Source: George P. Brockway, "The End of Economic Man", p. 200-211, 1995.
Inflation is ordinarily thought of as a rise in commodity prices that somehow is not accompanied by a proportionate rise in wages and other income. The cost of living increases, or seems to increase, faster than the ability to pay for it. Commodity prices are, of course, affected by the costs of doing business, which are the prices of the factors of enterprise-wages and salaries, interest rates, rents, entrepreneurial profits, and taxes. There is thus a strong tendency for commodity prices and factor prices to rise or fall together. The exceptions to this rule are numerous, but they are not sufficiently numerous to explain the hold the inflation problem has on society.
If a general price increase should affect all prices, not just those of commodities, but including the conditions of long-term contracts, and if all prices should go up proportionately, in lockstep, everyone would be more or less inconvenienced, but no one would be much hurt, and no one would be much advantaged. If such an event should occur, it would be cause for brief wonder and casual conversation, not for the constant turmoil and agitation we have experienced this past half century. In the other direction, when in 1969 France substituted one new franc for one hundred old ones, thus "deflating" all prices, the exchange went as smoothly as anything does in French politics. It has, moreover, been recognized, at least since the time of David Hume, that a little price inflation stimulates entrepreneurial juices.
In short, the inflation that has been alternately a curse and a nuisance of our time has been something other than a simple rise of commodity prices or a general price rise. What we have experienced is a pervasive and continuing disruption of the price system, resulting in a massive redistribution of wealth and income.
ii
During the last nine years of his life, Joseph A. Schumpeter worked on the posthumously published History of Economic Analysis, a remarkable work of some twelve hundred pages that be almost, but not quite, finished. Schumpeter had studied, practiced, and taught law in Egypt, Austria, and the United States before becoming involved in politics at the end of World War I. He was for a brief time Austrian minister of finance and subsequently president of the Biedermann Bank until it collapsed in 1924. He then taught economics at the University of Bonn before going to Harvard, where he remained from 1932 until his death in 1950.
These biographical details are suggestive in relation to a surprising fact about Schumpeter's monumental work. Although be discusses in great detail the work of all the major economists and almost all those of the second, third, and even fourth and fifth ranks (the index of authors runs to twenty-one double-column pages), there is no entry in the subject index (which runs to thirty pages) for "Inflation." Given the cacophony that has oppressed us in recent years, his silence is deafening. Here is a tremendous scholar who, as government official, banker, and teacher, was in the thick of one of the great hyperinflations of all time, and be finds nothing worth noting on the subject in the writings of the great and near-great economists from Aristotle to 1950. He has a great deal to say on monetary theory and on business cycles (be himself wrote a massive book on the subject), but nothing on inflation as such.
The foregoing anecdote strongly suggests that inflation as we know it is a comparatively recent phenomenon, dating roughly from World War II. This is the first thing to understand about it. Before the second half of the twentieth century, there were price dislocations aplenty. Price increases were characteristic of the boom phase of the business cycle, and the bust phase had contrary dislocations. What went up, came down. Whether the cycle was one of forty or fifty years, as Kondratieff thought, or something of shorter duration, it was a cycle, and inflation was followed by deflation as day the night, whereupon the sequence repeated itself. The Great Depression convinced many that Marx was right, and that the vibrations of the capitalist system would shake it apart. Much attention was therefore paid to proposals for damping the vibrations down, leading Keynes to remark, "The right remedy for the trade cycle is not to be found in abolishing booms and thus keeping us permanently in a semislump; but in abolishing slumps and thus keeping us permanently in a quasi-boom."1
Inflation was not a primary concern of Schumpeter's generation, not only because their attention was distracted to the business cycle but also because prices, from the Industrial Revolution to the end of the nineteenth century, had been trending steadily downward.2 In recent years, of course, they have been trending steadily upward. We have had eight recessions of varying severity in the past half century, and through them all, prices have kept going up. The business cycle used to be marked by a harrowing deflationary phase. We have suffered none of that. In the recessions there has been some moderating of inflation, but there has been no overt deflation, at least not in the industrialized world. When we congratulate ourselves on licking inflation, we mean merely that we have (we hope) slowed it down.
The second thing to understand about inflation is that hyperinflation is special and different. Its conditions and consequences are special, and there is no reason to believe that it grows out of inflation as we know it. In every case of hyperinflation, the afflicted country is saddled with massive foreign debts denominated in foreign currencies, and usually has wages and prices indexed to each other. This was true of the Weimar Republic, and it is true of the Third World today. The Weimar hyperinflation was quite quickly stopped because payment of the war debts was delayed, restructured, and ultimately forgotten. The Third World's hyperinflations will continue until the creditors face the fact that the debts will not be repaid.3 The United States debt poses no such threat to the nation. It is denominated in dollars. Even if a large portion of it is held abroad, it remains under American control, because it is payable in dollars under American control.
Perhaps the most important thing to understand about inflation is the vacuity of the popular cliche that it is "too much money chasing too few goods." Examples abound of insatiable demands arising for particular goods at a particular time and place. The excitement of an auction can lead to extravagant prices. More seriously, when the wheat crop-or the distribution thereof-failed in prerevolutionary France, desperate need bid the price of bread up catastrophically. But there was not "too much money" chasing that bread. On the contrary, people were impoverished as they sold everything they had at distress prices in a frantic effort to raise money for food. In ancient Egypt, Joseph's foresight in the seven fat years enabled him, in the lean years, to squeeze the people and reduce the country's freeholders to sharecroppers. He could scarcely have done this if the pbaraoh's subjects had had "too much money."
The modern economy is so large and substitutes are so plentiful that it is difficult for any person or group of people to corner a market as Joseph did; yet the economy is so interdependent that trouble anywhere tends to spread. The gas lines at fhe beginning of OPEC were only a temporary annoyance, but petroleum enters widely into industry and agriculture, and the rise in its price contributed to rises in all commodities, especially those produced by corporations that value their supplies and inventories on the last-in-first-out basis. Just as there was panic filling of gasoline tanks by motorists and of oil tanks by homeowners, so there was panic stockpiling of all supplies by manufacturers and of all merchandise by retailers. An expected general shortage of commodities resulted in temporary and localized actual shortages. But the general shortage never ensued. In fact, the stores were full of goods, and business was sluggish, because prices jumped faster than people's ability to pay. There was not, at any time in the movement, too much money chasing too few goods. If you can't afford to pay the prices asked, it is silly to claim you have too much money.
Nevertheless this cliche is the explicit or implicit rationale for many doggedly pursued public policies, many of which, as we shall see, are not even well designed to satisfy these fallacious premises.
iii
Mathematically, it is impossible for too much money to be chasing too few goods, provided that the goods that workers produce are at least equal in value to their wages. Since nonfinancial corporate output is currently about 1.5 times wages and salaries, this condition would seem not too difficult to meet. On these premises, perfectly full employment (not 4 percent unemployment or 6 percent unemployment) cannot be inflationary. Indeed, any unemployment whatever will have an inflationary effect because the unemployed will be receiving some sort of relief, thus increasing the money in circulation either directly or indirectly, but will be producing no goods for money to be spent on.
It is safe to say that no one- especially no conservative- accepts the foregoing reasoning; yet it is a logical implication of Say's law, which is widely accepted-especially by supply-side conservatives-as a guide to public policy. Say wrote, "[T]he only way of getting rid of money is in the purchase of some product or other. Thus the mere circumstance of the creation of one product opens a vent for other products."4 The usual, more aphoristic, formulation of Say's law is "Production creates its own demand." The policy recommendation that follows seems obvious: "It is the aim of good government to stimulate production and of bad government to encourage consumption."5
If consumption is to be discouraged, one wonders what is to be done with the encouraged (and presumably increased) production. Why should tens and hundreds of thousands of men and women be encouraged to build automobiles that no good citizen is supposed to buy? How will the wage costs and interest costs and supply costs of the automobile manufacturers be met if their output is not to be sold? Where will the millions and millions of unused cars be put? Or will a new industry of reducing them to scrap be encouraged?
The trouble with Say's law is that empirically it is insupportable. If it were valid, a universal glut (that is, goods no one could afford to buy) would, as be said, be impossible, and inflation would, as we have seen, be next to impossible. But there certainly have been depressions, and there certainly is inflation. Something is wrong with his analysis, and anyone who has ever, as polemicists used to put it, met a payroll knows what it is. It is a distinct possibility that you can't sell all of what you make. Sometimes you can't sell any of it. Mathematically, production creates its own demand; actually, it does not.
What is true of the demand for products is also true of the demand for labor. It may be that my skills are so specialized- or so minimal- that there is no demand for them at any price. It may be that business is so sluggish that a universal glut really happens, in which case it would be folly for an entrepreneur to hire me to produce more. Keynes's quarrel with classical economists turned on his insistence that involuntary unemployment can and does occur. Millions of citizens in all lands can testify that he was right. 6
iv
David Ricardo was insistent on what is known as the wage-fund theory, which holds that a business has a certain fund out of which it pays its costs and its profits; consequently, as Ricardo wrote, "There can be no rise in the value of labour without a fall of profits."7 This theory continues to be supported by strong gut feelings in many corporate boardrooms, but Schumpeter dismissed it with the observation that "high rates of profit and high wages normally go together."8
Yet Ricardo was right- or almost right. His Mistake- very common in his day and not uncommon today- was in confusing profits with interest rates. Interest rates and wages are indeed in conflict with each other, because both are costs of doing business. No business can exist without labor, and no business can exist without explicit or implicit interest costs. Both interest and wages are contracted costs agreed to before sales are known, while actual profits, as we have previously noted, are a residual.
Actual profits are a residual, but what I have called planned profits are a determining factor in business estimates and have the interest rate as an opportunity cost. The interest rate thus has a double effect on business plans. In general, a project will not be undertaken unless expected sales are at least equal to the sum of labor costs, materials costs, marketing costs, interest costs, and planned profits. (Whether fixed costs are considered will not affect the point before us.) Since in the actual world prices are set not in an auction but as a result of estimating and planning, labor costs and the double factor of interest costs and planned profits are in the wage-fund relationship with each other. If prices are held steady, these rival costs cannot both go up. If either goes up, the other must come down. If one goes up while the other holds steady or if both go up, the selling price must go up or the project must be abandoned.
On the basis of the foregoing, we should expect a positive correlation between high interest rates and inflation, the former being a cause of the latter.9 It is, however, widely believed that high interest rates stop inflation rather than contribute to it. The belief is so settled that everyone expects as a matter of course that the Federal Reserve Board will raise the interest rate whenever it is imagined that inflation threatens.
Since World War II, there have been two periods of relative stability. In 1952-56, the annual change of the Consumer Price Index fluctuated between 1.9 percent and minus 0.4 percent, while the prime was between 3.0 and 3.77 percent. And from 1961 through 1965, the change of the CPI inched up from 1.0 percent to 1.7 percent, while the prime was steady at 4.50 percent, except for 1965, when it was 0.04 point higher. Politically speaking, the first period embraced the last year of President Truman's term and the first four years of President Eisenhower's; the second period included the last year of President Eisenhower's presidency, all of President Kennedy's, and the first two years of President Johnson's.
We might debate whether the low CPI of these years caused the relatively low prime, or vice versa; but neither way do the figures support a doctrine that relates a high prime to a low CPI. Indeed, if there is any correlation between prime and CPI, it is that they go up and down together. From 1949 to 1967, the CPI increased less than 3 points in every year but one, and the prime was under 5 percent in every year but the last two. In the twenty years following 1968, the CPI increased more than 3 points in every year except one, while the prime was above 6 percent in every year except two.
Some might be tempted to argue that the Federal Reserve Board was not resolute in restricting the money supply, and that it subsequently was forced, as the sports announcers say, to play catch-up. The record, however, is that M1 as a percentage of GNP fell from 28.2 percent in 1959 to 14.5 percent in 1981. The fall was remarkably steady, with only three upbeat years and only one year in which the fall was more than 3 points. But starting at 15.2 percent in 1982 (the year in which the Reserve is supposed to have got control of inflation) the figure rose to 16.8 percent in 1986, the year of lowest inflation in twenty-two years.
If M1 is the money supply (and it was in fact the quantity that the Federal Reserve claimed to control during these years), it was, as a percentage of GNP, cut almost in half in the years when inflation was growing, but increased with the decline of inflation. The experience with M2 has been different and essentially flat, with a low of 58.8 percent of GNP and a high of 66.4 percent, but its second highest point (66.1 percent) came in 1986, the recent year of lowest inflation.
In short, the empirical record does not support the theory that a high interest rate controls inflation, and it directly contradicts the theory that inflation is controlled by contracting the money supply.
V
There is every reason to expect a high prime to cause a high CPI First, let us make a minor observation. The inflation rate is not a figure you read off an instrument like a barometer. It is a statistical construct, and one of its factors is the interest rate. This is an arbitrary effect, and one that could be arbitrarily eliminated (though the rate at which homeowners and other consumers can borrow is indubitably an element in their cost of living); but it stands as a real fact in the real world.
Second, let us repeat the much more important observation that speculation is vastly stimulated by volatile and rising interest rates. It was said in the 1980s that if high interest rates bad not been available to bring in foreign money, federal borrowing as a result of the budget deficits would have crowded producers out of the market. But as we saw in Chapter 8, speculation can always crowd out production, and that is what happens during bull markets, despite foreign money.
There is, third, a much more serious effect than either of these. If you're running a business, and your friendly banker says be wants 10 percent to renew your 5 percent loan, your first defense is to cut the payroll, and your second is to raise your prices. Moreover, the loan isn't the only thing that bothers you, because the opportunity cost of investing in your business rises with the interest rate; so you must raise your planned profit, which increase runs geometrically through the economy, raising prices as it goes.
Of course, it happens, sooner or later, that high prices, high unemployment, and low wages have their adverse effects on business. Sales fall, and payrolls are squeezed further. Unions fear to strike. But since wages have only an arithmetical effect on costs, the net pressure on prices will still be upward as long as interest rates remain high. Even a very severe recession will at best only slow inflation; it will not stop it as long as interest rates remain high.
If the Federal Reserve controlled inflation in the early 1980s, it did it by so increasing one of the costs of doing business (interest) that a worldwide recession was induced. The claim is made that this bad to be done in order to break what was called the wage-price spiral. And what was the vice of the spiral? If it bad not been broken, it would, they say, have so increased one of the costs of doing business (labor) that a worldwide recession would have resulted.
One could dispute the relative inefficiency or the relative injustice of the two recession-inducing measures, but on the premises there is no essential difference between them. They both work by escalating the costs of doing business. But that is only theory. No one knows whether a wage-price spiral would actually cause a recession, because such a spiral has never rmn its course. On the other hand, everyone knows- or should know- what happens when you push up the interest rate. There is a further irony here. The Federal Reserve Board has interfered grossly and grievously with the free market in order to save it. And what was the free market being saved from? It was being saved from a market in which prices moved freely.
Vi
The most popular theory of inflation (too much money, too few goods) is fallacious in ways we I've already discussed. Yet, letting that pass, one wonders bow raising the interest rate, or allowing it to rise, could be thought appropriate to the problem. A high interest rate no doubt chills the ardor of borrowers and thus may hold down the amount of money in circulation. Not all borrowers, however, are equally chilled. Speculators, as we have seen, find high rates stimulating.
Consumers are said to try to maintain their accustomed or desired standard of living. They will shoulder heavy debts at usurious rates to do so. Thus their readiness to assume mortgages at more than double the legal maximum interest rate of a few years ago; thus the cavalier expansion of credit-card borrowing; and thus the failure of high interest rates to impede the chase for goods. In fact, since high rates have proved acceptable to consumers, the consumer-loan business has become so attractive to banks that the paradoxical probability is that high rates have resulted in more money chasing goods, not less.
The famed bottom line, on the other hand, enforces a more circumspect demeanor on businesses, few of which find it profitable to expand when the cost of financing is in the double-digit range. Many find it impossible even to continue. Consequently, high interest rates, which perhaps have only a minor effect on demand, may have a major effect on supply. Whether or not there is more money in the chase, there are fewer goods in the running. Putting it more generally, there are fewer goods than there would have been otherwise.
The interest rate is a special cost of doing business. It is a pervasive, invasive cost. It is an inescapable cost. Even if one does not need to borrow, one does need to weigh the opportunity cost of investing one's money in one's business instead of lending it out. Interest exerts a steady upward pressure on all costs, and hence on prices. Thus interest is ipso facto inflationary. It is also necessary; it is the cost of investment. In a noninflationary economy or a healthy business, it is much less than the profitable output that results from investments.
The interest cost is the only cost that has this universal effect.
We used to hear much about a wage-price spiral, but a wage increase in the automobile industry (for many years the pundits' whipping boy) works its way only slowly through the economy. Initially it affects only the price of automobiles, and it never brings about a uniform wage scale. Wages of grocery clerks remain low, and all wages in Mississippi remain low. A boost in the prime rate of a prominent bank, on the other hand, immediately aff ects the rates charged by every bank in the land; and while it is possible for borrowers to shop around a bit for a loan, they find that rates vary within a very narrow range.
************************************************************ NOTES:
1. Keynes, General Theory, p. 322.
2. Commons, in Legal Foundations of Capitalism, dates a transformation of the American economy from the Minnesota Rate Case decision of 1890. The growth
of the holding company followed, despite the Sherman Antitrust Act of the same year. The prime example was United States Steel, which in 1901 completed the amalgamation of some 228 mills. See Louis D. Brandeis, Other People's Money (Washington: National Home Library, 1933), p. 104.
3. The debts almost certainly will not be fully paid. Whether or not they could be paid is a moot point. Stephen A. Sebuker argues convincingly that Germany had the economic capability of paying World War I reparations, and that Latin America is similarly able to pay its debts today. See Schuker, American "Reparations" to Germany, 1919-33: Implications for the Third World Debt Crisis, Princeton Studies in International Finance, no. 61 (July 1988). Germany would not pay because the reparations were considered unjust, and Latin America will not pay because the interest rates are considered usurious
4. Jean-Baptiste Say, A Treatise on Political Economics (New York: Kelley, 1971), pp. 134-3 5.
5 Say, Treatise, p. 139.
6 Keynes, General Theory, chap. 2.
7. Ricardo, Principles, p. 2 1. For Marx the wage-fund theory turned the conflict between capital and labor into a zero-sum game that would ultimately be won by the most numerous team. It can, I think, be shown that such a game is a consequence of regarding commodities as finite (see Appendix E: On General Equilibrium, p. 287). Piero Sraffa's curious little book Production of Commodities bY Means of Commodities (Cambridge: Cambridge University Press, 1960) thus contends that "to any one level of the rate of profits there can only correspond one wage, whatever the standard in which the wage is expressed" (p. 62). Sraffa, who was editor of Ricardo's works, follows Ricardo in confusing actual profits with planned profits and hence with the interest rate. The rate of profits, he writes, is "susceptible of being determined from outside the system of production, in particular by the level of the money rate of interest" (p. 3 3).
8. Schumpeter, History, p. 655 n. 22.
9 "Whatever their indirect impact, the direct effects of interest rate rises are inflationary. Interest plays a major role in the consumer price index, especially through the housing and consumer credit component. It is a large factor in utility costs. Regulatory agencies allow interest increases to affect rates almost immediately. Movements of interest rates increase the uncertainties and therefore the risks and costs of doing business. Tightening monetary policy has an effect on Productivity and efficiency. Investment for the next several years will be less and its costs more because of past interest rate gyrations." Sherman J. Maisel, Managing the Dollar (New York: W. W. Norton, 1973), pp. 17-18.
***************************************************************
1. Keynes, General Theory, p. 322.
2. Commons, in Legal Foundations of Capitalism, dates a transformation of the American economy from the Minnesota Rate Case decision of 1890. The growth of the holding company followed, despite the Sherman Antitrust Act of the same year. The prime example was United States Steel, which in 1901 completed the amalgamation of some 228 mills. See Louis D, Brandeis, Other People's Money (Washington: National Home Library, 1933), p. 104.
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