How Inflation Breeds Recession; H. Hazlitt

How Inflation HENRY HAZLITT BOTH general economic and purely monetary theory are supposed to ha ve made immense advances since the middle of the eighteenth century, yet the confusion and chaos in economic and monetary theory have never been greater than they are today. One would think, listening to television and reading the newspa.pers and mag azines, that inflation - in the pop ular sense of soaring prices were some infinitely complicated, mysterious and incurable afflic tion that had suddenly struck us from the blue, instead of simply what it is - the inevitable conse quence of the actions of govern ment in overspending and then printing paper money. And as the cause is obvious and simple, so is the .fundamental cure. Mr. Hazlitt, noted economist, journalist and author, adds what might well be another chap ter to one of his books: What You Should Know About Inflation. This article is based on a paper delivered January 6, 1975, at a monetary conference in Miami.

ds The direct cause of soaring prices is printing too much papermon ey; the direct cure is to stop printing it. The indirect cause of inflation is government over spending and unbalancing the bud get; the indirect cure is to stop overspending and to balance the budget. But if the cause and cure of in flation are so fundamentally sim ple, why is there so much befud dlement? One reason, of course, is that the problem is not merely economic, but. political. The prob lem is not merely, for example, to get the politicians to recognize the true cause and cure of inflation. It is also to get them to ackno'wl edge that cause and adopt that cure. In brief, one reason so many politicians do. not understand the problem is not merely that they are too stupid to understand it, but that they do not want to un derstand it. They realize that inflation is a 131 132 THE FREEMAN Ma,rch political racket. They find that the way to get into office is to advocate inflation, and the way to stay in is to practice it. They find that the way to be popular is to appropriate handouts to pressure groups who represent mass votes, and not to raise taxes except those that seem to fall mainly on some unloved or envied minority group - oil companies, corporations gen erally, the reputedly "rich" or "superrich."

The ultimate result of such poli cies is to bring about exactly what we have today - inflation plus re cession. But we are brought back to the fact that politicians could not ex ploit the befuddlement of the pub lic about inflation if that befud dlement did not already exist. So though we must not overlook the political side of the problem, we must recognize that our main task is still one of educating the public. This is a much bigger problem than it is commonly thought to be. Even when we have explained to people that inflation is caused by excessive issues of paper mon ey, and by budget deficits that lead to excessive issues of paper money, we have done only a small part of our task. We have ex plained what causes inflation, but we have not explained why infla tion is so pernicious. The truth is that the greater part of the public still thinks that inflation is on the whole beneficial. They knovv that it raises the prices of com modities, but the chief thing they consider bad about this is that it may not raise their wage-rates or salaries to the same extent. Near ly everybody thinks that inflation is necessarily stimulating to busi ness, because they think it must raise profit margins and so lead to greater production and employ ment.

This is indeed usually true in the first stages of inflation. But what is still recognized only by a tiny minority is that in the later stages of inflation this ceases to be true. In its later stages inflation tends to bring about a disorgani zation and demoralization of busi ness. It tends to do this in several ways. First, when an inflation has long gone on at a certain rate, the public expects it to continue at that rate. More and more people's actions and demands are adj usted to that expectation. This affects sellers, buyers, lenders, borrowers, workers, employers. Sellers of raw materials ask more from fabri cators, and fabricators are willing to pay more. Lenders ask more from borrowers. They put a "price premi urn" on top of their normal interest rate to offset the ex pected decline in purchasing pow er of the dollars they lend. Work1975 HOW INFLATION BREEDS RECESSION 133 ers insist on higher wages to compensate them not only for present higher prices but against their expectation of still higher prices in the future.

The result is that costs begin to rise at le'ast as fast as final prices. Real profit margins are no longer greater than before the inflation began. In brief, inflation at the old rate has ceased to have any stimulative effect. Only an in creased rate of inflation, only a rate of inflation greater than gen erally expected, only an acceler ative rate of inflation, can con tinue to have a stimulating effect. But in time even an accelerative rate of inflation is not enough. Expectations, which at first lagged behind the actual rate of inflation, begin to move ahead of it. So costs often rise faster than final prices. Then inflation actu ally has a depressing effect on business. A Crucial Oversight This would be the situation even if all retail prices tended to go up proportionately, and all costs tended to go up proportionately. But this never happens - a crucial fact that is systematically con cealed from those economists who chronically fix their attention on index numbers or similar aver ages. These economists do see that the average of \vholesale prices usually rises faster than the aver age of retail consumer prices, and that the average of wage-rates also usually rises faster than the average of consumer prices. But vvhat they do not notice until too late is that market prices and costs are all rising unevenly, dis cordantly, and even disruptively.

Price and cost relationships be come increasingly discoordinated. In an increasing number of in dustries profit margins are being ,viped out, sales are declining, losses are setting in, and huge layoffs are taking place. Unem ployment in one line is beginning to force unemployment in others. All this is the consequence of an inflation in its later stages. But the irony is that this conse quence is systematically misin terpreted. The real trouble, every body begins to think, is that there is not enough inflation; it must by all means be speeded up. This is the stage at which we have now arrived. A swelling chorus of voices has been de manding that the Federal Reserve "temporarily," at least, increase the growth rate of the money supply. It is almost universally believed that the reason the banks' prime lending rate was recently at 12 per cent is that the Federal Reserve was following a "tight money" policy. The Federal Re serve authorities even themselves 134 THE FREEMAN seem to believe this. In early De cember they reduced the discount rate from 8 to 7314 per cent, and a month later to 714 per cent, to prove that they meant to follow a less stringent money policy.

The truth is that market money rates have been high precisely because we have been inflating, precisely because the Federal Re serve has for too long been fol lowing a recklessly loose money policy. As compared with the 8 per cent discount rate of the Fed, the discount rate of the Bank of England was last year between II1j2 and 121j2 per cent, the dis count rate of the Bank of Brazil 18 per cent, the discount rate of the Bank of Chile 75 per cent. Discounting Inflation None of these rates was a result of a tight money policy in the countries concerned. Quite the contrary. The greater the past or present rate of inflation, the high er the present prevailing interest rate. This is because, in the later stages of an inflation, people ex pect the recent rate of inflation to continue. If they believe, for ex ample, that the dollars or pounds or cruzeiros or escudos that they lend today will have a purchasing power of x per cent less when they get them back a year from today, they will add that x per cent to the normal rate of interest they would otherwise have ex pected. If their expectations are justified, though they will be get ting a very high nominal rate of interest, their real rate of interest will not be above normal. But the high nominal rates of interest will none the less tend to discourage borrowing.

Again, as· I have already point ed out, labor unions will begin to demand so-called "protective" pay increases sufficient not only to compensate them for the commod ity price increases that have taken place since their old contract was signed, but for the price increases that they fear will take place in the future life of their new con tract. Union demands will tend to become increasingly unreasonable. The number of strikes will tend to increase. Profit margins will be squeezed or wiped out arbitrarily. Price-and-cost relationships among different industries will become increasingly unsettled, unpredict able and disorganized. In short, "protective" actions and other compensatory reactions to inflation and expected inflation will often turn inflation in its later stages from a stimulating force to a depressing and demor alizing force. But the public and politicians will increasingly be lieve that these depression conse quences of continued inflation are the consequences of insufficient in1975 HOW INFLATION BREEDS RECESSION 135 flation. They will demand that the inflation be still further accele rated.

The reason an inflation is not stopped is that people begin to dread more· and more what will happen if it is stopped. They fear a stabilization crisis. They fear mass unemployment. The only al ternative seems to be to accelerate the inflation. But, as we see, this simply leads to increasing disor ganization and demoralization of business. In the end, we begin to get mass unemployment anyway. Suppose, by some miracle, the government stopped inflating now. Would the consequences real ly be as bad as most people fear? There is every reason to think that they would be incomparably better than if the demoralizing ef fects of the inflation are allowed to continue. German HyperInflation We can get some light on this if we study what happened in the great German hyperinflation which ran roughly from 1919 to the end of 1923. In the course of that inflation the German paper mark fell to a purchasing power equal to only one-trillionth of what it had been before the inflation set in. This is another way of say ing that prices soared a trillion fold.

In the last stages of that inflation production beca.me disorgan ized and unemployment soared. In dustrial production plunged from an index number of about 125 in 1921 to about 60 in 1923. Unem ployment a.mong trade union members, which had been as low as 0.6 per cent in July of 1922, rose to 19.1 per cent in October, 1923, to 23.4 per cent in Novem ber, and to 28~2 per cent in De cember. The index of the real in come of the German industrial population plunged from a. range of 75 to 105 in 1921 (with 1913-14 equal to 100) to a. range of only 36 to 47 in November of 1923. These figures are taken from Prof. Frank D. Graham's 1930 book on the German inflation. They show how inflation in its later stages can demoralize pro duction, real income and employ ment. Was the stabilization crisis so dreadful when this inflation was finally brought to a halt? I regret that the commonly available fig ures are not quite adequate to an swer this question satisfactorily.

Practically all the tables published in the books of both Frank D. Graham and Costantino Bresciani Turroni end at December, 1923. But supplementary evidence indi cates that the s.tabilization crisis was brief and the recovery quick. The index of the physical vol ume of industrial production per 136 THE FREEMAN March capita, taking 1913 as a basis of 100, had faUen to 54 at the peak of the inflation in 1923. It rose to 77 in 1924, to 90 in 1925, and to 111 in 1927. This was a better com parative record of recovery from 1913 than that of England, Italy, or West Europe generally. Heavy Unemployment? C. W. Guillebaud of Cambridge University, in his book The Eco nomic Recovery of Germany (1939), tells us that "The cessa tion of inflation brought with it as its immediate effect a large in crease in recorded unemployment, which rose to 1,533,000 on J anu ary 1, 1924." The justification for this state ment depends on what date we place on "the cessation of infla tion." The monetary reform was introduced by a decree issued on October 15, 1923. The actual in troduction of the new currency, the rentenmark, did not come un til November 20, 1923. But the Reichsbank kept grinding out pa per marks at accelerative and as tronomical rates continuously through the end of December.

If we consult the monthly sta tistical series (not given in any table in Guillebaud's book) from which his January figure was ap parently taken, we find that re corded unemployment in October, 1923 was 534,000, in November 955,000, and in December 1,473, 000. So the January figure of 1,533,000 of recorded unemployment was not much above this. In any case this unemployment was shortlived. In spite of interest rates, in terms of the new currency, as high as 100 per cent in January, and even from February to May at an aver age, figured annually, of 35 per cent, Guillebaud tells us that "ac tivity revived, and, unemployment for the first time since August, 1923 began to decline, and was not more than 700,000 in April, 1924." It fell to 328,000 by July, better than a normal average. Rapid Recovery A similar picture of recovery is given by Costantino Bresciani Turroni, in his book The Econom ics of Inflation (1931). This is the most thorough and the most fa mous of the books written on the great German inflation. Bres ciani-Turroni tells us that in the first months of 1924, when the in flation was over, there was "a re markable increase in wages," and that this "big increase in the av erage income of workers was the combined effect of the rise in wage-rates and the fall in unem ployment" (p. 396). And in the final summary paragraph of the book he writes: "At first inflation stimulated 1975 HOW INFLATION BREEDS RECESSION 137 production because of the diver gence between the internal and external values of the mark, but later it exercised an increasingly disadvantageous influence, disor ganizing and limiting production.

It annihilated thrift; it made re form of the national budget im possible for years; it obstructed the solution of the Reparations question; it destroyed incalculable moral and intellectual values. It provoked a serious revolution in social classes, a few people ac cumulating wealth and forming a class of usurpers of national prop erty, whilst millions of individ uals were thrown into poverty. It was a distressing preoccupation and constant torment of unnumer able families; it poisoned the German people by spreading amon,g all classes the spirit of speculation and by diverting them from proper and regular work, and it was the cause of incessant political and moral disturbance. It is indeed easy enough to under stand why the record of the sad years 1919-23 always weighs like a nightmare on the German peo ple." The lesson is clear. We should stop our own inflation now. Not some time in the future, but now.

We should not slow down the rate gradually over the years, but stop inflation now. And this means, to repeat, two main measures: first, balance the budget, balance it wholly by slashing expenditures and not at all by raising taxes; and second, stop expanding bank credit and printing paper money. Some other measures will be necessary to make these two basic steps effective, but I will mention only one of them, because of its overriding importance. We should repeal all the labor laws, passed over the last forty years, that build up the power of labor un ions, strengthen the extortionate strike-threat system, and in effect force employers to capitulate to labor union demands. This means the repeal of the Norris-Laguardia Act, of the Wagner-Taft-Hartley Act, of the Davis-Bacon Act, and probably a nest of others. f) IDEAS ON LIBERTY Inflation THE FATAL ERROR - that the credit and currency of the Continental money could be kept up and supported by acts of compulsion entered so deep into the mind of Congress and of all departments of administration through the states that no considerations of justice, religion, or policy, or even experience of its utter inefficacy, could eradicate it.

PELATIAH WEBSTER, "Strictures on Tender Acts" (1780) LAWRENCE FERTIG JUST A FEW MONTHS AGO when President Ford took office it was proclaimed from the White House, and nightly on television and in the press, that inflation is our Enemy Number One. But then - in the words of the famous play - a Funny Thing Happened on the Way to the much-publicized Sum mit meetings. It was discovered by many authorities that inflation is not necessarily Enemy Num ber One, but. might be considered Enemy One-Half, One-Fourth or perhaps Enemy Zero. It was said we faced what was called "Stagflation," and it was asserted that we had better fight Mr. Fertig is a noted economist and journal ist. This article is extracted by permission from a paper delivered November 14, 1974 at a conference of the Committee for Monetary Research and Education. 138 the "Stag" part and not pay too much attention to the "flation."