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 public 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 7 3/4 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 trillionfold.
In the last stages of that infla-tion 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 Ill 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
shortlived. 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
Bresciani-Turroni, 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.
Mr. Hazlitt, noted economist, journalist and author,
adds what might well be another chapter to one of his books: What You
Should Know About Inflation.
This article is based on a paper
delivered January 6, 1975, at a monetary conference in Miami.
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
March, 1975, Vol. 25, No. 3.
Yourname@libertyhaven.com
