Business Cycles, Growth, and Inflation

However, many prominent economists (not to mention scores of lesser writers and outright cranks) have linked inflation and growth, or pictured inflation in one form· or other as -a helping or even an indispensable condition of economic growth. Keynes has devoted much space to the discussion of inflation in almost everyone of his economic writings. In one of his first books, The Economic Conse quences of the Peace (of Versailles), he had this to say: Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. . .. Lenin was certainly right. There is no subtler, no surer means of over turning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one in a miUion is able to diagnose.2 1 See A. F. Burns and W. C. Mitchell in their authoritative study Measuring Business Cycles} National Bureau of Economic Research, New York, 1949, p. 460.

2 London, 1919, g. 220.

This sounds like an indictment of the slow creeping inflation, but was actually directed against open war inflation which makes the description of the process as ltsubtle" somewhat inappropriate. 3 In the 1930's Keynes became, understandably, more and more preoccupied with the dangers of deflation and, by comparison, in flation lost in Keynes' mind much of its dread and ominous qualities. But it is incorrect and unfair to call Keynes, as is done so often, an out-and-out inRationist. It is true that in his A Treatise on Money,4 he sings the praise of ltprofit inflation" as a stimulus to economic progress and, carried away as he often was by the flash of an idea 3 The next paragraph reads as follows: In the latter stages of the war all. the belligerent governments practised, from necessity or incompetence, what a· Bolshevist might have done from design. Even now, when the war is over, most of them continue out of weakness the same malpractices.

But further, the Governments of ~urope, being many of them at this moment reckless in their methods as well as weak, seek to direct on to a class known as "profiteers" the popular indignation against the more obvious consequences of their vicious methods. These "profiteers" are, broadly speaking, the entrepreneur class of capitalists, that is to say, the active and constructive element in the whole capitalist society, who in a period of rapidly rising prices cannot but get rich quick whether they wish it or desire it or not. If prices are continually rising, every trader who has purchased for stock or owns property and plant inevitably makes profits. By directing hatred against this class, therefore, the European Governments are carrying a .step further the fatal process which the subtle mind of Lenin had consciously con ceived. The profiteers are a consequence and not a cause of rising prices. By combining a popular hatred of the class of entrepreneurs with the blow already given to social security by the violent and arbitrary disturbance of contract and of the established equilibrium of wealth which is the inevitable result of inflation, these Governments are fast rendering impossible a continuance of the social and economic order of the nineteenth century.

4 Vol. II, Chapter 30, Historical Illuj-trations.

and his own eloquence, puts forward a theory which almost amounts to an ((inflationary interpretation of history." He speaks of ~tthe extraordinary correspondence between periods of Profit Inflation and Profit Deflation and with those of national rise and decline." The greatness of Spain coincides with the Profit Inflation from 1520 to 1600 and her eclipse with the Profit Deflation from 1600 to 1630. . .. In the years of The Armada, Philip's Proht Infla tion was just concluded, Elizabeth's had just begun. And if we compare France with England, the contrast between the financial strength of Louis XIV and the financial weakness of James II is seen to be due to the fact that wages in France did not rise relatively to prices in the last two decades of the 17th century as they did in England. 5 These are fascinating 'speculations. But Keynes was clearly in a playful mood and wrote with tongue in cheek, especially when he pictured Shakespeare riding the wave of inflation.

We [in England] were just in a financial position to afford Shakespeare at the moment when he presented himself. . .. I offer it as a thesis for examination by those who like rash gen eralizations that· by far the larger proportion of the world's greatest writers and artists have flourished in an atmosphere of buoyancy, exhilaration and the freedom from economic cares felt by the. governing class, which is engendered by profit inRa tion. G To be'serious, Keynes' historical examples are taken mostly from the pre-capitalist or early-capitalist era. It may be true that under those circumstances inflation was sometimes an explosive force which served'to shake countries loose from feudal bonds and in this way promoted economic progress. But Keynes made it quite clear that he was not speaking of inflations resembling the present creeping type. t1t is the teaching of this Treatise," he said, ((that the wealth of nations is enriched, not during Income Inflations but during Profit Inflations-at times', that is to say, when prices are running away from costs," i.e., from wages and hence real wages are falling.

7 5 Ibid., p. 16l. 6 Ibid., p. 154. 7 Ibid., p. 154.

The clear implication is that Keynes would have looked with great concern on the present kind of inflation, no matter whether it is of the pure wage-push type in the sense that wages are pushed up and prices follow, or whether prices forge ahead and wages follow with out delay, quickly annihilating the profits produced· by the price rise. What matters from Keynes' standpoint was that wages (and other nonprofit incomes) should lag substantially behind prices so as to leave a large and long-lasting margin for profits. This is clearly out of the question under present-day conditions. It is probably for this reason that Keynes, despite all he said in favor· of profit inflation, summed up his position as follows: HI am~not yet converted, taking everything into account, from a preference for a policy to-day which, whilst avoiding Deflation at all costs, aims at the stability of purchas ing power as its ideal objective." 8 There is no reason to believe that.

he ever changed his position. During World War II he became again concerned with the problem of inflation. But he, like many others, underestimated the danger of inflation for the postwar period and was too much preoccupied in his postwar plans with guarding against deflation, thus preparing to fight, like many famous generals, .the battles of the last war. There can be no doubt, however, that if Keynes had lived longer he would energetically have taken up the fight against chronic inflation which, in his scheme of things, clearly is in the nature of income rather than of profit inflation. Schumpeter, too, attributed to inflation an important role .for economic growth under the capitalist system, of whose capacity to increase output and to raise the economic welfare of the masses he had the highest opinion. 9 According to him, the capitalist, free 8 Ibid., p. 163. 9 It is true that he was peSSImIstIc, in fact unduly pessImIstIc, with respect to the chances of capitalism to survive. But his gloom was not based on the belief that capitalism, under present-day economic circum stances, has lost its productive power. On the contrary, he said explicitly and emphatically that there was every reason to believe that the capitalist system, if given a chance, would continue to produce spectacular results.

His theory was that by an inimical anticapitalistic social and political atmosphere and misguided policies (which by complicated sociological enterprise economy necessarily develops and grows in cycles. Mild fluctuations of business activity 10 are an essential part of the capitalist growth mechanism and credit inflation is an essential ingredient of the business cycle upswing. The prosperity phase of the cycle is the time when the innovating entrepreneurs introduce new ventures (new products, new markets, new methods of production, etc.) into the economic system. These innovations require large investments which are partly financed by inflation. Inflation and the forced saving which it entails, are the method by which the innovating entre preneurs draw resources away from the more stagnant or routine parts of the economy. Just as Keynes, so Schumpeter regards only profit inflation-in flation which is not too quickly followed by wage rises-as poten tially productive. He makes it clearer than Keynes that in the nature of the case this productive inflation can be no more than a passing phase of limited duration and must be unforeseen and unanticipated.

In fact, he was of the opinion that in a well-functioning capitalist economy the Unatural" long-run trend of the price level is downward rather than upward, because during the depression phase of the cycle, when the new innovating investments undertaken during the upswing begin to bear fruit, prices normally would fall more than they rose during the preceding boom. Without necessarily accepting every detail of Schumpeter's theory, I find it difficult to believe that it does not contain a good measure of truth. Another conclusion is also clear, namely, that the current type of chronic inflation in which wage push plays an important role, either theorizing he explained as the very consequence of the prodigious produc tion feats of the capitalist system) capitalism would not be given much longer the chance to demonstrate its undiminished productive capability. (See his Capitalism, Socialism and Democracy, 2nd edition, New York, Harper & Bros., 194 passim.) 10 Severe depressions like the Great Depression of the 1930's are, of course, entirely different. They definitely retard growth, but are due to special factors that are not inherent in the mechanism of capitalist development.

as an initiator or as a quick-acting intensifier of a demand-initiated inflation, cannot possibly be justified on Schumpeterian grounds. Attempts have often been made to shed light on the question whether chronic inflation is likely to help or to hinder economic growth by statistically correlating price changes and growth rates. Such computations are designed to answer questions like these: Are periods of rapid growth in anyone country concentrated in time spans of rising, stable, or falling prices? Has there been a tendency during a given period for output to grow faster in those countries that managed better to keep prices stable than in those that were less successful in containing inflation? Brief reflection should make it clear that a mechanical approach to the growth problem is likely to be grossly misleading or completely worthless. For example, a correlation between annual growth rates and annual price changes would lead to the conclusion that inflation is highly conducive to economic growth, because as everybody knows business cycle expansions are almost invariably associated with rising prices and business cycle contractions with falling prices. This result is entirely useless for the problem of whether chronic inflation is likely to help or to hinder economic growth. Of much importance, however, is the fact revealed by closer study that it is by no means the most vigqrous business cycle expansions that are associated with the largest price rises.

Also misleading are comparisons between price changes and output changes in different countries over the same time interval. S. H. Slichter, for example, found that for the period of 1948-57 in Austria a large price rise (124 percent) was associated with a large increase in real product per head (94 percent), while Switzerland, with a very stable price level, had one of·the smallest increases in per capita output. 11 As a consequence of a highly destructive war, Austria started in 1948 from an extremely low output level. Production per capita"wa5; 11 "Slow Inflation: Our Inescapable Cost of Maximum Growth Rate," The Commercial and Financial Chronicle, March 26, 1959. For other countries he finds similar though less extreme results. [59 ] therefore, bound to rise sharply. In view of the fact that in 1948 scores of consumer goods were still unavailable, severely rationed, or of exceedingly poor quality, a situation which completely changed during the next ten years; the rise in the price level was partly spurious. To the extent that it was real, it was simply a necessary adjustment to international levels, which is highlighted by the fact that during the same period the real international value (black market quotation) of the Austrian currency almost doubled. On the question whether chronic inflation is conducive to economic growth, such comparisons contribute very little. And the example of Austria shows how ignorance or disregard of local conditions, especially in such disturbed periods as the postwar years, is apt to vitiate com pletely the conclusions.

12 A better method has been used by Otto Eckstein. 13 Using Simon Kuznets' data, he gives rates of growth of output per decade and rates of change of price per decade for the U. S., the U. K., and several other advanced countries covering the period of 1870 to 1954. It is highly important that during Hthe late decades of the 19th century, which saw some of the most rapid growth of Western countries, prices generally were falling." It is, of course, not surprising that there exist periods of falling prices associated with very low growth rates (e.g., in the U. S. in 1929-38) and decades of rapidly rising prices (mainly war inflation) that also were ,periods of exceptionally slow growth. That destructive wars and deflation retard economic growth is to be expected, but I should like to' recall that falling prices, when the price decline is due to rising output (as' in the late decades of, the 19th century), are radically different from falling prices that are due to the contraction of the monetary demand-' deflation of MV. Also recorded are decades of rising prices associated with rapid growth (e.g., in the U. S. in 1904-13 and 1939-48).

This checkered statistic~l 'picture has induced some investigators to 12 See also A. W. Marget, "Inflation: Some Lessons of Recent,Foreign Experience," American Economic Review, May 1960, p. 205. 13 Ope cit., pp. 361-62. [60 ] throw up their hands in despair and to conclude that nothing general can be said on whether inflation is good or bad for economic growth. In my opinion, this conclusion is much too defeatist. Surely decadal figures (the only ones available for earlier periods) are too crude, because they overlap cycles and war periods. But it does not follow that a more careful historical-statistical investigation, which pays attention to the cyclical phases and other special conditions of each period and country, would not lead to useful generalization. To my knowledge, a systematic investigation of that kind has not yet been made and this gap cannot be filled on this occasion. I confine myself to making a few general observations.

Such an investigation ought to keep three points firmly in mind. First, it cannot be denied, I believe, that a moderate inflation can stimulate investment and growth provided (a) that prices keep suffi ciently ahead of cost, in particular of wage costs, to create the neces sary profit incentives· for investment; and (b) that strong inflation psychology does not develop. If the latter happens, the chances are that even if profits are still satisfactory, the wrong kind of investments will be stimulated which entail a waste of resources and inevitably come to grief, causing losses and contraction of output and employ ment. It seems to me clear that in our times in both respects little margin is left for Ucreative" inflation d la Schumpeter and Keynes. Wages have become very flexible in the upward direction (while remaining rigid downward) and inflation psychology has become widespread and is ready to re-emerge quickly even when allayed by a lull in the price rise.

The second point to keep in mind is that the stimulus to investment and growth, which inflation can temporarily afford, can also be pro vided by non-inflationary policies without the same limitation and detrimental side effects. If it is true (as Schumpeter and Keynes say) that inflation promotes growth by creating profits which serve both as incentives and as financial sources of investment, it is also clear that the same incentives can be provided at stable or even at slightly fall ing prices, if only the increase in wages (and other costs) is kept in [ 61 ] bounds. I refrain from trying to specify what kind of wage rise would be compatible with non-inflationary growth. Depending on the circumstances it may be a little more or a little less than the average rise in labor productivity. But it should be stressed that under non-inflationary growth real wages will rise just as much, and in the long run faster, than under inflationary conditions.

14 That rapid growth is possible with stable or even falling prices is confirmed by the experience of the last decades of the 19th century and during the postwar period by the phenomenal growth of Western Germany and Switzerland. (The latter looks less impressive only because it started from a much higher base.) The third point to remember is that avoidance of chronic inflation is a necessary, though not a sufficient, condition for maximum growth. It is easy, for example, to think of methods of stopping inflation which would make things worse than they are under inflation. Sup pose we stop inflation in the 'face of a strong wage push by monetary or fiscal policy. The consequences will be losses, low investment, and unemployment. If nothing can be done about wage push, the only choice left is one between two evils-the wastes and dangers of inflation or unemplpyment. Which one is greater depends primarily upon the strength of the wage push and the vulnerability of the economy to inflation. The American economy, like the economies of other financially and economically highly-developed countries, is undoubtedly very vulnerable to chronic inflation, much more so than the more primitive economies of underdeveloped countries. In the U. S., the wage push (not to mention other types of cost push) is hardly strong enough to justify continuation of inflation with its mounting dangers and losses. In other countries, the scales may be weighted differently. But whatever one's judgment in this matter, onething is clear: chronic inflation can never be the best policy for growth, but only th~ lesser evil.

K~eping -all this in mind, it is not surprising that the statistical record does not show a one-to-one correlation between stable prices 14 In the short run, it may be possible to squeeze fixed income (not so much profits) in favor of wages. [62 ] and rapid growth. On the contrary, a priorione would expect to find in history periods of rising prices that are associated with higher rates of growth than certain periods of stable prices. But to repeat, it is highly signific~nt that one does also find periods of stable or even of falling prices which are characterized by rapid growth. A more extensive study would have to pay attention to several factors other than growth and prices--especially the movement of wages, other cost items, and profits and the ups and downs of the business cycle. It is sometimes said that inflationary wage push is good for growth because it forces entrepreneurs to invest in laborsaving machinery, to cut waste, and improve methods of production in every possible manner in order to protect their profits and not to be squeezed out of business.

This {(shock theory" of high wages attributes to wage push and inflation what in reality is the result of the normal forces of com petition. The inducement to expand, invent and invest, improve methods, and introduce new products, obviously depends upon profit expectatio~s (including avoid~nce of losses) and profits as a source of finance (to be ploughed back). Profits (and losses) depend (given technological knowledge and the entrepreneur's abilities) upon the relation between costs and prices. Now whatever is the relation of wages (and other costs) to prices that provides the necessary profits, it evidently can be realized at a rising as well as at a stable price level. Suppose we have wage push, wages rising 8 percent per year. Suppose, furthermore, that this wage rise requires a price rise of 5 percent a year in order to provide the necessary profits as an inducement and finance for investments and improvements (the excess of the increase of wages over the rise in prices being covered by a rise in productivity). Suppose now that there is no wage push; there is then no reason whatever why the same price-cost relationship, providing exactly the same profits as finance and inducement to invest and improve, cannot be had with stable prices and wages rising 3 percent, instead of wages rising 8 percent and prices 5 per cent a year.

[63 ] INFLATION AND THE DEFICIT IN THE U. S. BALANCE OF PAYMENTS ONLY TWO years ago it would have been difficult to find anyone, economist or not, who would have. thought that the state of the balance of payments could in the foreseeable future become an im portant factor in the choice between a Hlittle" inflation and no in flation. (It would have been conceded though that a Hbig" inflation, a price rise of 5 percent or more per year, after a while might cause balance of payments troubles.) Now the unexpected has happened. The state of the balance of payments has become a matter of widespread concern. It is true that the change has not come overnight. While many, experts and lay men, were ta.lking of a dollar shortage which was supposed to be perpetual and incurable (except by drastic measures incompatible. with a free enterprise economy relying on market forces), the U. S. has been running a deficit in its balance of payments of about $1· billion in every year since 1950 (except in 1957). But in 1958 the deficit jumped to $3.4 billion and continued at $3.7 billion through 1959. The D·. S. gold stock has fallen from $22.86 billion in 1957 to $19.51 billion in 1959 and short-term foreign liabilities which were at $7.12 billion in 1950 rose to $13.64 billion in 1957 and $16.11 billion in 1959.