Friday, July 29, 2016

Inflation and wage growth

Last time that we spoke about inflation, we defined it as a raise in price of the things that you can buy with your money like tangible assets (houses), intangible assets (stocks, bonds), consumer goods (food, clothes, laptops), commodities (oil, gas, metals, wheat, coffee). 
Nevertheless, inflation can also affect also the cost of services: for example, education is also provided through a service (you pay the books and, above all, teaching and certifications), and so is medical care (cost of medicines plus the cost of the doctors and hospitalisation), or the swimming pool for your kids or the gym. Nevertheless, when you think about inflation, you do not usually think about raising fees for university or books, or tolls, but you are concerned about raising costs of vegetables, bread, meat, gas and power. That is, something that you usually buy and use. So, that is why you are typically concerned about what is defined as consumer's inflation. 
Inflation is always referred to a precise period of time and to a particular country. It  is of little use to know that the price of a loaf of bread has risen from 1 euro to 2 euro if you do not specify over which period this has happened and in which country. Typically, government provides data for inflation over a period of one year (year-over-year, or yoy inflation rate) or over one quarter of a year, that is quarterly. 

The goods (ie stuff) and services (the work of somebody) that you can buy with your money in a particular moment of your life are referred to as "purchasing power". 
So, if there is inflation in France, you would expect that the buying power of the citizens in Paris decreases: if the current inflation rate is 2% year over year, you can expect that a loaf of bread costs you 2% more this year than last year.
Is it the same for an apartment? or for gas? 
You start to see that one thing is an inflation impacting the cost of a loaf of bread, that you buy every day; another thing is an inflation affecting the cost of a TV, that you buy once every 5-10 years; another thing is an inflation impacting the cost of an apartment that you buy once every thirty years.
In this post, for the sake of simplicity, let's imagine that the same inflation rate applies to everything evenly. That is, both an apartment and the gas and a loaf of bread costs you 2% more every year.
If an inflation rate of 2% yoy is applied to an apartment costing today 300.000 euros, in 5 years the same apartment would cost you 331000 euro, that is 10.3% more.
Let's suppose that your salary is linked to the inflation, that is you get a raise in your salary, each year, equal to the rate of inflation. 
Let's suppose that you get 40.000 euros per year. So, after 5 years, you earn 44.163 euros.

Today, to buy the apartment, you would need 300.000/40.000=7.5 years of your salary
If you buy the same apartment in five years, you would need 331000/44000 = 7.5 years of your salary

If your wage increase keeps the pace with inflation, you would still need 7.5 years of your salary. In this ideal world, there would be no difference between today and tomorrow for your purchasing power. Yes, things cost more; but you also get more money, so there is no issue. You don't care a thing about inflation. Bear in mind that we are assuming that:
1. inflation is the same for everything
2. your wage increases with same rate of inflation

NOTE: Also bear in mind that in this scenario, you are a consumer, that is, you BUY things with your income. And your only defence against the raise in prices is that your income, that is only your salary, grows at the same rate of inflation. More on this in our future post.

Now let's suppose that inflation is still 2%, but your salary is growing up at only half the inflation rate, ie 1%. In five years your salary will be 40.000*1.01^5 = 42000 €.

The apartment today still costs you 300000 € and it requires you 7.5 years of your annual salary to repay it. No change.
But, if you buy the same apartment in five years, you would need 331000/42000 = 7.9 years of your salary

As you can see, you need to work longer, 7.9 years instead of 7.5 years, to repay the house (you lost 2000 euros of purchasing power) Should inflation have been the same, but had the government raised the taxes by 2000 euros in 5 years, the effects for you would have been the same. That is why some people consider inflation as a hidden tax. 

But this is wrong: you see, if it was a hidden tax, like the tax on your income, then you would pay this tax to the government only and the government would increase, or at least, not decrease the quality levels of the services it provides to you. Inflation is different. Inflation affects people differently according to the nature of their income and to the proximity of the source of money creation. But we will deal with this topic in the future. 

We may question: is it true that salaries have been keeping up with inflation in the last years?

Let's have a look at data from US for the last ten years.

The situation is not so bad. 
Let's have a look at the situation for the Netherlands, the country that is hosting me.

The situation is a bit worse. Inflation rate has exceeded the wage growth for years since 2010. Or, putting it in different perspective, the wages were too low with respect to inflation.

Let's have a look at how Italy has been doing.​

Italy is not so far away from the Netherlands.

Italy and the Netherlands share the same currency. It seems that in both cases the situation is worse than in the US.

In any case, everybody in the middle class, overseas in the US or in Europe, is complaining about the fact that they are overburdened with debt and that the wages are not sufficient to raise kids and guarantee them a proper education. At the time of my parents, with one salary, a family father could grow up a family of four. Now, this is no longer possible. 

So, if the graphs show us that at least in last ten years, when we are continuously told that we are in crisis, or not in so good times like in the 90's or 80's, we are not so bad, have all of us a problem of perception, that is we believe we are poorer than our parents but in reality we are in good shape? In other terms, our memories are fallacy and we suffer from a bias in perception? 

Frankly speaking, it seems strange. I mean, we have colleagues, friends, parents, relatives, and, at least in Europe, they say the situation has got worse in the last years. They cannot afford things they once could afford.

So, is it possible that the way the wages and inflation are not computed as they should be, to correctly reflect the real cost that an average family has to withstand?

Let's put it like this. Thirty years ago, to get a decent paid job, you just needed a high school diploma. Now you need a degree. So, you have extra cost that once you did not have. Books, teaching, extra time to study that is taken away from the time you could instead work.
Ten years ago, internet access was much more expensive than today, and suffering from worse quality of service
Ten years ago, gas was much cheaper than today. 
Ten years ago, a car was less expensive than today, but with less optionals
Ten years ago, a television was less expensive than today, but with less optionals.
Ten years ago, medical care was less expensive than today

So, according to the goods (gas, books, television) and the services (internet, medical care) you consider when you compute the change in prices and so estimate the inflation rate, you may say end up saying that inflation rate i 2%, or 3% or 4% or 10%  starting from the same dataset.

It is not that you are richer or poorer, it is that the government released inflation data are not reliable, or that it is a problem of the middle class. Maybe the middle class is suffering, but others (the poorest and the richest) are improving their lifestyles in your country.

  • we need to understand the difference between the median and the average to understand what a middle class is.
  • we need to understand what a regression is, to understand how inflation is computed. 
  • we need to understand what causes inflation.
  • we need to understand who benefits from inflation.
  • we need to understand how we can defend ourselves from, or taking advantage of, inflation.

NOTE: deflation is simply negative inflation, that is inflation with the minus sign.

Until next time.

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