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A few
days ago I had an exchange with another brilliant product of one of
Australia’s economics departments. This rather conceited young man argued
that a little bit of inflation is necessary to maintain economic growth. I
tried to get it across to him that inflation is as about as healthy as
leprosy. Nevertheless, this young man’s dangerous belief is shared by most of
our economic commentariat and this is why one still hears it.
One of
those commentators is the renown Terry McCann, no less. This brought to mind
his statement of belief that “inflation is not only desirable in its own
right. It’s the absolute foundation of sustained growth in the economy and of
living standards” (Herald Sun, The prices
are right, 9 March 2007). As I recall, McCrann seemed to be coming
from one of two positions. The first one was the nonsensical belief that a
‘modest’ rate of inflation is necessary to promote spending and investment.
Therefore, without inflation prices would fall which would then curb spending
and investment and so depress economic activity. But the idea that any rate
of inflation can fuel genuine economic growth is utterly absurd, unless one
believes in the ‘beneficial effects’ of “forced saving”.
Jeremy
Bentham was, I believe, the first economist to outline the forced saving
doctrine (the process of using inflation to restrict consumption in order to
raise the rate of capital accumulation) which he called “Forced
Frugality”. (A Manual of Political Economy,
written in 1795 but not published until 1843, p. 44). Thomas Malthus, his
contemporary, pointed out the dangers and injustice of “forced savings”. (Edinburgh Review, February 1811, pp.
363-372.) John Stuart Mill described the process as one of “forced
accumulation” and condemned it with the statement that accumulating capital
by this means “is no palliation of its iniquity”. (John Stuart Mill, Essays on Economics and Society,
University of Toronto Press 1967, p. 307).
In the
early to mid-1720s Richard Cantillon, an Irish banker living Paris, produced
a brilliant work of sophisticated economic analysis that vividly described
how inflation distorts the pattern of production and causes a redistribution
of incomes and wealth. (Essay on the
Nature of Commerce in General, Transaction Publishers, 2001). It
was this essay that gave us the concept of the “Cantillon effect”. Yet not a
single member of our economic commentariat appears to have the slightest
acquaintance with this invaluable work. It’s not even as if Cantillon’s
opinion that money is not neutral is eccentric.
The
same vital point that Cantillon made was also stressed by Peter Lord King and
Henry Thornton et al. On the other hand, David Ricardo and John Wheatley
(both of whom, like Lord King, were bullionists) argued that the effect of
increases in the money supply on prices was strictly proportional. Hence a 10
per cent increase in the money supply would raise prices by the same amount.
Nevertheless, Ricardo1 and his supporters understood that
increasing the stock of money did nothing to improve the general welfare. As
Ricardo himself put it:
The
successive possessors of the circulating medium have the command over this
capital: but however abundant may be the quantity of money or of bank-notes;
though it may increase the nominal prices of commodities; though it may
distribute the productive capital in different proportions; though the Bank,
by increasing the quantity of their notes, may enable A to carry on part of
the business formerly engrossed by B and C, nothing will be added to the real
revenue and wealth of the country. B and C may be injured, and A and the Bank
may be gainers, but they will gain exactly what B and C lose. There will be a
violent and an unjust transfer of property, but no benefit whatever will be
gained by the community. (The High Price
of Bullion, a Proof of the Depreciation of Bank Notes, Printed by
Harding & Wright, St. John’s square, 1810, 49*).
Naturally
our current crop of sophisticated economic commentators would dismiss all of
the above as old fashioned stuff and nonsense that has been discredited by
modern economics. (A dismissive approach always beats having to debate
anyone). According to these economic pundits a steady increase in the money
supply is necessary if production is to be expanded. Oddly enough, this
thinking is strictly mercantilistic though the renowned David Hume2
also subscribed to it. (David Hume, Essays,
Moral, Political, and Literary, William Clowes and Sons,
Limited 1904, p.296.) Edward Misselden and Thomas Mun were 17th century
mercantilists who believed that “treasure” would stimulate production if
allowed to circulate. For example, Mun wrote:
[W]hat
shall we then do with our mony? the consideration of this, doth cause divers
well-governed States to be exceeding provident and well-furnished of such
provisions, especially those Granaries and Storehouses with that famous
Arsenal of the Venetians, are
to be admired for the magnificence of the buildings, the quantity of the
Munitions and Stores both for Sea and Land; the multitude of the workmen, the
diversity and excellency of the Arts, with the order of the government. They
are rare and. worthy things for Princes to behold and imitate; for Majesty
without providence of competent force, and ability of necessary provisions is
unassured. (England’s Treasure by Forraign
Trade. or The Ballance of our Forraign Trade is The Rule of our Treasure,
published for the Common good by his son John Mun of Bearsted in the County
of Kent, Esquire, 1664, Macmillan &
Co, 1895, p, )
Proto-Keynesians
like Misselden and Mun believed that the more gold in circulation the greater
would be a country’s prosperity. This thinking is but a single step from the
doctrine that a little inflation is good for a country. It was a step that
both men enthusiastically took, with Misselden cheerfully declaring:
And for
the dearnesse of things, which the Raising of Money bringeth with it, that
will be abundantly recompensed unto all in the plenty of Money, and quickning
of Trade in every mans hand. And that which is equall to all, when hee that
buye’s deare shall sell deare, cannot bee said to be injurius unto any. And
it is much better for the Kingdome, to have things deare with plenty of
Money, whereby men may live in their severall callings: then to have things
cheape with want of Money, which now makes every man complaine. (Free Trade or, The Meanes To Make Trade Florish,
Printed by John Legatt, for Simon Waterson, 1622, p. 106.)
Perhaps
the greatest proto-Keynesian of them all was John Law. It was his
proto-Keynesian belief that money stimulates trade, though he clearly
understood that the value of money was determined by its quantity and demand.
His error was to make employment a function of total spending which in turn
was determined by the quantity of money, as is evident in the following
quote:
Domestic
trade depends on the Money. A greater Quantity employs more People than a lesser
quantity. A limited Sum can only set a number of People to Work proportioned
to it, and ’tis with little success Laws are made, for Employing the Poor and
Idle in Countries where Money is scarce : Good Laws may bring the Money to
the full circulation ’tis capable of, and force it to those Employments that
are most profitable to the Country : But no Laws can make it go further, nor
can more people be set to Work, without more Money to circulate so as to pay
the Wages of a greater number. They may be brought to Work on Credit, and
that is not practicable, unless the Credit have a Circulation, so as to
supply the Workman with necessaries; If that’s suppose’d, then that Credit is
Money, and will have the same effects, on Home, and Foreign Trade.(Money and Trade Considered, R
& A foulis, 1750, p. 20).
Sounding
like a graduate of Chicago University he argued that there could be no
inflation so long as the increased output kept in step with an expanding
paper money. However, he did warn that a rise in nominal incomes could cause
an increase in the demand for “Forreign Goods”. What Law apparently did
was confuse the immediate effects of monetary expansion with its longer term
effects. To cut the story short, Law’s monetary policy caused a massive boom that
devastated the French economy. Consequently he was forced to leave the
country, dying in poverty and exile in 1729.
The
current orthodoxy that McCrann unthinkingly clings too brings to mind a 1952
article by Sumner H. Slichter (a Harvard professor) that was published in Harper’s Magazine. Calling the article How Bad is Inflation Slichter contended
that a price level of 2 to 3 per cent is essential for prosperity. However,
Dr Winfield Riefler of the Federal Reserve pointed out at the time, even if
an inflation rate of 2 per cent a year could be controlled “it would be equal
to an erosion of the purchasing power of the dollar by about one-half in each
generation”. But as I said earlier in the piece, there would be no uniform
change in prices, meaning that inflation distorts, as Cantillon explained,
the pattern of production and incomes. This fact moved Gottfried Haberler to
write:
… the
process of inflation always leaves behind it permanent or at least
comparatively long-run changes in the volume of trade and in the structure of
industry. The impact effect is a change in the direction of demand. At he
points where the extra money first comes into circulation purchasing-power
expands; elsewhere it remains for a time unchanged. (The Theory of Free Trade, William Hodge
and Company LTD, 1950, p. 54, first published 1933).
Readers
are probably aware of the fact that Milton Friedman was also of the opinion
that a steady increase in the money supply was necessary to stabilise the
price level and to prevent recessions from emerging. Yet the very same
Friedman could write that
[T]he
price level fell to half its initial level in the course of less than fifteen
years and, at the same time, economic growth proceeded at a rapid rate. The
one phenomenon was the seedbed of controversy about monetary arrangements
that was destined to plague the following decades; the other was a vigorous
stage in the continued economic expansion that was destined to raise the
United states to the first rank among the nations of the world. And their coincidence
casts serious doubts on the validity of the now widely held view that secular
price deflation and rapid economic growth are incompatible. (Milton Friedman
and Anna J. Schwartz, A Monetary History
of the United States 1867–1960, Princeton, N.J.: Princeton
University Press, 1971, p. 15).
Of
course this is not the kind of opinion that will not influence those who
think like McCrann. And why should it when Friedman ignored his own evidence
in favour of ‘controlled inflation’? Nevertheless, seeing, as they say, is
believing. For those of you who still remain uncertain about the relation of
economic growth to the money supply, the following charts provides ample
historical evidence that neither economic history nor sound economics
supports the fallacy that inflation drives promotes economic growth.
The
charts were taken from S. B. Saul’s The
Myth of the Great Depression:1873-1896 (Macmillan Publishers LTD,
1969). The first one clearly shows prices falling from about 1874 to 1896.
This was a productivity-induced price change. Now what matters for the
businessman is not the price of his product as such but his price margin. In
the absence of an inflationary policy additional investment embodying new
technologies will lower marginal costs thus increasing labour productivity.
The result will be increased output, falling prices, a continual rise real
wages and, at the very least, the maintenance of price margins3.
Unlike today’s crop of economists, classical economists were very much aware
of this fact. Therefore, to describe this period as one of deflation is to
commit a gross error. The second chart leaves no doubt that productivity
increases led to a steady increase in real wage rates until about 1900.
I think
I shall leave the final word to the late Lionel Robbins:
The
history of economic thought has a twofold function; to explain the past and
to help us to understand the present. By examining the economic theories of
the past we can learn to see the problems of earlier times, as it were,
through the eyes of their contemporaries. By comparing them with the theories
of the present we can realize better the implications and the limitations of
the knowledge of our own day. (Chi-Yen Wu, An Outline of International Price
Theories, George Routledge and Sons LTD, 1939, p. xi)
1Ricardo
actually acknowledged that monetary expansion can distort the capital
structure and incomes. (The High Price of
Bullion, p. 49).
2Hume
contradicted himself. On page 294 he points out that the a gold inflow is
only favourable until prices rise. However, also observes that money is not
neutral. The passage was pregnant with possibilities that he failed to see.
3Austrians
stress the danger of monetary policies designed to stabilise the price level.
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