The idea that inflation can drive economic growth exposed as rubbish by economic history

Gerard Jackson

The view 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”¹ is the generally accepted one among the economic commentariat. We have basically two positions here: The first one is the nonsensical belief that a ‘modest’ rate of inflation is necessary to promote spending and investment. Therefore, without this rate of inflation prices would continually fall which in turn would curb spending and investment and so depress economic activity. (This argument is also used to promote the idea of a stable price level). But it is absurd to assume that any rate of inflation can fuel economic growth, unless one believes in the ‘beneficial effects’ of “forced saving”, which some people do.

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”². Thomas Malthus, a contemporary, pointed out the dangers and injustice of “forced savings”³. Henry Thornton damned the process as an “injustice”⁴. 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”⁵.

 In the early to mid-1720s Richard Cantillon, an Irish banker living in Paris, produced a brilliant work of sophisticated economic analysis that vividly described how inflation distorts the pattern of production and brings about a rearrangement of incomes and wealth⁶. It was this essay that gave us the concept of the “Cantillon effect”. Yet not one of our economic commentators appears to be the slightest bit acquainted with this invaluable piece of 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  Henry Thornton and the remarkable Lord King⁷ 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, Ricardo 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 community⁸.

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 beats having to debate anything). According to these commentators a steady increase in the money supply is necessary if production is to be expanded. Oddly enough, this thinking is strictly mercantilist. Edward Misselden and Thomas Mun were 17th century mercantilists who believed that “treasure” would stimulate production if allowed to circulate. For example, Mun wrote:

 …what shall we then do with our mony? …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 multitute 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 unassured⁹.

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 complaine¹⁰.

Perhaps the greatest proto-Keynesian of them all was John Law. It was his 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:

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 Forreign Trade¹¹.

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”. (Ibid. p. 7). 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 devastated the French economy. Consequently he was forced to leave the country, dying in poverty and exile in 1729.

 Proving that economic commentators and Harvard Professors never learn from economic history or the history of economic thought, Sumner H. Slichter (who was a Harvard professor) argued in a 1953 article¹² that a slowly rising price level is essential for maintaining a low level of unemployment. He also managed to confuse booms and rising prices with periods of genuine prosperity that a slowly rising price level is essential for maintaining a low level of unemployment. He also managed to. It was pointed out to Slichter, to no avail, that an inflation rate of 2 per cent a year would halve the value of dollar every generation. To his mind the depreciation of the currency was a price worth paying.

One truly egregious mistake that Slichter made, as did most of his critics, was to assume that a relatively stable price level would also mean relatively stable prices for land and capital goods. But the exact opposite is the case. During a boom the prices of these factors always rise faster than consumer goods prices. And even if the price level remains ‘stable’ for a time these factor prices still rise. This is precisely what happened during the 1920s. Now money is not neutral, meaning, as Richard Cantillon explained, that inflation distorts 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 the points where the extra money first comes into circulation purchasing-power expands; elsewhere it remains for a time unchanged¹³.

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 incompatible¹⁴.

 Of course this is not the kind of opinion that will influence the economic commentariat. 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 provide ample historical evidence that the commentariat has committed a gross economic error and that neither economic history nor sound economics supports their inflationary views.

The first chart shows  the trend in prices from 1815 to 1912. Those few economists who take an interest in this subject tend to focus on the 1874 to 1896 period¹⁵.  As was the case with the earlier secular decline in prices this one was also created by productivity outstripping the increase in the supply of gold. The second chart should leave no doubt that productivity increases led to a steady rise in real wage rates until about 1900¹⁶.

It’s a great pity that our current crop of economists and economic commentators failed to note Lionel Robbins observation that

[t]he 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 day¹⁷.

* * * * *

¹Herald Sun, The prices are right, 9 March 2007.

²A Manual of Political Economy, p. 44. Written in 1795 but not published until 1843,

³Edinburgh Review, February 1811, pp. 363-372

⁴Thornton’s An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, 1802, London: George Allen and Unwin, 1939, p. 239.

⁵John Stuart Mill, Essays on Economics and Society, University of Toronto Press 1967, p. 307.

⁶Essay on the Nature of Commerce in General, Transaction Publishers, 2001)

⁷A Selection from the Speeches and Writings of the Late Lord King, Longman, Brown, Green, and Longmans,

⁸David Ricardo, The High Price of Bullion: A Proof of the Depreciation of Bank Notes, John Murray, Fleet Street, 1811.

⁹England’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

¹⁰Free Trade or, The Meanes To Make Trade Florish, Printed by John Legatt, for Simon Waterson, 1622./p>

¹¹Money and Trade Considered, , Andrew Anderson, Printer to the Queens most Excellent Majesty, 1705, p. 5

¹²Michigan Business Review, March 1953, p.p. 6-8

¹³The Theory of Free Trade, William Hodge and Company LTD, 1950, p. 54, first published 1933.

¹⁴Milton Friedman and Anna J. Schwartz, A Monetary History of the United States 1867–1960, Princeton, N.J.: Princeton University Press, 1971, p. 15. Monetarists simply refuse to distinguish between a goods-induced change in purchasing power and a monetary-induced change. Only the former can be deflationary or inflationary.

¹⁵Although 1873 or 1974 is usually given as the starting point for the price decline it actually began around about the mid-1860s but was interrupted by a boom that culminated in the 1873 crisis. Using Saul’s chart I estimated a price decline of 38 per cent, which works out at about 1.6 per cent per annum

¹⁶There is some dispute about the degree of movement in real wages after 1900. The principle point, however, is that both real and money wages rose considerably during the this period. Moreover, it’s quite clear that even if money wages had remained constant they would still have been a considerable rise in real terms.  Another point that should be considered is that these wage indexes understate the true situation because they can only account for changes in prices but not the greater range and improved quality in goods that took place.

¹⁷Chi-Yen Wu, An Outline of International Price Theories, George Routledge and Sons LTD, 1939, p. xi. (Robbins wrote the preface).