Harry Geels: A K-shaped economy is less susceptible to inflation
This column was originally written in Dutch. This is an English translation.
By Harry Geels
Why is it that the relatively high inflation of recent years seems to have had little impact on economic growth, particularly in the US? Part of the explanation may well lie in the K-shaped economy. According to recent analyses, the top 10% of earners account for around half of all spending in this economy.
The lesson we always learn is that inflation is a problem. Ernest Hemingway said: ‘The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring temporary prosperity; both bring permanent ruin.’ Milton Friedman called inflation the most harmful phenomenon in the economy and noted: ‘Inflation is just like alcoholism. In both cases, when you start drinking or when you start printing too much money, the good effects come first. The bad effects only come later.’
Yet something seems to have changed regarding the harmfulness of inflation. Since the coronavirus pandemic, inflation has risen sharply and remained above average for a prolonged period, whilst economic growth appears to have been barely affected, particularly in the US. From the start of 2021, cumulative inflation there stood at around 24%, whilst real economic growth, i.e. adjusted for inflation, was approximately 15%. In the EU, inflation over this period was comparable, but growth was around three percentage points lower.
How is it that, particularly in the US, relatively high inflation goes hand in hand with high real growth? The initial reaction might be that wages have also risen sharply. That is partly true. In the US, wages have, on average, risen roughly in line with inflation, meaning there was no substantial loss of purchasing power at the macro level. In the EU, however, there was a decline in real incomes over the aforementioned period. Wages therefore do not explain the puzzle of relatively high inflation coupled with relatively high real growth. What does, then?
K-shaped economy
Last month I wrote a column on the K-shaped economy, prompted by an analysis in the Wall Street Journal with a striking conclusion: an ever-growing group of (ultra-)wealthy individuals in the US is responsible for a disproportionate share of economic growth and consumption. This is no longer just about visible billionaires, but a broad upper echelon of entrepreneurs, investors and top executives who largely remain out of the spotlight, yet carry significant economic weight.
Four observations stood out. Firstly: the top of the income distribution (particularly the top 10%) in the US now accounts for almost half of all consumer spending. Their spending keeps sectors afloat in which the middle class is increasingly unable to keep up. Secondly, this reinforces a K-shaped economy: at the top, prosperity and consumption continue to grow, whilst at the bottom, purchasing power is under pressure from inflation, higher interest rates and limited wage growth, which is reflected in growing concerns about financial security.
Thirdly, businesses and cities are increasingly adapting to this changing economy. Luxury goods, healthcare, education and services are increasingly targeting affluent customers explicitly, with visible differences between neighbourhoods, schools and local economies. A new trend is the integration of luxury housing and entertainment within exclusive business centres. All of this makes the economy more vulnerable: when stock or property markets correct, confidence can quickly turn, with potentially negative consequences for growth and employment.
The top 10% are not sensitive to inflation (on the contrary)
The argument that inflation is harmful holds true mainly when consumption is broadly based. That is no longer the case in a K-shaped economy. Economically, this means that the marginal consumer has become increasingly wealthy. This has major consequences for the way inflation affects the economy. Aggregate consumption is now dominated by households with a so-called low MPC (marginal propensity to consume): their consumption need only be adjusted to a limited extent in the event of price rises.
The top 10% of the population are relatively less affected by inflation. Firstly, because this group does not spend their entire income, but also saves and invests. With higher inflation, they simply save slightly less. Secondly, alongside price inflation, there is also wealth inflation. After all, the inflationary policies of central banks also lead to rising share and property prices. This increase in wealth has clearly been stronger than price inflation. Since early 2021, US shares have risen by around 85%, whilst European shares have increased in value significantly less over the same period.
It is therefore no coincidence that the US weathered this period of inflation relatively well. The labour market was tight (higher wages), stock markets recovered quickly (consumption supported by capital gains), and the upper echelons of society continued to spend. In Europe, the situation was different. There, consumption is more broadly distributed, wealth participation is lower and labour markets are less tight. The result: significantly less growth for comparable levels of inflation. In Europe, therefore, we are currently seeing the more ‘traditional’ negative effects of inflation more strongly.
Support from other economists
Further research suggests that I am not alone in my view that a K-shaped economy is less sensitive to inflation. Mark Zandi of Moody’s, for example, states: ‘The economy is being held up by the spending of the well-to-do.’ Jason Furman, a professor at Harvard University and former policy adviser to Barack Obama, points out that inflation causes less macroeconomic damage when it is borne by groups that do not need to restrict their spending.
With a more K-shaped economy, the nature of recessions also changes. They may become less frequent, but potentially more severe. After all, this model relies heavily on confidence in assets. When stock or property markets correct, demand can suddenly dry up. The buffer lies not with the masses, but with a relatively small group, and that group may also stop spending at the same time. This makes the K-shaped economy both stable and fragile at the same time: stable in the face of inflationary shocks, fragile in the face of asset shocks.
In conclusion
All this does not mean that inflation has become ‘harmless’. On the contrary, it is more unevenly distributed and therefore politically more explosive. But that is not the same as being macro-economically destructive. Perhaps we need to recalibrate our intuitions about inflation. Not because Hemingway or Friedman were wrong, but because they were looking at a different economy, one in which the middle class was the driving force. That economy is becoming increasingly rare.
This article contains a personal opinion by Harry Geels