Some Consequences of Inflation

I take it for granted that an inflation of, say, 5 percent or more per year continued for more than a few years would become intolerable "in a modern industrial country like the United States. It would bring revolutionary changes in the income distribution, rapidIy depreciate hundreds of billions of dollars worth of bonds, life insurances, mortgages, and other monetary assets, and would be extremely hard on fixed income receivers. It is true that our capitalist. economy has shown tremendous re cuperative power. The two war inflations have, in fact, brought about some of the changes I just mentioned, but our productive capacity and social fabric remained undamaged. The war experience does not, however, in the least contradict the statement that a peacetime infla.tion of 5 percent ot more per year would soon become intolerable. Before it brought about radical changes, it surely would accelerate.

It would start a flight from monetary assets, raise interest rates, and lead to the introduction of escalator clauses in wages, salaries, and later in debt contracts. We can be sure that before it took on aspects of hyperinflation it would be stopped, if not by financial measures, then by direct controls. So far, the United States has been spared that type of inflation. The inflations we have had were war inflation, short-run cyclical inflations, and recently chronic, though intermittent, creeping in flation. Rapid, prolonged inflation is, however, rampant in many underdeveloped countries, especially in Latin America. There can be no doubt, I believe, that it retards economic growth. If some of the [46 ] highly inflationary countries, e.g., Brazil, have experienced economic growth nevertheless, they would have grown even faster with less inflation.! Let me briefly indicate how inflation damages the economies of underdeveloped countries and retards their economic growth.

Chronic inflation discourages·thrift and makes the development of a capital market well-nigh impossible. It is a constant complaint in underdeveloped countries that they are handicapped by the absence of a well-functioning capital market. But how could it be otherwise? It is true, a poor country cannot hope, even without inflation, to develop a capital market that distributes more capital-or to look at it from the other side, which absorbs more securities-·than the meager savings plus the funds that may be attracted from abroad permit. 'Inflation does not only discourage saving, it also drives sav ings abroad, i.e., it encourages capital flight and impedes capital imports. Without inflation there is no reason why small and poor couniries should not have well-functioning capital markets which efficiently and economically distribute the limited amounts of capital available among competing uses.

Furthermore, inflation not only dries up the sources of capital funds but also misdirects capital funds that become available. It may not discourage global investment, but it encourages the wrong kind of investment-excessive tperchandising, building, and inventories. Open inflation stimulates excessive investment in inventories. Con trolled or repressed inflation--if it is really effectively controlled sometimes does the opposite. Thus, the British economy in 1946 and 1947 under repressed inflation was denuded of commodity reserves, which greatly contributed to its brittleness and lack of adaptability. But in underdeveloped countries where inflation is more of the open kind, there is more danger of excessive inventory accumulation. The situation is made much worse by import controls. If businessmen are never sure whether materials, spare parts, and replacements will 1 It goes without saying that this statement has to be qualified with respect to the means used to stop inflation. It is always possible for Beelzebub to chase the devil.

[47 ] be available they lay in reserves which they otherwise would not need. Large amounts of capital are thus tied up and diverted from more productive uses. Even in underdeveloped countries prices are not entirely uncon trolled. The existence side by side of controlled and uncontrolled prices and areas creates very serious distortions. A glaring example is public utility rates. The prices of telephone and telegraph services, railroad fares, and electricity rates are subject to control. These prices then lag far behind in the general rise and the consequence is serious undermaintenance and underinvestment in these vital services. The problem becomes especially acute if these services are provided by foreign companies. Inflation, Hplanning," and government inter ventionthus lead to a deficiency in social overhead capital, the im portance of which for economic development the advocates of gov ernment planning never get tired of emphasizing.

The modern form of repressed inflation and semi-repressed infla tion causes or implies a proliferation of controls and interventions price control, import controls, exchange control, rationing, allocation, etc. This overtaxes and corrupts the administrative apparatus and diverts government energies and know-how from more important functions. This is a serious matter for any country, but especially for underdeveloped countries which are poorly endowed with the precious resource of governmental know-how, administrative effi ciency, and political honesty; it involves a great waste of scarce man power and brainpower which underdeveloped countries can ill afford. It is unfortunately, in general, impossible to estimate concretely the loss of income due to inflation in a particular country. But let me cite one informed guess of the order of magnitude of the loss in a concrete case. This estimate has been made by Professor Theodore W. Schultz of the University of Chicago. After careful investigations, Professor Schultz comes to the conclusion that Utoday Chile is operat ing about 2<1 or 25 percent below its normal output simply because of the way it is trying to live with its chronic inflation. If you go, around in Chile and just assess the resources in agriculture, and in the shops in the cities, and so forth, you have rather a firm basis that if for a few years, there were to be a stable price level, and expectations [48 ] got adjusted, one would see that economy produce about 20 or 25 percent more than is now the case. There is that much slack in the economy, and the slack comes from the fact that there are price rigidities, price controls, and some factor prices, and product prices are held down, foreign exchanges are regulated, all sorts of devices are brought into play, and each distorts the economy a bit, and in Chile these distortions have become serious." 2 Chile may present an extreme case, but there are others not much less serious.

Let me concede freely that situations are thinkable and do arise in which inflation, even rapid inflation, may appear to be the lesser evil -a terrible evil to be sure, but still better than some alternatives. If a country grows despite inflation, this may be deemed better than no growth at all. And governments sometimes manage to maneuver themselves into a position where this is the only alternative. Let me give two examples, for which it would be easy to cite concrete instances from recent Latin American history. If wage rates of indus trial workers are raised exorbitantly by minimum wage legislation-50 or 100 percent jumps of statutory minimum wages are no rarity in Latin America---or by government-coddled labor unions, massive inflation may be the only way to prevent disaster. Or if governments by means of deficit financing continuously try to capture a larger and larger fraction of the national product for unproductive purposes (for the upkeep of an exorbitant military establishment, lavish gov ernment .buildings, expansion of a huge bureaucracy, overambitious social welfare establishments, etc..) it may well be the lesser evil to top the government inflation by private credit inflation, i.e., to intensify inflation, in order to prevent the government from bidding away too large a portion of available resources from productive investment for its wasteful purposes. But it cannot be emphasized too strongly that such situations where rapid inflation appears to be the lesser evil are always the result of faulty policies. They may be 2 Hearings before the Subcommittee on Foreign Economic Policy of the Joint Committee on the Economic Report, Foreign Econolnic Policy J 84th Congress, 1st Session, 1955, pp. 581-82.

[49 ] socially and politically difficult to avoid but there is no intrinsic economic reason, even in underdeveloped countries, why they should not develop without inflation-and without· the continuous sapping of economic strength which the losses and wastes of inflation entail. 3 Let us turn our attention now to the slow creeping type of inflation with which the United States and other industrial countries are con fronted. An annual price rise of 2 to 3 percent is, of course, a lesser evil than one of 5 percent or more. 4 Some people may argue that if the alter native to such inflation is permanent unemployment of, say, 6 or 7 percent of the labor force (on the average over good and bad years) with the corresponding annual loss of output and income, this condi tion would still be preferable to the in justices and evils of an inflation of 5 percent per year or more; but that they would accept a 2 to 3 percent inflation as the price fOf reducing unemployment by 3 or 4 percentage points and for avoiding the annual income loss that the unemployment entails. They might add that in the case of a slow inflation it would be easy to eliminate the more glaring injustices by frequent adjustment of fixed incomes and escalator clauses in .long term contracts.

The plausibility and reasonableness of the social preferences ««value judgments") implied by such views are debatable and I shall not discuss them. The crucial fact is that in reality there exists no such choice. A continuous creeping inflation of 2 to 3 percent a year could not go on indefinitely without causing unemployment. After a while the creeping inflation would accelerate, or if it were kept at the creeping pace the unemployment would emerge which the 3 On this point compare the eloquent paper "Inflation and its Control in Underdeveloped Countries" presented by A. W. Marget to a Round Table on Inflation organized by the International Economic Association in Elsinore, Denmark, 1959. 4 This statement could be questioned only on the ground that a rapid inflation would soon become clea~ly intolerable and therefore stopped, while a creeping inflation is more likely to drag on for a long time before something is done about it.

creeping inflation was supposed to forestall. I am speaking now of continuous creeping inflation. The case of the intermittent} that is, from time to time interrupted or reversed, creeping inflation is not quite so clear. Its course and outcome depend on the frequency and magnitude of the interruptions or reversals. That the pace of continuous creeping inflation will inevitably tend to quicken, if it is not halted or reversed, follows from the fact that as creeping inflation continues, more and more people will expect a further rise in prices'and will take steps to protect themselves. Interest rates will go up because the lender wants protection from the depreciation of the value of money and the borrower thinks he can afford to pay higher rates because the price of his products will go up; labor unions will ask for high wage increases in order to secure real improvement; the frequency of wage and salary adjust ments will increase and cost of living escalators will be built into more and more· contracts; and eventually Hfixed" incomes will be regularly adjusted.

It is, therefore, an illusion to believe that a creeping inflation can remain so indefinitely. How long it takes before it starts to accelerate, and the rate of acceleration, depend on many factors, among them past history. People who have gone through a disastrous inflation react quicker than those, like Americans, who have had less experi ence with inflation. But the fact that this country has not experienced a significant price fall for a long time has made many people more sensitive to inflation than they were before World War II. For that reason, it is quite misleading to compare the price rise from 1955 to 1957 with the price rise during earlier periods of business cycle expansion, ·as is often done, and to conclude that there is no reason to worry. Intermittent creeping inflation is less serious than continuous in flation, for the lulls in the price rise provide a breathing spell during which confidence in the stability of the value of money can revive But it seems that since the end of World War II, the intermission~ have been too short fully to restore confidence. It takes then only a short period of renewed upcreep of prices to rekindle fears of infla[ 51 ] tion, which in turn lead to anticipatory actions tending to turn the creep into a trot.

Some proponents of the theory that creeping inflation is no serious menace take the position that the monetary authorities always have it in their power to prevent creeping inflation from accelerating. The late Professor S. H. Slichter, for example, called upon the Federal Reserve to keep money sufficiently tight to prevent prices from rising by something like 5 percent a year, but to make sure that prices are allowed to go up by 2 to .3 percent. An annual price rise of more than 4 or 5 percent would be dangerous inflation. Less than 2 or 3 percent would create unemployment because of the irresistible wage push exerted by labor unions. It is, of course, true that sufficiently tight money can prevent prices from rising faster than 5 percent annually-or any· other pre assigned rate. But everything will not be fine if an acceleration of the price rise is prevented by monetary policy. That belief forgets that once.a creeping inflation tends to accelerate-because wages, interest, ~nd other cost items are increased in anticipation of rising prices the policy of keeping the price rise to a creep must have the. same results, i.e., unemployment, as would prevention of the price creep in the first place. Creeping inflation is only a temporary stopgap if Professor Slichter were right in saying that labor unions will always insist on, and have the power to obtain, wage increases in excess of the general rise in average productivity. Only under one condition would the distortion be rectified: if unidns, and everybody else, could be fooled indefinitely to regard, despite rising prices, exactly balancing increases in money incomes as representing increases in real income.

5 5 It is interesting to recall that Keynes, too, in T he General Theory, Harcourt, Brace & Co., New York, made the untenable assumption that workers are under such a strong money illusion that they don't realize the difference between money and real wages. But he wrote during the Great D'epression when prices were falling and he was thinking of wage reductions rather than wage increases. If confined to these conditions, the assumption is not so absurd as it is under inflationary conditions. [ 52 ] This obviously is entirely unrealistic, especially during a period of chronic inflation when awareness of changes in the value of mdney has been greatly sharpened. You cannot fool all the people all the time. If the dilemma of the wage push does in fact exist, inflation cannot avoid but only postpone it. Moreover, if a wage push did not exist in the first place, that is to say, if demand pull were the original cause ·0£ inflation, prolonged inflation is likely to create wage push, because inflation fosters the emergence of labor unions, it gives them prestige and power by offering them unending opportunities for easy (though under those circumstances largely phony) successes in the form of wage increases which would have come anyway, but for which the· unions take credit. This will accustom them to annual wage increases, which they then will try to continue when the demand pull has come to·a halt.

Professor Slichter's prescription for the monetary authorities-that they must allow a 3 percent inflation, but must not let it go to or beyond 5 percent-is tantamount to asking for a balancing act which defies the laws of physics; it prescribes that the central bank should walk a tightrope, not straight, but bent over with all the weight on one side! [ 53 ] BUSINESS CYCLES, GROWTH, AND INFLATION THE UNITED STATES has never before, certainly not during the 19th century, gone through a period of chronic inflation, continuous or intermittent, resembling the inflation of the last twenty years. The same holds true of Western Europe. The inflations that the country experienced before 1940 were war in.flations or cyclical inflations which almost always characterize the upward phase of the short-run business cycle, and beyond that the mild undulations of the so-called ulong waves," sometimes called HKondratieff cycles." The latter are, however, not very pronounced and some prominent experts who have made careful investigations, think that the long waves are Hto some extent illusory" or Hpartly an optical illusion." 1 Suffice it to say that none of the so-called long waves offers an example of an extended period of price rise of the same order of magnitude or the same character as the price rise of the last twenty years.