This article is based on a paper delivered January 6, 1975, at a monetary conference in Miami Florida.
Both general economic and purely monetary theory are supposed to have made immense advances since the middle of the eighteenth century, yet the confusion and chaos in economic and monetary theory have never been greater than they are today. One would think, listening to television and reading the newspapers and magazines, that inflation — in the popular sense of soaring prices —were some infinitely complicated, mysterious and incurable affliction that had suddenly struck us from the blue, instead of simply what it is — the inevitable consequence of the actions of government in overspending and then printing paper money.
And as the cause is obvious and simple, so is the fundamental cure.
The direct cause of soaring prices is printing too much paper money; the direct cure is to stop printing it. The indirect cause of inflation is government overspending and unbalancing the budget; the indirect cure is to stop overspending and to balance the budget.
But if the cause and cure of inflation are so fundamentally simple, why is there so much befuddlement? One reason, of course, is that the problem is not merely economic, but political. The problem is not merely, for example, to get the politicians to recognize the true cause and cure of inflation. It is also to get them to acknowledge that cause and adopt that cure. In brief, one reason so many politicians do not understand the problem is not merely that they are too stupid to understand it, but that they do not want to understand it.
They realize that inflation is a political racket. They find that the way to get into office is to advocate inflation, and the way to stay in is to practice it. They find that the way to be popular is to appropriate handouts to pressure groups who represent mass votes, and not to raise taxes except those that seem to fall mainly on some unloved or envied minority group — oil companies, corporations generally, the reputedly “rich” or “superrich.”
The ultimate result of such policies is to bring about exactly what we have today — inflation plus recession.
But we are brought back to the fact that politicians could not exploit the befuddlement of the public about inflation if that befuddlement did not already exist. So though we must not overlook the political side of the problem, we must recognize that our main task is still one of educating the public.
This is a much bigger problem than it is commonly thought to be. Even when we have explained to people that inflation is caused by excessive issues of paper money, and by budget deficits that lead to excessive issues of paper money, we have done only a small part of our task. We have explained what causes inflation, but we have not explained why inflation is so pernicious. The truth is that the greater part of the pub-lie still thinks that inflation is on the whole beneficial. They know that it raises the prices of commodities, but the chief thing they consider bad about this is that it may not raise their wage-rates or salaries to the same extent. Nearly everybody thinks that inflation is necessarily stimulating to business, because they think it must raise profit margins and so lead to greater production and employment.
This is indeed usually true in the first stages of inflation. But what is still recognized only by a tiny minority is that in the later stages of inflation this ceases to be true. In its later stages inflation tends to bring about a disorganization and demoralization of business.
It tends to do this in several ways. First, when an inflation has long gone on at a certain rate, the public expects it to continue at that rate. More and more people’s actions and demands are adjusted to that expectation. This affects sellers, buyers, lenders, borrowers, workers, employers. Sellers of raw materials ask more from fabricators, and fabricators are willing to pay more. Lenders ask more from borrowers. They put a “price premium” on top of their normal interest rate to offset the expected decline in purchasing power of the dollars they lend. Workers insist on higher wages to compensate them not only for present higher prices but against their expectation of still higher prices in the future.
The result is that costs begin to rise at least as fast as final prices. Real profit margins are no longer greater than before the inflation began. In brief, inflation at the old rate has ceased to have any stimulative effect. Only an increased rate of inflation, only a rate of inflation greater than generally expected, only an accelerative rate of inflation, can continue to have a stimulating effect.
But in time even an accelerative rate of inflation is not enough. Expectations, which at first lagged behind the actual rate of inflation, begin to move ahead of it. So costs often rise faster than final prices. Then inflation actually has a depressing effect on business.
A Crucial Oversight
This would be the situation even if all retail prices tended to go up proportionately, and all costs tended to go up proportionately. But this never happens — a crucial fact that is systematically concealed from those economists who chronically fix their attention on index numbers or similar averages. These economists do see that the average of wholesale prices usually rises faster than the average of retail consumer prices, and that the average of wage-rates also usually rises faster than the average of consumer prices. But what they do not notice until too late is that market prices and costs are all rising unevenly, discordantly, and even disruptively. Price and cost relationships become increasingly discoordinated. In an increasing number of industries profit margins are being wiped out, sales are declining, losses are setting in, and huge layoffs are taking place. Unemployment in one line is beginning to force unemployment in others.
All this is the consequence of an inflation in its later stages. But the irony is that this consequence is systematically misinterpreted. The real trouble, everybody begins to think, is that there is not enough inflation; it must by all means be speeded up.
This is the stage at which we have now arrived. A swelling chorus of voices has been demanding that the Federal Reserve “temporarily,” at least, increase the growth rate of the money supply. It is almost universally believed that the reason the banks’ prime lending rate was recently at 12 per cent is that the Federal Reserve was following a “tight money” policy. The Federal Reserve authorities even themselves seem to believe this. In early December they reduced the discount rate from 8 to 73/4 per cent, and a month later to 71/4 per cent, to prove that they meant to follow a less stringent money policy.
The truth is that market money-rates have been high precisely because we have been inflating, precisely because the Federal Reserve has for too long been following a recklessly loose money policy. As compared with the 8 per cent discount rate of the Fed, the discount rate of the Bank of England was last year between 111/2 and 121/2 per cent, the discount rate of the Bank of Brazil 18 per cent, the discount rate of the Bank of Chile 75 per cent.
Discounting Inflation
None of these rates was a result of a tight money policy in the countries concerned. Quite the contrary. The greater the past or present rate of inflation, the higher the present prevailing interest rate. This is because, in the later stages of an inflation, people expect the recent rate of inflation to continue. If they believe, for example, that the dollars or pounds or cruzeiros or escudos that they lend today will have a purchasing power of x per cent less when they get them back a year from today, they will add that x per cent to the normal rate of interest they would otherwise have expected. If their expectations are justified, though they will be getting a very high nominal rate of interest, their real rate of interest will not be above normal. But the high nominal rates of interest will none the less tend to discourage borrowing.
Again, as I have already pointed out, labor unions will begin to demand so-called “protective” pay increases sufficient not only to compensate them for the commodity price increases that have taken place since their old contract was signed, but for the price increases that they fear will take place in the future life of their new contract. Union demands will tend to become increasingly unreasonable. The number of strikes will tend to increase. Profit margins will be squeezed or wiped out arbitrarily. Price-and-cost relationships among different industries will become increasingly unsettled, unpredictable and disorganized.
In short, “protective” actions and other compensatory reactions to inflation and expected inflation will often turn inflation in its later stages from a stimulating force to a depressing and demoralizing force. But the public and politicians will increasingly believe that these depression consequences of continued inflation are the consequences of insufficient inflation. They will demand that the inflation be still further accelerated.
The reason an inflation is not stopped is that people begin to dread more and more what will happen if it is stopped. They fear a stabilization crisis. They fear mass unemployment. The only alternative seems to be to accelerate the inflation. But, as we see, this simply leads to increasing disorganization and demoralization of business. In the end, we begin to get mass unemployment anyway.
Suppose, by some miracle, the government stopped inflating —now. Would the consequences really be as bad as most people fear? There is every reason to think that they would be incomparably better than if the demoralizing effects of the inflation are allowed to continue.
German Hyper-Inflation
We can get some light on this if we study what happened in the great German hyper-inflation which ran roughly from 1919 to the end of 1923. In the course of that inflation the German paper mark fell to a purchasing power equal to only one-trillionth of what it had been before the inflation set in. This is another way of saying that prices soared a trillion-fold.
In the last stages of that inflation production became disorganized and unemployment soared. Industrial production plunged from an index number of about 125 in 1921 to about 60 in 1923. Unemployment among trade union members, which had been as low as 0.6 per cent in July of 1922, rose to 19.1 per cent in October, 1923, to 23.4 per cent in November, and to 28.2 per cent in December. The index of the real income of the German industrial population plunged from a range of 75 to 105 in 1921 (with 1913-14 equal to 100) to a range of only 36 to 47 in November of 1923. These figures are taken from Prof. Frank D. Graham’s 1930 book on the German inflation. They show how inflation in its later stages can demoralize production, real income and employment.
Was the stabilization crisis so dreadful when this inflation was finally brought to a halt? I regret that the commonly available figures are not quite adequate to answer this question satisfactorily. Practically all the tables published in the books of both Frank D. Graham and Costantino Bresciani Turroni end at December, 1923. But supplementary evidence indicates that the stabilization crisis was brief and the recovery quick.
The index of the physical volume of industrial production per capita, taking 1913 as a basis of 100, had fallen to 54 at the peak of the inflation in 1923. It rose to 77 in 1924, to 90 in 1925, and to 111 in 1927. This was a better comparative record of recovery from 1913 than that of England , Italy , or West Europe generally.
Heavy Unemployment?
C. W. Guillebaud of Cambridge University , in his book The Economic Recovery of Germany (1939), tells us that “The cessation of inflation brought with it as its immediate effect a large increase in recorded unemployment, which rose to 1,533,000 on January 1, 1924.”
The justification for this statement depends on what date we place on “the cessation of inflation.” The monetary reform was introduced by a decree issued on October 15, 1923. The actual introduction of the new currency, the rentenmark, did not come until November 20, 1923. But the Reichsbank kept grinding out paper marks at accelerative and astronomical rates continuously through the end of December.
If we consult the monthly statistical series (not given in any table in Guillebaud’s book) from which his January figure was apparently taken, we find that recorded unemployment in October, 1923 was 534,000, in November 955,000, and in December 1,473,000.
So the January figure of 1,533,000 of recorded unemployment was not much above this. In any case this unemployment was short-lived. In spite of interest rates, in terms of the new currency, as high as 100 per cent in January, and even from February to May at an average, figured annually, of 35 per cent, Guillebaud tells us that “activity revived, and unemployment for the first time since August, 1923 began to decline, and was not more than 700,000 in April, 1924.” It fell to 328,000 by July, better than a normal average.
Rapid Recovery
A similar picture of recovery is given by Costantino BrescianiTurroni, in his book The Economics of Inflation (1931) . This is the most thorough and the most famous of the books written on the great German inflation. Bresciani-Turroni tells us that in the first months of 1924, when the inflation was over, there was “a remarkable increase in wages,” and that this “big increase in the average income of workers was the combined effect of the rise in wage-rates and the fall in unemployment” (p. 396). And in the final summary paragraph of the book he writes:
“At first inflation stimulated production because of the divergence between the internal and external values of the mark, but later it exercised an increasingly disadvantageous influence, disorganizing and limiting production. It annihilated thrift; it made reform of the national budget impossible for years; it obstructed the solution of the Reparations question; it destroyed incalculable moral and intellectual values. It provoked a serious revolution in social classes, a few people accumulating wealth and forming a class of usurpers of national property, whilst millions of individuals were thrown into poverty. It was a distressing preoccupation and constant torment of unnumerable families; it poisoned the German people by spreading among all classes the spirit of speculation and by diverting them from proper and regular work, and it was the cause of incessant political and moral disturbance. It is indeed easy enough to understand why the record of the sad years 1919-23 always weighs like a nightmare on the German people.”
The lesson is clear. We should stop our own inflation now. Not some time in the future, but now. We should not slow down the rate gradually over the years, but stop inflation now. And this means, to repeat, two main measures: first, balance the budget, balance it wholly by slashing expenditures and not at all by raising taxes; and second, stop expanding bank credit and printing paper money.
Some other measures will be necessary to make these two basic steps effective, but I will mention only one of them, because of its overriding importance. We should repeal all the labor laws, passed over the last forty years, that build up the power of labor unions, strengthen the extortionate strike-threat system, and in effect force employers to capitulate to labor union demands. This means the repeal of the Norris-Laguardia Act, of the Wagner-Taft-Hartley Act, of the Davis-Bacon Act, and probably a nest of others.
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