INFLATION.

Inflation is best described as a sustained rise in the general price level. That is sometimes expressed as nominal income rising in excess of real income. It is a relatively recent phenomenon in world history, belonging mainly—but with exceptions in a few rare episodes—to the twentieth century. There can be many pressures that produce price changes in the short term, but there is no inflation without a corresponding growth in the stock of money. That growth was not easily achieved before technology allowed the production of a reliable paper currency, and that technology belongs to the twentieth century. This in itself is highly suggestive of the basic cause.

For most of the world's history, the time plot of the general price level was almost flat. Occasionally, the discovery of silver and gold or improved mining or production techniques would produce a period of rising prices, though these were generally modest—seldom much above 5 percent per annum. There were one or two episodes before the twentieth century, such as in Britain during the Napoleonic Wars, when metallic backing for the currency was abandoned. But even in that period, inflation rates were quite low, 2 or 3 percent at most over a twenty-five-year period. Some other more extreme cases, such as the French Revolution or the U.S. civil war, are good examples of the use of paper money and consequent rapid inflation. What changed after 1914 was that inflation became a common feature of economies. Certainly after the mid-1930s there was a relentless rise in the general price level for the rest of the century, and that continued into the twenty-first century.

A discussion of "world prices" can be useful for individual commodities, but for the general price level it can be tolerated only up to a point. It is difficult enough constructing an index of prices for one country without attempting it for the world. However, since many countries have similar price experience, one modern industrial country tends to look like another in that respect. There are also some interesting differences that help in an understanding of inflation.

OVERVIEW OF TWENTIETH CENTURY

The general pattern of inflation in the twentieth century was as follows. Prices rose sharply after 1914 until about 1920. There was then a decade or so of hesitancy when major countries were pursuing deflationary policies in order to restore and then adhere to the new gold standard. But after that attempt collapsed in the 1930s, the monetary discipline of a metallic base had largely disappeared and prices rose almost without interruption. World War II gave a boost to inflation, despite all manner of attempts at containing it. After 1945, inflation appeared to become endemic and increasingly a problem. After 1971, when the world was for the first time ever exclusively reliant on paper money, inflation accelerated almost everywhere. That 1970s experience concentrated attention on the problem, and there developed a widespread desire to contain and even kill inflation. In the last twenty years of the twentieth century, inflation seemed to be completely under control in most developed countries. There was even some concern that the opposite—deflation, a sustained fall in prices—might be emerging. But that was never a serious prospect, and in the early years of the twenty-first century concern about deflation had already all but disappeared. As of 2005 most Organisation for Economic Cooperation and Development (OECD) countries live with inflation, albeit at low levels by twentieth-century standards.

SOME MORE EXTREME EPISODES

In the course of the twentieth century, there were some experiences of violent inflation and some others that were extremely serious. The most violent have been described as hyperinflations. That can be defined in different ways, but one of the most accepted definitions is that of economist Philip Cagan: prices rising at more than 50 percent per month and accelerating. And the period of hyperinflation was over by this definition when the rate fell below 50 percent per month. The other "extreme" cases can be thought of as rates in excess of 100 percent per annum. There were several episodes of hyperinflation in the 1920s, mostly between 1919 and 1924. In these years, Hungary, Poland, Russia, Austria, and Germany all experienced hyperinflation, in fact in the millions percent per annum. In Germany, the worst of these, prices were rising at a rate of 1,000 million percent per annum in 1923–1924.

There was another burst of violent inflation episodes in the 1940s, when Greece, Hungary again, and China all suffered hyperinflation as defined by Cagan. In the years after the 1950s, there have been scores of examples of countries where inflation has been in excess of 100 percent per annum but without taking off into hyperinflation. These were usually for brief—though sometimes recurring—periods. Many Latin American countries, for example, suffered persistent bouts of very rapid inflation right up until the 1990s. The same is true for many countries in Africa and others, such as Indonesia in the mid-1960s, Serbia and some other Balkan countries in the 1980s and 1990s.

The striking feature about all these episodes of very rapid inflation or of hyperinflation is that of an unbacked paper currency. The growth in the money supply was enormous. Such a growth was impossible in the absence of paper currency. The velocity of circulation can always change, but with a metallic currency it cannot change fast enough to produce such high inflation: it is just not possible to move it around quickly enough. The other feature that stands out is that money growth was accompanied by huge and growing fiscal deficits.

Deficits cannot be sustained for very long, eventually requiring monetization. What were the circumstances that produced such deficits? It has frequently been asserted that it is war that forces expenditure rapidly above the ability to tax. Up to a point, that is true. But the history of the world is in large part the history of war, and yet there is little or no inflation before the twentieth century. A closer look at these episodes reveals that it is civil war or revolution, or at minimum serious social unrest, that is present in almost all cases: in Russia after 1917; in Hungary in 1919; in Poland in the early 1920s. In Germany, too, there were attempted communist coups (and in Bavaria, a Bolshevik government, so the threat was real). In 1922 and 1923, there were armed uprisings and major breakdowns in public order in Germany. Then in the 1940s, there was civil war in China and in Greece. Hungary in 1946 was the worst case of hyperinflation up to that date, but it was slightly different in the way in which it was subjected to Soviet pressure.

SOME EXPLANATION

Governments have always been keen to get hold of resources, and on occasions they simply confiscate resources. The simplest way of doing that is through the inflation tax. The authorities can maximize their revenue from this when inflation is in excess of 100 percent per annum. Of course, such levels of inflation would have potentially dire political consequences. When would it be worth pursuing such a course? The answer must be when the state is seriously threatened from within. An external threat is not critical, since that usually stimulates patriotism so that borrowing can be carried out more easily and tax can be raised without too much complaint. But with a major threat from within, a government may calculate that the risk attached is worth running. Thus civil war is a prime cause of inflation. Expenditure rises sharply as the established authority fights to resist the rebellion, but tax revenues fall since tax payments from the rebellious section disappear. Borrowing becomes equally difficult. A resort to the printing press is immediate.

Not all wars have produced inflation, nor have all civil wars produced great inflation. One line of explanation is that monetary growth does not of itself lead to inflation. The prevailing and anticipated fiscal positions have to be considered in conjunction with monetary policy. The argument is that in a fiat money (that is, command money, usually by decree of government) regime, an appropriate fiscal policy can back the money stock: the value of government liabilities is determined in the same way as a firm's liabilities. An issue of additional shares in the absence of prospective improvement in the future stream of income leads to a fall in the price of the shares. In the case of government, an increase in its liabilities (bank-notes) without an increase in prospective tax receipts provides an expectation of a fall in the value of the liabilities; that is, in inflation. An illustration of this might be found in Britain during World War I. Not only did Britain borrow on a huge scale, but huge budget deficits also opened up as the enormous scale of spending went on. The deficits were in excess of 50 percent of gross domestic product (GDP). Yet comparatively low inflation was recorded. Why did it not burst into the extreme kind? The explanation outlined above seems to have some applicability. As soon as it came to be believed that victory was likely, so did the appreciation that there would be a return to Gladstonian principles of finance—balanced budgets. And that is what happened very soon after the war.

WORLDWIDE INFLATION AFTER WORLD WAR II

The general path of prices for the world in the second half of the twentieth century was of a relentless rise across the period. Translated into inflation rates, what shows up is how inflation accelerated in the 1970s and that the rate of inflation has moderated greatly since the beginning of the 1980s. The path for some countries varies a bit. While there was inflation in all countries, and that pattern was similar, in some cases it was significantly lower than in others. The principal reason for the similarity was that in the years up to the early 1970s, most countries were on a fixed (or more accurately, a pegged) exchange rate—essentially tied to the U.S. dollar through the 1944 Bretton Woods Agreement. Under such a system, the small countries import the monetary policy of the large country.

From the early 1970s, though, exchange rates have floated and countries then regained control of their money supply. Those who exercised appropriate control appear to have had greater success with inflation.

MORE GENERAL EXPLANATION

There have been two main competing views on the explanation for the accelerating inflation that began in the mid 1960s. One has been called "international monetarism," and the other wage-push or "sociological." The first regards inflation as a monetary phenomenon. The second denies this and sees it as non-economic, pointing to supposedly spontaneous wage explosions of the late 1960s and early 1970s. Thus for international monetarism, the explanation lies in the United States in the 1960s. The United States had embarked on a huge spending program: domestically on the Great Society and abroad on the Vietnam War. The latter was unpopular, so could not be financed from borrowing or from increased taxation without serious electoral damage. It therefore had to be done by printing money. The monetary expansion produced inflation, and that was transmitted to other countries through the exchange-rate system. Other countries therefore experienced similar inflation to the United States. There were occasions when some countries changed their parity with the dollar—some up, some down—and that reflected their relative individual success or failure in controlling inflation.

The great weight of the evidence suggests that inflation is a monetary phenomenon. But outcomes depend on the relative strengths of the parties involved—the government on the one hand and the people, or powerful interest groups, on the other. If there is strong government that can be trusted to behave with prudence, there is unlikely to be inflation. If the opposition to the government is sufficient to get its way, there will be inflation. It always requires an expansion of the money supply at a rate greater than the growth of real income, and over the long run that rate will be the rate of inflation.

The sociological explanation for inflation is that the cause was trade unions. The argument was that they exerted monopoly power, and monopolies can change the price—in this case wages—of their product when they wish. However, what this does is change relative prices—the wages of one union (or perhaps more) and not the general price level. What if the majority of the labor force belonged to monopoly unions? That is unlikely, but it takes us back to the relative strength of government in resisting the claims and not expanding the money supply. Further, monopolies are much less common than was once supposed, and are much less likely to appear in an open world economy.

Other explanations have focused on the price of a major commodity—in the 1970s, this commodity was oil. However, a price shock does not produce inflation. Where it is accommodated by the monetary authorities, it can shift the price level to a higher point. But that is not inflation; it is a once and for all change. Thereafter, the trend rate of inflation will carry on from where it was, unless the authorities persist in monetary ease after having accommodated the shock.

POLICIES TO COMBAT INFLATION

Throughout history there have been attempts at controlling prices directly. This practice was given a great boost in the twentieth century during wartime. Price controls were imposed in many countries, including the United States and the United Kingdom. And in some respects they did seem to work. However, they were supported by other factors. In wartime, patriotism possibly plays some part and people are more prepared to play by the rules for the sake of the greater good. More than that, rationing often accompanied the price controls and it was difficult or impossible to make purchases without coupons. That certainly supported the price controls. Subsidies were used, as well. And there were severe penalties for breach of the controls.

But while price controls seem to have worked for a period, the common experience was that when they were removed, prices jumped up to where they would have been had the controls never existed. They may have served their purpose in wartime, but not beyond that. Price controls were tried in peacetime, too, but in the absence of these other factors, they invariably failed.

Another approach to the control of inflation was to attempt to control wages or incomes more generally. This followed from the belief that trade unions caused inflation. So there were attempts in the 1960s and 1970s to contain inflation by resorting to controls on incomes. This was tried in many countries without success. Apart from being incompatible with a free society, there were simply too many ways of circumventing the controls.

There was for a while the belief that the economy could be managed primarily by operating on demand through fiscal policy. When the economy was growing "too fast" and inflationary pressures developing, tightening fiscal policy would dampen activity down. This course also proved a failure.

It was only after there was a better appreciation of the role of money in causing inflation that there developed a desire to control the growth of money as the means of controlling inflation. This appreciation and desire began to emerge in the 1970s. There was much debate about whether this monetary control was best exerted by trying to operate directly on monetary aggregates or by using interest rates. But whatever the conclusion of this debate, it became clear that it was only central banks that could control monetary growth; and increasingly it was seen that they should be given the independence to do this—to produce the particular kind of price stability that governments laid down.

SOME CONSEQUENCES

There are several reasons for regarding inflation as a bad thing. The first is that it has damaging effects on the distribution of wealth. It works to the advantage of debtors and to the disadvantage of creditors. Huge debts disappear over a period of inflation. While this might be thought a useful way of rearranging the distribution of wealth, the fact is that it is governments who were the largest debtors in the twentieth century. They were thus able to cheat their populations out of their savings in a number of ways. (This may also be seen as a contribution to the distrust of government, and of the lack of trust more generally, which has led to ever-increasing and costly regulation, regulation being a substitute for the trust that formerly obtained.) Creditors suffer and that in turn dissuades saving and ultimately damages investment and so probably economic growth.

Inflation acts adversely on production in another way. When producers detect an increase in demand for their product, they have difficulty in distinguishing between the demand for their product alone and what might be a general increase in demand from the extra money (excess balances) that consumers are spending. The producer might therefore expand plant to cope with the new demand and then later be left with unwanted plant when the temporary burst of general spending is over.

Inflation distorts prices and interest rates. As inflation rises it becomes more volatile, and this contributes to the difficulty in using prices as good signals—their key function. Different prices will be affected in different ways. Long-term contracts will suffer at the expense of short-term and of flexible arrangements. To that extent it will discourage long-term contracts, and therefore some activity will not be undertaken that otherwise would have been in conditions of less uncertainty.

All in all, inflation is bad for morale and the sum of the distortions it creates makes it bad not only for income and growth, but bad for democracy and for a free society.

See alsoBretton Woods Agreement; Germany; World War I.

BIBLIOGRAPHY

Cagan, Philip. "The Monetary Dynamics of Hyperinflation." In Studies in the Quantity Theory of Money, edited by Milton Friedman, 25–117. Chicago, 1956.

Capie, Forrest. "Conditions in Which Very Rapid Inflation Has Appeared." Carnegie-Rochester Conference Series on Public Policy 24 (1986): 115–168.

Capie, Forrest, ed. Major Inflations in History. Aldershot, U.K., 1991.

Gordon, Robert. "Can the Inflation of the 1970s Be Explained?" Brookings Papers on Economic Activity 1 (1977): 253–277.

Hall, Robert, ed. Inflation: Causes and Effects. Chicago, 1982.

Sargent, Thomas J. "The End of Four Big Inflations." In Inflation: Causes and Effects, edited by Robert Hall, 41–97. Chicago, 1982.

Velde, Francois. "Poor Hand or Poor Play? The Rise and Fall of Inflation in the U.S." Economic Perspectives (spring 2004): 35–51.

Forrest Capie