Inflation and Wealth

~ 1250 words, ~7 min reading time

There’s been an interesting run of the media publishing articles about how great inflation is for ordinary people and how it hurts the rich. As an economist, these strike me as *VERY* weird articles. So, let’s flesh out the argument and what I think is wrong with it.

Basic argument: inflation is good for debtors, bad for creditors

This is correct, but leaves out some really important stuff. So, let’s consider 4 hypothetical people, and show how inflation affects them.

Person 1: Drowning in Credit Card Debt

This person is in very bad financial shape. Perhaps they lost their job during the pandemic, and could only find something paying much less, but didn’t manage to bring their expenses down. This person is renting, and has a credit card balance. They’re currently paying 12% interest on the credit card. They have, however, finally managed to achieve a “primary balance”, so, if it weren’t for credit card payments, they’d be just barely getting by. For these calculations, I’ll ignore that credit card interest compounds, so my estimates for credit card debt a year from now are a bit too low.

Before inflation:

Monthly income (after taxes): $2000
Monthly expenses: $2200
Credit Card Debt: $10,000 (this is growing by ~$300 per month, $100 from interest and $200 from additional charges)
Credit Card Debt 1 year from now: ~$13,600, about 6.8x monthly incom

Inflation happens: raising expenses (except credit card payment) by 6%, and wages by 4%. Interest rates on credit cards also rise to 15%. (Wages have been lagging behind inflation recently, and credit card interest rates have gone up.)

After inflation:

Monthly income (after taxes): $2080
Monthly expenses: $2320
Credit Card Debt: $10,000 (this is growing by ~$365 per month, thanks to a bigger gap between income and expenses and higher credit card interest charges)
Credit Card Debt 1 year from now: $14,380, about 6.9x monthly income

So, in comparison to income, the debt-laden person found their debts get *heavier*. This seems to contradict the basic argument. However, the basic argument assumes *fixed* interest rates (see: most mortgages and car loans in the US). With variable interest rates, interest rates will adjust to at least partially reflect the increased inflation rates.

Person 2: Living nearly paycheck-to-paycheck.

Here we have a person who is basically living paycheck to paycheck, but manages to save about 5% of their income in an emergency fund. Their income is the same as the previous person, but they don’t have the debt burden, and have a better balance between income and expenses – this may reflect that Person 1 was probably unexpectedly earning less than they were used to, while Person 2 has had time to adjust their life to their income. Like Person 1, this person is a renter – so all of their expenses are subject to inflation.

Before inflation:

Monthly income (after taxes): $2000
Monthly expenses: $1900
Accumulated savings: $1000 in a savings account earning 0 interest, saving $100 per month.
Current Savings = 53% of monthly expenses
(This was pretty close to “me in grad school before I got married” – though I did have some investments.)

Then, inflation strikes. Prices go up 6%, but wages go up 4%. (Recently, wages have been on the way up – but have been lagging behind inflation.)

After inflation:

Monthly income (after taxes): $2080
Monthly expenses: $2014
Accumulated savings: $1000 in a savings account earning 0 interest, saving $66 per month.
Current savings = 49.7% of monthly expenses

So, this person is *clearly* worse off. Their ability to save has been cut by 34%, and the value of their savings has been eaten into, making that emergency fund less of a cushion than it was before.

Person 3: Middle-class with Mortgage

Now, we have someone who earns a bit more, and is setting aside significant savings (20% of their income). But, like most people in the middle class, their main asset is their house. Their income comes from wages or salaries.

Before inflation:

Monthly income (after taxes): $5000
Monthly house payment: $1000
Monthly other expenses: $3000
Monthly expenses (total): $4000
Saving: $1000/month (20% of income)

Assets:
House: $150,000
Savings Acct: $20,000
Stocks: $100,000
Total: $270,000 – 67.5 months of expenses

(Note: I’m ignoring the mortgage itself here, since its value is fixed. Also, if that house value looks low – remember, I live in NE Ohio. Houses aren’t nearly as expensive here as most places.)

Inflation happens – 6% increase in “other expenses”, 4% in pay. House prices follow inflation rates, and stocks do better than that, earning 20% (approximately correct for this year).

After inflation:

Monthly income (after taxes): $5200
Monthly house payment: $1000
Monthly other expenses: $3180
Monthly expenses (total): $4180
Saving: $1020/month (19.6% of income)

Assets:
House: $159,000
Savings Acct: $20,000
Stocks: $120,000
Total: $299,000 – 71.5 months of expenses

Here, the result is a bit less clear – in terms of assets, the person is clearly better off, judging by months of expenses covered by the assets – because stocks did so well. However, saving has become slightly more difficult. But, thanks to the mortgage payment being fixed, they can at least save more in dollar terms than before, unlike Person 2 who didn’t have the benefit of any of their expenses being fixed.

Person 4: An Independently Wealthy Person

Here, I’m imagining an independently wealthy person. They have a bunch of assets that they can live off of – so they don’t have any “earned” income. Let’s say that it breaks down roughly like the overall holding of assets for US households as a whole. (This might seem like a weird assumption – but we have quite a bit of wealth inequality, so it’s not *way* off to do things this way.) 30% is in nonfinancial assets that will follow the inflation rate (6%). 15% in cash and bonds with fixed values, and 55% in stocks and business equity that outperforms inflation (20%). I’m going to arbitrarily say that they have assets = 100 months of expenses to start out, and that all expenses are affected by inflation.

Before inflation:

Monthly expenses: $100,000

Assets:
Nonfinancial Assets: $3,000,000
Cash/Bonds: $1,500,000
Stocks/Equity: $5,500,000
Total: $10,000,000 – 100 months of expenses

After inflation:

Monthly expenses: $106,000

Assets:
Nonfinancial Assets: $3,180,000
Cash/Bonds: $1,500,000
Stocks/Equity: $6,600,000
Total: $11,280,000 – 106 months of expenses

So, this person is certainly made better off, though, measuring *just* from how much assets/expenses increased in % terms, the middle-class person with a mortgage benefited slightly more (about a 7% increase v. a 6% increase), thanks to the fixed part of their expenses.

Conclusions

While I developed all of these examples in good faith, we shouldn’t take them *overly* seriously. For example, while I do think that, in general, the wealthy gain from inflation while the poor lose, these illustrations were intended instead to make a few points:

(1) People with fixed expenses gain from inflation. In our example, that was just the middle-class with a mortgage. Everyone else was made worse off, or, in the case of the wealthy, had their gains offset, because of inflation hitting expenses harder than wages. (Aside: Robert Kiyosaki has suggested that really poor people don’t have debt, since they can’t qualify for it. I think this isn’t actually true now – instead, the truth is that poor people have *particularly bad*, variable payment debt.) It’s not as simple as “debtors gain”, since some debts have variable interest rates which tend to rise in inflationary environments. So, the *type* of debt matters.

(2) People with assets with variable values can gain from inflation. In this case, that was “stocks” – which benefited the wealthy and middle class particularly.

It is true that, for any particular fixed payment debt, the person who is paying it is made better off if inflation happens, and the person receiving the payment is made worse off. But, we shouldn’t be too quick to assume that the debtor is poor or the creditor rich.

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