Inflation for BeginnersTags Money and Banking
[Newsweek columns from September 3, 10, 17, 24, and October 1, 1951, and reprinted in Business Tides: The Newsweek Era of Henry Hazlitt.]
Inflation for Beginners—I
No subject is so much discussed today—or so little understood—as inflation. The politicians in Washington talk of it as if it were some horrible visitation from without, over which they had no control—like a flood, a foreign invasion, or a plague. It is something they are always promising to “fight”—if Congress or the people will only give them the “weapons” or “a strong law” to do the job.
Yet the plain truth is that our political leaders have brought on inflation by their own money and fiscal policies. They are promising to fight with their right hand the conditions they have brought on with their left.
Inflation, always and everywhere, is primarily caused by an increase in the supply of money and credit. In fact, inflation is the increase in the supply of money and credit. If you turn to the recent American College Dictionary, for example, you will find the first definition of inflation given as follows: “Undue expansion or increase of the currency of a country, esp. by the issuing of paper money not redeemable in specie.”
In recent years, however, the term has come to be used in a radically different sense. This is recognized in the second definition given by the American College Dictionary: “A substantial rise of prices caused by an undue expansion in paper money or bank credit.” Now obviously a rise of prices caused by an expansion of the money supply is not the same thing as the expansion of the money supply itself. A cause or condition is clearly not identical with one of its consequences. The use of the word “inflation” with these two quite different meanings leads to endless confusion.
The word “inflation” originally applied solely to the quantity of money. It meant that the volume of money was inflated, blown up, overextended. It is not mere pedantry to insist that the word should be used only in its original meaning. To use it to mean “a rise in prices” is to deflect attention away from the real cause of inflation and the real cure for it.
Let us see what happens under inflation, and why it happens. When the supply of money is increased, people have more money to offer for goods. If the supply of goods does not increase—or does not increase as much as the supply of money—then the prices of goods will go up. Each individual dollar becomes less valuable because there are more dollars. Therefore more of them will be offered against, say, a pair of shoes or a hundred bushels of wheat than before. A “price” is an exchange ratio between a dollar and a unit of goods. When people have more dollars, they value each dollar less. Goods then rise in price, not because goods are scarcer than before, but because dollars are more abundant.
In the old days, governments inflated by clipping and debasing the coinage. Then they found they could inflate cheaper and faster simply by grinding out paper money on a printing press. This is what happened with the French assignats in 1789, and with our own currency during the Revolutionary War. Today the method is a little more indirect. Our government sells its bonds or other IOU’s to the banks. In payment, the banks create “deposits” on their books against which the government an draw. A bank in turn may sell its government IOU’s to the Federal Reserve Bank, which pays for them either by creating a deposit credit or having more Federal Reserve notes printed and paying them out. This is how money is manufactured.
The greater part of the “money supply” of this country is represented not by hand-to-hand currency but by bank deposits which are drawn against by checks. Hence when most economists measure our money supply they add demand deposits (and now usually, also, time deposits) to currency outside of banks to get the total. The total of money and credit so measured was $64,099,000,000 at the end of December 1939, and $174,200,000,000 at the end of June this year. This increase of 171 percent in the supply of money is overwhelmingly the main reason why wholesale prices rose 135 percent from 1939 to June of this year.
Inflation for Beginners—II
It is often argued that to attribute inflation solely to an increase in the volume of money is “oversimplification.” This is true. Many qualifications have to be kept in mind.
For example, the “money supply” must be thought of as including not only the supply of hand-to-hand currency, but the supply of bank credit—especially in the U.S., where most payments are made by check. And it is an oversimplification to say that the value of an individual dollar depends simply on the present supply of dollars outstanding. It depends also on the expected future supply of dollars. If most people fear, for example, that the supply of dollars is going to be even greater a year from now than at present, then the present value of the dollar (as measured by its purchasing power) will be lower than the present quantity of dollars would otherwise warrant.
Again, the value of any monetary unit such as the dollar, depends not merely on the quantity of dollars but on their quality. When a country goes off the gold standard, for example, it means in effect that gold, or the right to get gold, has suddenly turned into mere paper. The value of the monetary unit therefore usually falls immediately, even if there has not yet been any increase in the quantity of money. This is because the people have more faith in gold than they have in the promises or judgment of the government’s monetary managers. There is hardly a case on record, in fact, in which departure from the gold standard has not soon been followed by a further increase in bank credit and in printing-press money.
In short, the value of money varies for basically the same reasons as the value of any commodity. Just as the value of a bushel of wheat depends not only on the total present supply of wheat but on the expected future supply and on the quality of the wheat so the value of a dollar depends on a similar variety of considerations. The value of money, like the value of goods, is not determined by merely mechanical or physical relationships, but primarily by psychological factors, which may often be quite complicated.
In dealing with the causes and cure of inflation, it is one thing to keep in mind real complications; it is quite another to be confused or misled by needless or nonexistent complications. For example, it is frequently said that the value of the dollar depends not merely on the quantity of dollars but on their “velocity of circulation.” Increased “velocity of circulation,” however, is not a cause of a further fall in the value of the dollar; it is itself one of the consequences of the fear that the value of the dollar is going to fall. (Or, to put it the other way round, of the belief that the price of goods is going to rise.) It is this belief that makes people more eager to exchange dollars for goods. The emphasis by some writers on “velocity of circulation” is just another example of the error of substituting dubious mechanical for real psychological reasons.
Another blind alley: in answer to those who point out that inflation is primarily caused by an increase in money and credit, it is contended that the increase in commodity prices often occurs before the increase in the money supply. This is true. This is what happened immediately after the outbreak of war in Korea. Strategic raw materials began to go up in price on the fear that they were going to be scarce. Speculators and manufacturers began to buy them to hold for profit or protective inventories. But to do this they had to borrow more money from the banks. The rise in prices was accompanied by an equally marked rise in bank loans and deposits. From May 31, 1950, to May 30, 1951, the loans of the country’s banks increased by $12,000,000,000. If these increased loans had not been made, and new money (some $6,000,000,000 by the end of January 1951) had not been issued against the loans, the rise in prices could not have been sustained. The price rise was made possible, in short, only by an increased supply of money.
Inflation for Beginners—III
One of the most stubborn fallacies about inflation is the assumption that it is caused, not by an increase in the quantity of money, but by a “shortage of goods.”
It is true that a rise in prices (which, as we have seen, should not be identified with inflation) can be caused either by an increase in the quantity of money or by a shortage of goods—or partly by both. Wheat, for example, may rise in price either because there is an increase in the supply of money or a failure of the wheat crop. But we seldom find, even in conditions of total war, a general rise of prices caused by a general shortage of goods. Yet so stubborn is the fallacy that inflation is caused by a “shortage of goods,” that even in the Germany of 1923, after prices had soared hundreds of billions of times, high officials and millions of Germans were blaming the whole thing on a general “shortage of goods”—at the very moment when foreigners were coming in and buying German goods with gold or their own currencies at prices lower than those of equivalent goods at home.
The rise of prices in the United States since 1939, or since the outbreak of war in Korea, is constantly being attributed to a “shortage of goods.” Yet official statistics show that our rate of industrial production in June of this year, for example, was two and a quarter times as much as from 1935 to 1939, and 12 percent higher than in June of 1950. Nor is it any better explanation to say that the rise in prices is caused by a shortage in civilian goods. Even to the extent that civilian goods were really short, the shortage would not cause a rise in prices if taxes took away as large a percentage of civilian income as rearmament took of civilian goods.
This brings us to another source of confusion. People frequently talk as if a budget deficit were in itself both a necessary and a sufficient cause of inflation. A budget deficit, however, if fully financed by the sale of government bonds paid for out of real savings, need not cause inflation. And even a budget surplus, on the other hand, is not an assurance against inflation. This was shown in the fiscal year ended June 30, when there was substantial inflation in spite of a budget surplus of $3,500,000,000. A budget deficit, in short, is inflationary only to the extent that it causes an increase in the money supply. And inflation can occur even with a budget surplus if there is an increase in the money supply notwithstanding.
The same chain of causation applies to all the so-called “inflationary pressures”—particularly the so-called “wage-price spiral.” If it were not preceded, accompanied, or quickly followed by an increase in the supply of money, an increase in wages above the “equilibrium level” would not cause inflation; it would merely cause unemployment. And an increase in prices without an increase of cash in people’s pockets would merely cause a falling off in sales. Wage and price rises, in brief, are usually a consequence of inflation. They can cause it only to the extent that they force an increase in the money supply.
The accompanying chart compares the percentage increase in the money supply (currency plus bank deposits) since 1939 with the rise in wholesale prices and in the cost of living during the same period. The correlation is obvious—though the factors involved are too complex to expect it to be exact. The chief reason why prices have not increased as much as the money supply is that the production rate of goods has also greatly increased since 1939.
A warning must also be given concerning the accuracy of the two price indexes themselves. They show apparent stability from the end of 1942 to the middle of 1946, and a sharp rise then when price control was taken off. But this is chiefly because official price and cost-of-living indexes tend to become fictional under price control. They do not measure the realities of black market prices, shortages, rationing, queues, favoritism, deterioration of quality and non-existent goods. When price control is taken off, the government’s increase of the money supply has its full effect on the official price indexes.
Inflation for Beginners—IV
As long as we are plagued by false theories of what causes inflation, we will be plagued by false remedies. Those who ascribe inflation primarily to a “shortage of goods,” for example, are fond of saying that “the answer to inflation is production.” But this is at best a half-truth. It is impossible to bring prices down by increasing production if the money supply is being increased even faster.
The worst of all false remedies for inflation is price fixing and wage fixing. For if more money is put into circulation, while prices are held down, most people will be left with unused cash balances seeking goods. The final result, barring a like increase in production, must be higher prices.
There are broadly two kinds of price fixing—“selective” and “overall.” With selective price fixing the government tries to hold the prices merely of a few strategic war materials or a few necessaries of life. But then the profit margin in producing these things becomes lower than the profit margin in producing other things, including luxuries. So “selective” price fixing quickly brings about a shortage of the very things whose production the government is most eager to encourage. Then bureaucrats turn to the specious idea of an overall freeze. They talk of holding or returning to the prices and wages that existed on the day before war broke out in Korea. But the price level and infinitely complex price and wage interrelationships of that day were the result of the state of supply and demand on that day. And supply and demand seldom remain the same, even for the same commodity, for two days running, even without major changes in the money supply.
It has been moderately estimated that there are some 9,000,000 different prices in the United States. On this basis we begin with more than 40 trillion interrelationships of these prices. And a change in one price always has repercussions on a whole network of other prices. The prices and price relationships of June 24, 1950, were presumably those roughly calculated to encourage a maximum balanced production of peace time goods. They are obviously the wrong prices and price relationships to encourage the maximum production of war goods. Moreover, the price pattern of a given day always embodies many misjudgments and “inequities.” No single mind, and no bureaucracy, has wisdom and knowledge enough to correct these. Every time a bureaucrat tries to correct one price or wage maladjustment or “inequity” he creates a score of new ones. And there is no precise standard for measuring the economic “inequities” of a particular case that any two people seem able to agree on. Coercive price fixing would be an insoluble problem, in short, even if those in charge of it were the best-informed economists, statisticians, and businessmen in the country, and even if they acted with the most conscientious impartiality. But they are subjected in fact to tremendous pressure by the organized pressure groups. Those in power soon find that price and wage control is a tremendous weapon with which to curry political favor or to punish opposition. That is why “parity” formulas are applied to farm prices and escalator clauses to wage rates, while industrial prices and rents are penalized.
Another evil of price control is that, though it is always put into effect in the name of an alleged “emergency,” it creates powerful vested interests and habits of mind which prolong it or tend to make it permanent. Outstanding examples of this are rent control and exchange control. Price control is the major step toward a fully regimented or “planned” economy. It causes people to regard it as a matter of course that the government should intervene in every economic transaction.
But finally, and worst of all from the standpoint of inflation, price control diverts attention away from the only real cause of inflation—the increase in the quantity of money and credit. Hence it prolongs and intensifies the very inflation it was ostensibly designed to cure.
Inflation for Beginners—V
The cure for inflation, like most cures, consists chiefly in the removal of the cause. The cause of inflation is the increase of money and credit. The cure is to stop increasing money and credit. The cure for inflation, in brief, is to stop inflating. It is as simple as that.
But while simple in principle, this cure often involves complex and disagreeable decisions on detail. Let us begin with the Federal budget. It is next to impossible to avoid inflation with a continuing heavy deficit. That deficit is almost certain to be financed by inflationary means—that is, by directly or indirectly printing more money. Huge government expenditures are not in themselves inflationary—provided they are made wholly out of tax receipts, or out of borrowing paid for wholly out of real savings. But the difficulties in either of these methods of payment, once expenditures have passed a certain point, are so great that there is almost inevitably a resort to the printing press.
Moreover, though huge expenditures wholly met out of huge taxes are not necessarily inflationary, they inevitably reduce and disrupt production, and under-mine any free enterprise system. The remedy for huge governmental [deficits] is therefore not equally huge taxes, but a halt to reckless spending.
On the monetary side, the Treasury and the Federal Reserve System must stop creating artificially cheap money. That is, they must stop arbitrarily holding down interest rates. And they must stop buying at par the government’s own bonds. When interest rates are held artificially low, they encourage an increase in borrowing. This leads to an increase in the money and credit supply. The process works both ways—for it is necessary to increase the money and credit supply in order to keep interest rates artificially low. That is why the “cheap money” policy and the government-bond-support policy are simply two ways of describing the same thing. As long as Federal Reserve Banks buy the government’s 2½ percent bonds, say, at par, they hold down the basic long-term interest rate to 2½ percent. And they pay for these bonds, in effect, by printing more money. This is what is known as “monetizing” the public debt. Inflation will go on as long as this goes on.
The Federal Reserve System, if it were determined to halt inflation and to live up to its responsibilities, would not only halt this process of holding down interest rates and monetizing the public debt, but it would take the leadership in raising interest rates. It should never have departed, in fact, from the tradition that the discount rate of the central bank should normally (and above all in an inflationary period) be a “penalty” rate—that is, a rate higher than the member banks themselves get on their loans.
Congress should immediately restore the required legal reserve ratio of the Federal Reserve Banks to the previous level of 35 and 40 percent, instead of the present “emergency” level of 25 percent put into effect as a war-inflation measure in June, 1945. Congress should in addition authorize the Federal Reserve Board to increase this reserve ratio even further. Legal minimum reserve ratios are admittedly an awkward method of limiting the potential supply of money and credit. But they are an added safeguard when other methods are not properly used. As long as the Federal Reserve authorities, moreover, insist on the power to control the reserve ratios of member banks, they should also be obliged to control their own. An increase in reserve bank credit can cause far more inflation than an equal increase in member bank credit.
As a last resort the monetary authorities could actually freeze the credit supply, allowing no net increase in loans at all. But this will never be necessary if other measures have been wisely taken.
It can be said, finally, that the world will never work itself out of the present inflationary era until it returns to the gold standard. The gold standard provided a practically automatic check on internal credit expansion. That is why the bureaucrats abandoned it. In addition to its being a safeguard against inflation, it is the only system that has ever provided the world with the equivalent of an international currency.
The first question to be asked today is not how can we stop inflation, but do we really want to? For one of the effects of inflation is to bring about a redistribution of wealth and income. In its early stages (until it reaches the point where it grossly distorts and undermines production itself) it benefits some groups at the expense of others. The first groups acquire a vested interest in maintaining inflation. Too many of us continue under the delusion that we can beat the game—that we can increase our own incomes faster than our living costs. So there is a great deal of hypocrisy in the outcry against inflation. Many of us are shouting in effect: “Hold down everybody’s price and income except my own.”
Governments are the worst offenders in this hypocrisy. At the same time as they profess to be “fighting inflation” they are following a “full employment” pol-icy. And as one writer recently admitted frankly in the London Economist: “Inflation is nine-tenths of any full-employment policy.”
What he forgot to add is that inflation must always end in a crisis and a slump, and that worse than the slump itself may be the public delusion that the slump has been caused, not by the previous inflation, but by the inherent defects of “capitalism.”
Inflation, to sum up, is the increase in the volume of money and bank credit in relation to the volume of goods. It is harmful because it depreciates the value of the monetary unit, raises everybody’s cost of living, imposes what is in effect a tax on the poorest at as high a rate as the tax on the richest, wipes out the value of past savings, discourages future savings, redistributes wealth and income wantonly, encourages and rewards speculation and gambling at the expense of thrift and work, undermines confidence in the justice of a free enterprise system and corrupts public and private morals.
But it is never “inevitable.” We can always stop it overnight, if we have the sincere will to do so.