What You Should Know About Inflation
44. The ABC of Inflation
Suppose that, by a miracle, every family in the United States were to wake up one morning to find four times as much money in its pockets and its bank account as on the night before. Every family would then be eager to rush out and buy things it had previously longed for and gone without. The firstcomers might be able to buy things at the old prices. But the latercomers would bid prices up against each other. Merchants, with their stocks going down, would reorder, raising wholesale prices. Manufacturers and other producers, because they were doing a bigger business, would try to increase their labor force. This would force up wages. Eventually there would be an increase of prices and wages all around the circle.
This picture is, of course, a violent simplification. But it describes what has actually happened in this country, not overnight, but over the last twenty years or so. At the end of 1939 the amount of currency outside of banks was $6.4 billion. The amount of bank deposits subject to withdrawal by check (which is the main part of the “money supply” with which Americans do business) was $29.8 billion. This made a total active money supply of a little more than $36 billion. At the end of 1963 this money supply had grown to four times as much—$153 billion.
With this hugely increased supply of money bidding for goods, wholesale prices at the end of 1963 had increased 138 per cent above those at the end of 1939. In the same period the cost of living, as measured by the retail prices paid by consumers, had increased 122 per cent. In other words, the purchasing power of the dollar fell to less than half of what it was in 1939.
When we consider the extent of this increase in the money supply, it is surprising that prices have not risen even further. One reason why they haven’t is that the supply of goods in the meanwhile has also been increased. Industrial production at the end of 1963 was running at a rate of about 233 per cent greater than in 1939. While the supply of money has quadrupled, the rate of output of industrial goods has almost tripled.
Let us try to see what inflation is, what it does, and what its continuance may mean to us.
“Inflation” is not a scientific term. It is very loosely used, not only by most of us in ordinary conversation, but even by many professional economists. It is used with at least four different meanings:
1. Any increase at all in the supply of money (and credit).
2. An increase in the supply of money that outruns the increase in the supply of goods.
3. An increase in the average level of prices.
4. Any prosperity or boom.
Let us here use the word in a sense that can be widely understood and at the same time cause a minimum of intellectual confusion. This seems to me to be meaning 2.
Inflation is an increase in the supply of money that outruns the increase in the supply of goods.
There are some technical objections to this (as indicated in Chapter 23), but there are even more serious objections to any of the other three senses. Meaning 1, for example, is precise, but runs counter to all common usage. Meanings 3 and 4, though they do conform with common usage, lead, as we shall see, to serious confusion.
Whenever the supply of money increases faster than the supply of goods, prices go up. This is practically inevitable. Whatever the quantity of anything whatever increases, the value of any single unit of it falls. If this year’s wheat crop is twice as great as last year’s, the price of a bushel of wheat drops violently compared with last year. Similarly, the more the money supply increases, the more the purchasing power of a single unit declines. In Great Britain, for example, the supply of money increased some 226 per cent between 1937 and the end of 1957; at the same time the cost of living increased 166 per cent. In France, the money supply increased about thirty-six times between 1937 and the end of 1957; the cost of living in France, in the same period, went up about twenty-six times.
The rise of prices, which is merely a consequence of the inflation, is commonly talked of as if it were itself the inflation. This mistaken identification leads many people to overlook the real cause of the inflation—the increase in the money supply—and to think that the inflation can he halted by the imposition of government price-and-wage controls, even while the supply of money continues to increase. Under such conditions, however, government price-and-wage fixing only discourages, distorts, and disrupts production, without curing the inflation.
It is sometimes thought that it is “war” that is responsible for all inflations. But a great part of the present inflations in France, Italy, Great Britain, and the United States have occurred since the end of World War II. The American cost of living, for example, has gone up 63 per cent since 1945. And some of the most spectacular recent inflations have occurred in countries relatively untouched by the war. Between 1950 and the end of 1959, the money supply in Chile increased nineteen times, and the cost of living there increased twenty times. In Bolivia, between 1950 and 1959, the money supply was increased seventy times, and the cost of living there increased a hundred times. Similar records could be cited for other countries.
Thus we see that the connection between the increase in the supply of money and the rise in prices is extremely close. All the great inflations of earlier and modern times have been primarily the result of reckless deficit financing on the part of governments, which wanted to spend far more than they had the courage or ability to collect in taxes. They paid for the difference by printing paper money.
Most present-day governments are ashamed to pay their bills directly by printing money, so they have developed more sophisticated and roundabout ways of doing the same thing. Typically, they “sell” their interest-bearing securities to the central bank. The central bank then creates a “deposit” in their favor for the face value of the government securities, and the government draws checks against this “deposit.” But all this leads in the end to the same result as printing new money directly.
We are often told, however, that we have in America today a “new” kind of inflation, caused by labor unions forcing constant wage increases. This contention contains a political truth but is misleading economically.
Suppose that unions were able to force up their wage-rates, but that the management of currency and bank credit were such that there was no increase in the total money supply. Then the higher wage-rates would either wipe out profit margins, or they would force manufacturers to raise prices to preserve profit margins. If the higher wage-rates wiped out employers’ profits, they would lead directly to unemployment. If they forced a rise in prices, and if consumers had no more money to spend than before, consumers would buy fewer goods. The result would be smaller sales and hence less production and less employment.
An increase in wage-rates, in short, without at least a compensating increase in the money supply, would simply lead to unemployment. But very few governments have the courage to sit tight on the money supply and get the blame for the resulting unemployment. They prefer, instead, to try to make the constantly higher wage-rates payable by constantly increasing the money supply. In this way the rise in wage-rates has politically led to the continuance of many inflations.
But there is more than one reason why inflation, in spite of all the righteous lip-indignation it calls forth, is not only tolerated by the majority of us over long periods, but actively supported by special pressure groups.
The first of these reasons is “the money illusion.” We are so accustomed to measuring our incomes and our economic welfare in purely monetary terms that we cannot break ourselves of the habit. Since 1939 the cost of living in the United States has a little more than doubled. This means that a man whose income after taxes has gone up from $5,000 in 1939 to $10,000 now is no better off, in the things he can buy with his income, than he was in 1939.
He is, in fact, definitely worse off. A study by the National Industrial Conference Board, allowing not only for higher prices but for the higher income-tax bite in the later year, estimated that a man required a gross income of $12,307 in 1960 in order to enjoy a purchasing power equal to that of $5,000 in 1939. His gross money-income had to increase still more as he got into the higher income-tax brackets. It took a gross income of $26,030 in i960 to give him a purchasing power equal to that of $10,000 in 1939 and a gross income of $77,415 to give him a purchasing power equal to $25,000 in 1939.
A man whose dollar-income has risen from $5,000 in 1939 to only $7,500 today, after taxes, is definitely worse off. Yet so strong and persistent is the money illusion that millions of people who are worse off in terms of the real purchasing power of their incomes probably imagine themselves to be better off because their dollar income is so much higher.
The money illusion will often be found together with what we may call the special-case illusion. This is the belief that the reason my own money-income has gone up in the last five, ten, or twenty years is that I have been personally very lucky or very talented, whereas the reason the prices I have to pay have gone up is just “inflation.” I do not understand the inflation process, however, until I understand that the same forces which have pushed up the prices of what other people have to sell (including their labor services) have pushed up the price of what I personally have to sell. Looking at the matter from the other side, the same general forces which have raised my own income have also raised other people’s incomes.
Yet the special-case illusion is not entirely an illusion. Here we come to one of the main reasons for the political pressure behind inflation. At the beginning we imagined inflation occurring as the result of a simultaneous miracle by which every family awakened to find its money supply quadrupled overnight. Of course no such miracle happens in real life. No actual inflation happens by a simultaneous or proportional increase in everybody’s money supply or money income. No actual inflation affects every person and every price equally and at the same time. On the contrary, every inflation affects different persons and different prices unequally and at different times.
A typical war inflation, for example, starts when the government uses newly created money to pay armament contractors. First, the profits of the armament contractors increase. Next, they employ more workers, and they raise the wages they pay in order to get and hold more workers. Next, the tradespeople that cater to the armament company owners and employes increase their sales. And so on, in widening circles.
In the same way, in a “pump-priming” inflation, brought about by a great public works program or housing program, the first group to benefit are the construction companies, the second the construction workers, the third the tradespeople and others who directly cater to the construction workers—and so on.
Inflation always benefits some groups of the population before it benefits other groups, and more than it benefits other groups. And in most cases it benefits these first groups at the direct expense of the other groups.
Suppose, to make an extreme simplification, that one-half of the population has its dollar-income and the prices of its goods or services doubled, while the other half still retains the same dollar-income and can only get the same dollar-prices for its goods. The average prices received by the first half will go from 100 to 200. The average prices received by the second half will remain at 100. This means that the average price of all goods will now be 150, or 50 per cent higher than before. The first half of the population will then be about a third better off than before, though not twice as well off, even though its dollar-income has doubled. The second half of the population, though its dollar-income has remained the same, will be able to buy only two-thirds as much goods and services.
In any actual inflation, of course, the relative gains and losses will not be thus neatly split between just two distinct halves of the population; they will vary with every group and even, to some extent, with every family. Yet it will remain true that the losers from an inflation will probably be about equal in numbers to the gainers, even though the money illusion hides this from many of the losers.
The fact that there are always those who can relatively profit from an inflation, while it is going on, even though they do it at the expense of the rest of the community, helps to keep up the political pressure for the continuance of inflation.
The losers from an inflation, if they could always identify themselves and make themselves heard, could more than offset in their political strength the forces that temporarily profit from inflation.
Who are the losers? It is customary to identify them as savings bank depositors, holders of government bonds, elderly retired people or widows living on fixed pensions, insurance-policy holders, teachers and similar white-collar workers. The losers from inflation do include all of these, but they include many more.
Have you personally profited from inflation, or are you one of its victims?
Here is a simple way to find out. In the table on page 147, the second column is based on the U.S. Government’s Consumer Price Index. For simplicity of calculation this figure has been converted to a base of 100 for the year 1939. The third column is based on the government’s estimate of the per capita “disposable” income (i.e., income after deduction for taxes) in each year. This also has been converted to a base of 100 for the year 1939.
The first thing you want to find out is whether you are better or worse off absolutely than in some earlier year. Put down what your take-home pay was in any chosen past year in the table, add two zeros to it, and divide by the cost-of-living figure for that year. Then take your present take-home pay, add two zeros, and divide the result by the last figure in the column.
If your present income (so recalculated) is greater than your income so recalculated from the past year, then your real income has increased. Otherwise you have lost.
| 1939 average = 100 | ||
| Year | Cost of Living1 | Per Capita $ Income2 |
| 1939 | 100 | 100 |
| 1944 | 127 | 197 |
| 1945 | 130 | 200 |
| 1946 | 140 | 209 |
| 1947 | 161 | 218 |
| 1948 | 173 | 238 |
| 1949 | 171 | 234 |
| 1950 | 173 | 253 |
| 1951 | 187 | 272 |
| 1952 | 191 | 281 |
| 1953 | 193 | 291 |
| 1954 | 193 | 291 |
| 1955 | 193 | 304 |
| 1956 | 196 | 318 |
| 1957 | 202 | 326 |
| 1958 | 208 | 339 |
| 1959 | 210 | 352 |
| 1960 | 213 | 361 |
| 1961 | 215 | 369 |
| 1962 | 218 | 384 |
| 1963 | 220 | 396 |
3Source: U.S. Government Consumer Price Index, as converted from 1957-59 base.
4Source: U.S. Government estimate of per capita disposable personal income in dollars. From table on p. 227, Economic Report of the President, January, 1964. Converted to 1939 base.
Let us take an illustration. Your take-home pay in 1963 say, was $5,000 a year. In 1939 it was $2,500. As you both multiply and divide your 1939 income by 100, it remains at the same figure—$2,500. But you multiply, say, your 1963 income by 100 and divide by 210. This leaves you with only $2,270 of “real” income (i.e., in 1939 dollars) in 1963. Your income in terms of what it would buy, therefore, was lower than it was in 1939.
Suppose, now, you are interested in knowing not only whether you are better or worse off now than in some preceding year in what you can buy with your income, but whether you have done better or worse than the average American in the same period. In a progressive economy like ours, not only total production, and hence total real income, but per-capita production and hence per-capita real income, tend to increase year by year, as capital investment increases and machinery and techniques improve. But the income of some persons has increased much more than that of others. This is partly because, either through ability or good fortune, they hold better positions than formerly; but it may also be because inflation typically benefits some groups at the expense of other groups. As you will notice, unless your dollar income over the last two decades has increased more than enough to compensate merely for the increase in living costs in the period, you have not shared proportionately in the increase in the nations real output.
If you wish to get a closer idea of how you made out relatively to others, you can make the same sort of recalculation of your income in the third column as you made in the second. In this recalculation, however, you would have to take more factors into account (such as full family income, after taxes, relative number of persons in the family in the years compared, etc.). And just how much the operations of inflation can be held responsible for whatever the comparison turns out to be, it is impossible to say without a full knowledge of each individual case. But many a person who thinks he has been one of the special beneficiaries of inflation may sharply revise his ideas after such a calculation.
We have still to look at the strongest reason of all why inflation has such powerful political appeal. This is the conviction that it is necessary to maintain “full employment.”
Under special conditions inflation can, it is true, have this effect. If, following a boom, maladjustments of various kinds have caused a collapse of demand and of prices, while labor union leaders have refused to accept any compensating cuts in wage-rates, there will of course be unemployment. In such a case a new dose of inflation may raise monetary purchasing power to a point where the old volume of goods will once more be bought at the old price level, and employment may then be restored at the old money-wage level.
But the restoration of full employment could have been brought about just as well if the powerful unions had merely accepted the necessary wage-rate reductions. This would have involved no real sacrifice, because, as prices had collapsed, the cut in wage-rates would merely need to have been great enough to keep the same relative real wage-rates (i.e., wage-rates in terms of purchasing-power) as before. Nor, to restore full employment under such conditions, would it be necessary to put into effect any general or uniform cut in wage-rates. Only those wage-rates would have to be cut that had got out of equilibrium and were causing log-jams in the economy.
Moreover, even if we inject greater and greater doses of monetary inflation, and union demands are such that wage-rates continue to run ahead of prices, then though we will certainly have inflation and higher prices, we will not cure the unemployment.
If we continue to try to solve our difficulties by continued fresh doses of monetary inflation, what will be the upshot? Prices will certainly rise further. But this rise of prices will not guarantee the restoration of full employment. The latter, as we have seen, depends on a generally balanced economic situation, and particularly on the proper relationship between prices and wage-rates.
A serious or long-continued inflation is always in danger of getting out of control. Those who naively imagine that our monetary managers, or any other group, know any formula by which we could maintain a predetermined “creeping inflation,” with prices rising just 2 or 3 per cent a year, are entirely mistaken. Even if it were not extremely difficult to control exactly the supply of money and credit, there is no assurance whatever that a given percentage of expansion of the money supply from year to year will bring a merely proportional price rise each year. On the contrary, the very knowledge of the existence of such a planned inflation would undermine confidence in the value of the dollar. It would bring a racing inflation immediately that could quickly get out of hand.
Whenever any inflation gets beyond a critical point (which can never be known in advance), the social losses and evils it brings about are certain to cancel and exceed any initial gains. Holders of bonds or savings deposits at last become aware that the capital value of their savings is shrinking all the time in terms of what it will buy. This awareness discourages thrift and savings. The whole structure of production becomes distorted. Businessmen and corporations are deceived by the way inflation falsifies their books. Their inventory profits are illusory. Their depreciation deductions are inadequate. It becomes impossible for business managers to know to what extent their paper profits are real. But these profits often look bigger and bigger on paper. They provoke charges of “profiteering.” Demagogues use them to inflame class hatreds against business.
Inflation makes it possible for some people to get rich by speculation and windfall instead of by hard work. It rewards gambling and penalizes thrift. It conceals and encourages waste and inefficiency in production. It finally tends to demoralize the whole community. It promotes speculation, gambling, squandering, luxury, envy, resentment, discontent, corruption, crime, and increasing drift toward more intervention which may end in dictatorship.
How long will inflation continue? How far will it go?
No one has a sure answer to such questions. The answer is in the hands of the American people. Yet inflation is not necessary and it is never inevitable. The choice between chaos and stability is still ours to make.
- 1*Source: U.S. Government Consumer Price Index, as converted from 1957-59 base.
- 2**Source: U.S. Government estimate of per capita disposable personal income in dollars. From table on p. 227, Economic Report of the President, January, 1964. Converted to 1939 base.
- 3Cost of Living*
- 4Per Capita $ Income**
