Transitory Magic

June 11, 1956

The storm of criticism that has beaten upon the Federal Reserve authorities since they made a small increase in prevailing discount rates to 2¾ percent in April, and the indications that as a result those authorities are now planning to make money “easier,” raise some fundamental questions. One of them is whether constant new doses of easy money and inflation can really keep a “full employment” boom going indefinitely.

It is the present prevailing belief that they can. The most direct challenge to this popular belief from any official source has come from the chairman of the Federal Reserve Board himself, William McChesney Martin, Jr., in a statement quoted in this column of May 21: “We fight inflation partly because it is the forerunner of deflation. . . . If I thought inflation would create jobs and prosperity, I might be for it. But I am convinced that, apart from transitory effects, the result of inflation is the destruction of jobs and prosperity.”

PRICE-WAGE RACE

It is hard to get people to realize this today. Money-and-credit inflation has seemed to work its “full-employment” magic in the United States for the last fifteen years. Nevertheless, inflation can bring “full employment” only under special conditions, which are unlikely to prevail for more than a limited time.

The first of these special conditions is that prices must rise faster than wage costs in order to restore or increase profit margins. A second condition is that businessmen must be convinced that prices will continue to keep ahead of wage rates and other costs, otherwise business will not embark upon ambitious expansion plans. A third condition is that lenders, on their side, must be convinced that the inflation has come to an end. If they also believe that inflation will continue into the future, they will refuse to lend except at high rates that compensate for the expected depreciation of their money.

Whenever any one of these three major conditions ceases to exist, monetary inflation will cease to create “full employment.” Yet for these three conditions to exist, both workers and lenders must be the victims of what the economist Irving Fisher called the “money illusion.” The workers must fail to recognize that their real wage rates are going down (because prices are going up faster), and creditors must fail to recognize that they will lose real purchasing power as a result of their loans.

THE MONEY ILLUSION

An instructive table published in the May letter of the First National City Bank of New York showed that those who bought U.S. Savings Bonds at any time between 1935 and 1946, and held them for a ten-year period, suffered an actual loss from their investment. The interest received has not been enough to compensate for income-tax payable and the “inflation tax” levied in the form of a shrinkage in the buying power of the dollar. This condition continues. In the week ended, May 22 last, for example, wholesale commodity prices showed an average increase of more than 4 percent for the twelve-month period. This means that a businessman who lent out his money at 4 percent or less twelve months before got practically no real interest at all. When lenders come to expect any such annual rate of price increase in the future, they will insist on adding it as a “price premium” to what the rate of interest would otherwise be. That is why money rates tend to soar in the late stage of an inflation.

An inflation brings “full employment,” in short, only as long as prices are rising faster than wage or interest rates, or keeping ahead of them. As soon as wage costs start to race ahead of prices, as they now show signs of doing, then, whether or not there is more inflation, the result will inevitably be unemployment.

Inflation always brings about great strains and distortions in the economy. This is why Chairman Martin of the Federal Reserve Board is correct when he declares that the ultimate result of inflation is “destruction of jobs and prosperity.” The longer inflation is continued, the greater the correction that must ultimately be made. It is much better to permit a relatively mild adjustment now, than to force a more violent correction later.