a fire extinguisher under your kitchen sink reassures you.

Let's think about this a little more. If your teenage son came home from Sam's Club with six years' worth of bottled water, and proudly explained that he had emptied out the family checking account because there was "such a good deal," this would be incredibly stressful. And note that the precise reason for your anger would not be whether or not your son overpaid for the water, but rather that he drew down your cash balance and invested it in goods that were far less liquid (in the economic, not physical sense!) than cash.

At any given time, people want to hold a certain amount of purchasing power in the form of liquid cash (or completely trustworthy checkbook deposits). This desire constitutes the demand for money, and interacts with the supply of money to yield the price of money at that moment. In equilibrium, the available stock of money is distributed into all of the cash holdings of everyone in the economy, and all of the money prices of the various goods and services are at just the right amounts, so that each person is holding the desired amount of purchasing power.

Before leaving this section, let's go over a popular thought experiment to make sure we understand how to use this framework we've developed. Suppose one day that a helicopter drops extra dollar bills into everyone's back yard. What will happen?

The first, immediate effect will be that everyone who picks up the new money will have a higher cash balance (both in terms of absolute dollars and in purchasing power) than before. Let's suppose for simplicity that everyone originally had $1,000 in cash, and now the helicopter has doubled everyone's cash balance to $2,000. If the prices (quoted in dollars) of goods and services don't adjust, then people will be holding more purchasing power than they want to maintain. To be sure, people may always want more wealth, but they don't necessarily want to hold it in ever-larger stockpiles of cash.

If the demand for cash remains the same, then the only way to restore equilibrium is for the (money) prices of goods and services to rise. If we simplistically assume away all the real world complications of timing and so forth, we can imagine that the dollar price for every good and service in the economy doubles, as people rush out to spend some of their newly found money. Then things are back to how they were before the helicopter drop. People now hold $2,000 in their cash balances, but because prices have doubled, this represents the same purchasing power as it did before. The injection of new money hasn't created any real wealth, it has simply caused prices to rise. (And again, we are ignoring all of the distortions due to the adjustment phase.)

For those who like to think in terms of the dreaded graphs of undergraduate economics, what happened in the helicopter example is that the supply of money increased, while the demand for money stayed the same. This means that the price of money had to fall, i.e., the dollar prices of goods and services had to rise, making a particular unit of money less valuable relative to other items.

CAN UNIONS CAUSE PRICE INFLATION?

We can now return to the original issue: if union agitation leads to wage increases, will that cause prices in general to increase?

The quick answer is, "No, not if the demand for money remains the same." If unions succeed in wage hikes, and employers raise the prices they charge consumers to maintain their own profit margins, and the supply of money remains the same, then something else has to "give." Either the prices of goods and services in nonunion sectors have to fall and offset the union sector hikes, or people's cash balances need to fall, in terms of their purchasing power.

Remember, it is a mistake to think that the workers are sucking money out of the economy; the workers are a large portion of the consumers, after all. Rather, if the number of dollar bills remains constant, while prices in general go up, then cash balances (measured in purchasing power) must fall. This could be true even for the workers who achieved large pay hikes. They might consider their financial position superior to their previous one, but even so the amount of cash in their wallets and checking accounts could be uncomfortably low compared to the higher prices of the goods and services they want to buy in the coming weeks and months.

As we said above, if the demand for cash balances remains the same, then this situation cannot last. People are not holding enough purchasing power, and so they restrict their purchases in order to build up a larger stockpile of liquid funds. Merchants will experience a decline in sales, and will have to slash prices if they want to stay in business.

PIG to Capitalism $20
"It is the central bankers who continually add new dollars to their respective economies."

To repeat our conclusion: unions (or OPEC countries, for that matter) cannot change the supply of money. If their actions do not somehow indirectly alter the demand for money, then they clearly cannot change the price of money. In other words, unions can't directly cause price inflation. By distorting relative prices and insisting on inefficient workplace rules, they certainly hamper the economy, no question about it. But it is wrong to blame unions for rising prices.

CONCLUSION

In closing, I should acknowledge that there is a way for the European Central Bank story to work. The above framework doesn't rule out the theoretical possibility that union agitation leads to wage hikes, which in turn lead to general price hikes, and that a resigned populace shrugs its shoulders and accepts the lower purchasing power of its cash holdings.

However, I think in practice the population will react by "spreading the pain." Rather than directing the hit fully into depreciated cash holdings, people will cut back on their discretionary purchases. This greatly mutes the alleged power of the unions to raise prices in general, especially if the initial wage hikes are limited to a few industries.

No, when it comes to the reasons for rising prices — especially as this price inflation occurs year in, year out — the true culprit seems clear enough: it is the central bankers who continually add new dollars (and euros, etc.) to their respective economies. Rather than worrying about union-inspired "second-round" inflation, the ECB should focus on its own first-round inflation.


Robert Murphy is the author of The Politically Incorrect Guide to Capitalism. Send him mail. See his articles. Comment on the blog.