Inflation and the Redistribution of Nominal Wealth

The paper asks: “what would happen to the distribution of wealth among various types of economic agents if the United States were to enter a moderate inflation episode like that of the 1970s?” (Introduction, p. 1). It answers in two steps: first, it documents postwar nominal asset and liability positions for households (by age, wealth class, and instrument), the government, businesses, and foreigners, using the Flow of Funds Accounts and Survey of Consumer Finances; second, it performs “a simple thought experiment” – revaluing those documented positions under an assumed 10-year, 5-percentage-point-per-year inflation surprise – “if the real effects of inflation were due exclusively to the revaluation of nominal wealth, who would gain and who would lose?” (p. 1).

“For most securities, the data consist of book values that are hard to interpret and compare. We therefore construct the stream of future nominal payments associated with every major class of security, and then restate all positions at market value… [which] also allows us to estimate the duration of agents’ positions” (Introduction, p. 2). This matters because, as the paper’s results show, the redistributive effect of an inflation episode that is anticipated only gradually depends not just on the size of a position but on how long its payments are locked in at pre-inflation nominal terms – information book values do not reveal.

Under Full Surprise, “the nominal term structure remains unchanged, but the value of a dollar at date t is reduced to exp(-ΔT) by the jump in the price level,” so “the percentage gain or loss on a position is… independent of the maturity of that position” – agents are assumed not to adjust portfolios during the episode at all, or equivalently to always be surprised anew (Section 3.1, pp. 12-13). Under Indexing ASAP, “the new inflation path is announced at the end of the benchmark year, and bond prices immediately adjust,” with agents assumed to reindex “as soon as their nominal positions reach maturity,” so losses on short-duration positions are small and losses grow with duration (pp. 12-13). The paper is explicit that Indexing ASAP is “a lower bound on redistribution effects” and Full Surprise “an upper bound,” together bracketing plausible real-world episodes in which inflation “occurs in several surprising bursts” (p. 13).

“The early 1980s were a watershed”: before 1980 the household sector was the major net nominal lender in the U.S. economy, with the postwar reduction in government debt offset by rising business-sector debt, but starting in the 1980s “government and mortgage debt began to grow quickly, relative to GDP, and the rest of the world became a major net nominal lender” (Introduction, p. 2). By the early 2000s mortgage debt reached “a historic high relative to GDP,” and foreigners held more U.S. nominal assets than domestic households – a structural shift the paper shows fundamentally alters who bears inflation-induced losses across benchmark years.

“Under either scenario, the government is the only winner among end-user sectors; both domestic households and the rest of the world lose” (Section 3.2, p. 14). For the benchmark year 1989, interval estimates put government gains between roughly 5.1 and 15.0 percent of GDP depending on benchmark year and scenario (with historical extremes as low as 1.4-6.4 percent for 1981 and as high as 11.5-22.9 percent for 1954), while domestic households and foreigners lose; the paper notes that after the 1980s shift, “an inflation episode would have mostly amounted to a tax on the domestic household sector, with little effect on foreigners” only up through the early period, whereas later benchmark years show foreigners bearing substantial losses too (Section 3.2, pp. 14-15).

“The main losers from inflation are rich, old households, the major bondholders in the economy. The main winners are young, middle-class households with fixed-rate mortgage debt” (Abstract). For 1989, a coalition of rich and old households loses between 5.7 and 15.2 percent of GDP in present-value terms, with “about two-thirds of this loss” accruing to the top 10 percent of the wealth distribution; on the winning side, “about 75 percent of the total gains in the household sector benefit middle-class households under the age of 45,” who receive gains “worth up to 45 percent of mean cohort net worth” (Introduction, p. 2). Table 5’s cohort-level breakdown shows close to three-quarters of the youngest households gain (averaging 46-135 percent of annual income), while nearly 85 percent of the oldest households lose (averaging 50-150 percent of annual income) (Section 3.3, p. 18).

“A key innovation of the late 1970s was the introduction of mortgage-backed securities… this securitization led to an increase in the duration of nominal positions of both foreigners and domestic households. At the same time, securitization reduced the maturity mismatch in the financial system and, hence, shifted the risk of gradual inflation from financial system shareholders to bondholders” (Introduction, p. 2). Comparing benchmark years, “for a surprise inflation episode, the losses of elderly domestic households are reduced by half” between 1989 and 2001, while for a gradual episode the reduction is only about one-third, “because the portfolio shift toward longer-term assets makes households more vulnerable to gradual inflation and thus partly offsets the effect of smaller overall nominal positions” (p. 3). A worked decomposition for the middle-class 56-65 cohort shows the Full Surprise loss falling from 5.5 to 2.2 percent of net worth between 1989 and 2001, driven by smaller losses on short positions and larger gains on mortgage debt and indirect equity holdings, even as losses on long bond positions actually rose (Section 3.4, pp. 18-19).

“The effect of maturity on the size of the loss under Indexing ASAP becomes less pronounced as the inflation rate increases” – at 5 percent inflation over 10 years, a payment due in five years loses about 40 percent of value under Full Surprise but only about 20 percent under Indexing ASAP (half the loss), whereas at 25 percent inflation the two scenarios converge (92 percent versus 75 percent loss), and “in the extreme case of a hyperinflation, even payments due in a few months would be wiped out almost entirely, regardless of the expectations scenario” (Section 3.1, p. 13). This is why the paper finds duration matters most for moderate, gradual inflation episodes and least for very large or fully unanticipated ones.

The authors frame this study as isolating “the effects of inflation through changes in the value of nominal assets” alone (Abstract) – a partial, accounting-based exercise, not a general-equilibrium assessment of inflation’s aggregate real effects. The conclusion states two questions left open here: “how macroeconomic aggregates respond to a redistribution shock caused by an inflation episode… Do the responses of individual households cancel out, or do aggregate consumption, savings, and labor supply react?” – addressed in the companion paper Doepke and Schneider (2006a) – and how “fiscal policy… could offset or reinforce the redistributional effects,” since the government’s large gains in every experiment imply the budget constraint requires some fiscal adjustment, addressed in Doepke and Schneider (2006c) (Section 4, p. 19).

The authors position their contribution against two literatures: an older empirical literature on 1970s high-inflation redistribution (Bach and Stephenson 1974; Cukierman, Lennan, and Papadia 1985), which “lacks… the integration of sectoral and household data and the inclusion of indirect nominal positions and market-value adjustments,” and a literature on inflation-tax incidence through differential cash holdings (Erosa and Ventura 2002; Albanesi 2006), from which this paper differs because “we are concerned with unanticipated shocks on all nominal asset holdings, of which cash holdings are only a small part” (Introduction, p. 3). It also builds on Bohn’s (1988) point that debt revaluation can insure government finances against real shocks, extending that logic to a full household-level accounting of who ultimately bears the corresponding losses.