17. (a) Inflation—A Short-term Expedient: (b) Inflation—The Deceit is Short-lived

In the first of these two extracts, Professor Hayek points out that one effect of inflation in its initial stages is to keep afloat businesses that would otherwise suffer losses. But as inflation proceeds and comes to be expected, costs are bid up in anticipation, profits shrink back to non-inflationary levels (in real terms), and apparently deflationary symptoms begin to appear.

In the second extract he outlines a non-inflationary criterion for monetary stability in line with currently unchangeable historical circumstances, viz. maintaining the stability of a comprehensive price index. Given the change in union wage-rate policy outlined in earlier extracts, such a monetary policy would also produce stability in total employment.

Professor Hayek emphasises two social dangers of inflation. First, by destroying the value of savings and of fixed incomes it creates the problem of poverty in old age, as well as a dangerous gap between the wealthy minority and the propertyless majority. Second, it reinforces the disinclination to take long-term effects into account when determining policy.

17. (a) Inflation—A Short-term Expedient

Although there are a few people who deliberately advocate a continuous upward movement of prices, the chief source of the existing inflationary bias is the general belief that deflation, the opposite of inflation, is so much more to be feared that, in order to keep on the safe side, a persistent error in the direction of inflation is preferable. But, as we do not know how to keep prices completely stable and can achieve stability only by correcting any small movement in either direction, the determination to avoid deflation at any cost must result in cumulative inflation. Also, the fact that inflation and deflation will often be local or sectional phenomena which must occur necessarily as part of the mechanism redistributing the resources of the economy means that attempts to prevent any deflation affecting a major area of the economy must result in overall inflation.

Inflation Similar to Drug-taking

It is, however, rather doubtful whether, from a long-term point of view, deflation is really more harmful than inflation. Indeed, there is a sense in which inflation is infinitely more dangerous and needs to be more carefully guarded against. Of the two errors, it is the one much more likely to be committed. The reason for this is that moderate inflation is generally pleasant while it proceeds, whereas deflation is immediately and acutely painful.³⁴ There is little need to take precautions against any practice the bad effects of which will be immediately and strongly felt; but there is need for precautions wherever action which is immediately pleasant or relieves temporary difficulties involves much greater harm that will be felt only later. There is, indeed, more than a mere superficial similarity between inflation and drug-taking, a comparison which has often been made.

Inflation and deflation both produce their peculiar effects by causing unexpected price changes, and both are bound to disappoint expectations twice. The first time is when prices prove to be higher or lower than they were expected to be and the second when, as must sooner or later happen, these price changes come to be expected and cease to have the effect which their unforeseen occurrence had. The difference between inflation and deflation is that, with the former, the pleasant surprise comes first and the reaction later, while, with the latter, the first effect on business is depressing. The effects of both, however, are self-reversing. For a time the forces which bring about either tend to feed on themselves, and the period during which prices move faster than expected may thus be prolonged. But unless price movements continue in the same direction at an ever accelerating rate, expectations must catch up with them. As soon as this happens, the character of the effects changes.

Inflation at first merely produces conditions in which more people make profits and in which profits are generally larger than usual. Almost everything succeeds, there are hardly any failures. The fact that profits again and again prove to be greater than had been expected and that an unusual number of ventures turn out to be successful produces a general atmosphere favourable to risk-taking. Even those who would have been driven out of business without the windfalls caused by the unexpected general rise in prices are able to hold on and to keep their employees in the expectation that they will soon share in the general prosperity. This situation will last, however, only until people begin to expect prices to continue to rise at the same rate. Once they begin to count on prices being so many percent higher in so many months’ time, they will bid up the prices of the factors of production which determine the costs to a level corresponding to the future prices they expect. If prices then rise no more than had been expected, profits will return to normal, and the proportion of those making a profit also will fall; and since, during the period of exceptionally large profits, many have held on who would otherwise have been forced to change the direction of their efforts, a higher proportion than usual will suffer losses.

The stimulating effect of inflation will thus operate only so long as it has not been foreseen; as soon as it comes to be foreseen, only its continuation at an increased rate will maintain the same degree of prosperity. If in such a situation prices rose less than expected, the effect would be the same as that of unforeseen deflation. Even if they rose only as much as was generally expected, this would no longer provide the exceptional stimulus but would lay bare the whole backlog of adjustments that had been postponed while the temporary stimulus lasted. In order for inflation to retain its initial stimulating effect, it would have to continue at a rate always faster than expected.

Accelerating Inflation

We cannot consider here all the complications which make it impossible for adaptations to an expected change in prices ever to become perfect, and especially for long-term and short-term expectations to become equally adjusted; nor can we go into the different effects on current production and on investment which are so important in any full examination of industrial fluctuations. It is enough for our purpose to know that the stimulating effects of inflation must cease to operate unless its rate is progressively accelerated and that, as it proceeds, certain unfavourable consequences of the fact that complete adaptation is impossible become more and more serious. The most important of these is that the methods of accounting on which all business decisions rest make sense only so long as the value of money is tolerably stable. With prices rising at an accelerating rate, the techniques of capital and cost accounting that provide the basis for all business planning would soon lose all meaning. Real costs, profits, or income would soon cease to be ascertainable by any conventional or generally acceptable method. And, with the principles of taxation being what they are, more and more would be taken in taxes as profits that in fact should be reinvested merely to maintain capital.

Inflation thus can never be more than a temporary fillip, and even this beneficial effect can last only as long as somebody continues to be cheated and the expectations of some people unnecessarily disappointed. Its stimulus is due to the errors which it produces. It is particularly dangerous because the harmful after-effects of even small doses of inflation can be staved off only by larger doses of inflation. Once it has continued for some time, even the prevention of further acceleration will create a situation in which it will be very difficult to avoid a spontaneous deflation. Once certain activities that have become extended can be maintained only by continued inflation, their simultaneous discontinuation, may well produce that vicious and rightly feared process in which the decline of some incomes leads to the decline of other incomes, and so forth. From what we know, it still seems probable that we should be able to prevent serious depressions by preventing the inflations which regularly precede them, but that there is little we can do to cure them, once they have set in. The time to worry about depressions is, unfortunately, when they are furthest from the minds of most people.