Inflation for Beginners—III

September 17, 1951

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.