Inflation vs. Growth

May 4, 1964

In practically every country of the world today the great fetish is an increase in the rate of “economic growth.” And the almost universal assumption is that that can best be promoted by inflation.

This policy, however, is almost never recommended under that name. The growth planners simply argue that growth has been slow because of an “insufficiency of aggregate demand.” They think this can be rectified by more government spending. Some of them are candid enough openly to advocate government deficits and the creation of more money, i.e., inflation.

Those who propose the inflationary solution for unemployment usually forget to ask what has caused the unemployment. The cause is nearly always some discoordination of prices and wages. An injection of new money can, it is true, at least temporarily increase employment if it restores wage-price coordination if, for example, it leads to increased demand or higher prices for products without leading to higher wage rates.

Yet any price-wage adjustment brought about by inflation is likely to be only temporary. For unions, encouraged by demand for more workers, or trying to “catch up” with higher living costs, will demand still higher wages, with the result that the discoordination of wages and prices may occur all over again, and the situation can be cured once more only by a still fresh dose of inflation. On the other hand, if governments follow sound labor policies, inflation is unnecessary.

ILLUSORY PROFITS

Inflation is not only unnecessary for economic growth. It is the enemy of growth. It distorts and falsifies economic calculation. An economy grows and functions at its maximum rate, and the production of thousands of different commodities and services can be kept in optimum balance when producers, on the basis of current prices and wages, can make reasonably correct anticipations of supply and demand, of costs, profits, or losses.

But when inflation forces up prices, prices do not all rise in the same proportion or at the same rate.

Businessmen cannot distinguish between what is lasting and what is merely temporary, or know what the future demands of consumers will be or what the real costs of their own operations are. Depreciation and replacement allowances will be inadequate. Profits will be overestimated. Businessmen everywhere will be deceived. They will be using up their real capital when they think they are increasing it. They will think they have profits or capital gains when they really have losses.

By distorting economic calculation and creating illusory profits, inflation destroys the function of the free market in penalizing inefficiency and misjudgment and rewarding efficiency and good judgment. Because nearly everything seems to prosper, there are all sorts of maladjustments and investments in the wrong lines. Solid work tends to give way to speculation and gambling.

EFFECT OF CONTROLS

The price and wage rises brought about by inflation will lead to demands for price and wage controls. But such controls will reduce and distort production, and do far more harm even than the inflation itself.

What is likely even before price controls is some sort of exchange control, to prevent the quotation of the home currency from falling in terms of other currencies. But the effect of such exchange controls will be to bring about a deficit in the balance of payments. It will discourage exports, because they will be overpriced compared with foreign goods. It will encourage imports. The exchange authorities, to prevent this, will institute quota and licensing systems. But these will disrupt foreign trade and domestic production.

Thus the long-run effect of inflation can only be to distort production and to retard economic growth. Of course, this effect can be concealed from many people for a long time. For prices and wages and incomes will all be constantly going higher in dollar terms. The official gross national product figures will be constantly soaring. The euphoria can temporarily lull all misgivings. But eventually the bitter moment of truth must arrive.