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Inflation: the Theories and the Facts

Along with explaining what inflation is and why it happens, another question presents itself today. Why is it that a problem fairly widely understood half a century ago now completely baffles the majority of politicians and economists? Some of them admit that as far as they are concerned it is inexplicable and incurable; others offer explanations which a look at past inflations would show to be quite untenable. And now we have psychologists telling us it is not just an economic problem but is to be explained as indicative of a deep-rooted dissatisfaction with life.

A few facts show the irrelevance of most of the theories of inflation now current. Past inflations have always been halted when governments decided to halt them, and British capitalism operated continuously for a century before 1914 without any inflation at all. Are we to seriously believe that it was a century of "satisfaction with life" on the part of the workers? And what of the ten years 1921-31 when prices were not rising but falling, and the workers showed their "satisfaction" by the General Strike?

Understanding inflation may not be particularly easy, but most of the difficulty is the confusion introduced into it by economists. An economics handbook published in 1909 defined inflation in terms of its cause, depreciation of the currency: "high prices caused by an over-issue of inconvertible paper money". That is how Marx and many other economists correctly explained inflation, but nowadays most economists attempt to explain it in terms of its symptoms not its cause.

They talk about two kinds of inflation, "cost-push or wage-push" and "demand-pull", the one pushing prices up and the other pulling them up. That is about as useful a concept as Dr. Doolittle’s famous circus animal the Pushmi-Pullyu which had a head at both ends. (It would appear that the economists' monster has both heads at the same end but, like Dr. Doolittle’s, they mostly take control alternately and not both at the same time.)

If a general price rise had not been caused by currency depreciation its "cost" and "demand" symptoms would also not be there; which is not to say that individual and general price rises cannot happen for causes other than inflation. In the period 1820-1914 in this country, when there was no currency depreciation and therefore no inflation, there were alternate comparatively small falls and rises of the price level in depressions and booms. But it never once rose above the level of 1820 whereas, with inflation, the present price level is about six times what it was in 1938.

General price rises due to currency depreciation were known in previous centuries, but it was a mark of 19th-century British capitalism that, by deliberate government policy, prices were kept comparatively stable by the avoidance of inflation. It did not stop the growth of production and wages.

Marx dealt with one aspect of price changes in his lecture published in the pamphlet Value, Price and Profit, where he examined the erroneous proposition that wage increases cause a general price rise; but he did not there deal with currency depreciation or inflation. On the contrary, as he pointed out, he was dealing with the situation as it existed in Britain when there was no inflation. He was therefore assuming for his purpose no change whatever "in the value of the money wherein the values of products are estimated".

His examination of inflation is in Capital, Volume I, in the chapter "Money, or the Circulation of Commodities" where he put forward the proposition, based on his labour theory of value, that the excess issue of an inconvertible paper currency puts up prices.

J. M. Keynes in his Tract on Monetary Reform (1923, pages 42-3) gives a similar explanation. Marx pointed out that beyond a certain point an excess issue of notes will result in money "falling into general disrepute". Keynes, in the work referred to, dealt with the way this condition of general disrepute developed in Germany in the great inflation of the nineteen-twenties. Professor Edwin Cannan, without using the labour theory of value, reached much the same conclusion from observation of what actually happens (Modern Currency and the Regulation of its Value, 1931).      

It should be noted that Cannan, like Marx, dealt with "currency" (notes and coin). Some modern "monetarists" have introduced more confusion by trying to base their theories on "money" defined to include bank deposits as well as notes and coin..

What must be emphasised is that inflation is caused by those who control the note issue, which in this country is the Government through the Bank of England. It is often used in wartime because it is a speedy way of increasing government revenue to meet additional war expenditure. In Germany in the nineteen-twenties, in peace-time, it was a deliberate device (backed by big business) to pay off debts in depreciated currency: inflation, at least in the short term, serves the interest of debtors against lenders.

Marx and inflation

Marx's treatment started with the economic law that the use of a particular commodity to serve as the money commodity, e.g. gold or silver, rests on the fact that that commodity like all other commodities is an embodiment of value, the amount of "socially necessary labour" required to produce it. If for example one ounce of gold and one bicycle each require ten hours' labour they are equal values, and gold can serve as the "universal equivalent" for the exchange of all other commodities.

The conversion of value into price takes place through the minting of coins of uniform weight and purity. In Britain each £ or sovereign was, by law, fixed at a uniform weight of gold (about a quarter of an ounce). So the bicycle's price would be about £4 because its value was equal to that of one ounce of gold. If the British government had fixed the £ at one-eighth of an ounce of gold instead of one-quarter, the bicycle's price would have been £8 not £4 and all prices would similarly have been doubled. If they had fixed it at half an ounce, all prices would have been halved. On both suppositions, while the price of the bicycle (or other commodity) would have been doubled or halved, its relation to an ounce of gold would have remained unaltered.

The next stage in Marxian monetary theory was based on the proposition, confirmed by long experience, that with a given total volume of production and buying-and-selling transactions, and with gold minted into the £ or sovereign at about a quarter-ounce, a certain total amount of currency would be needed. (The fact that the required total varies from time to time with the velocity of circulation need not be gone into.) What Marx put forward was that the total value of needed currency represented a total mass of value, and therefore a total weight, of gold, and that if the total of gold is replaced by inconvertible paper money and the paper money is then issued in excess, prices will go up.

“If the paper money is in excess, if there is more of it than represents the amount of gold coins of like denomination which could actually be current, it will (apart from the danger of falling into general disrepute) represent only that quantity of gold, which, in accordance with the laws of circulation of commodities, is really required and is alone capable of being represented by paper. If the quantity of paper money issued is, for instance, double what it ought to be, then in actual fact one pound has become the money name of about one-eighth of an ounce of gold instead of about one-quarter of an ounce. The effect is the same as if an alteration had taken place in the function of gold as a standard of prices. The values previously expressed by the price £1 will now be expressed by the price £2.” (Capital Vol. I, page 108 in Allen & Unwin edn.)

Long experience has shown that Marx was right. Whenever inconvertible paper money has been issued in excess for a considerable period it has raised prices above what they would otherwise be.

In Britain the amount of notes in circulation in 1938 was £554 millions. It is now about £5,330 millions. Since 1938  the needed amount has been affected by certain changes, including greater total production (now more than double the 1938 level), and increased population, which would operate to raise the needed amount of currency. Working in the opposite direction has been the wider use of cheques, etc. and corresponding reduced need for notes and coin.

In the 19th century the issue of notes in excess amount was effectively prevented by law. Beyond a small fixed amount the Bank of England could only expand the note issue by placing an equivalent amount of gold in its reserve, and the paper was tied to gold by the requirement of "convertibility" –that is to say, the Bank of England was compelled by law to give gold in return for notes at the legally fixed rate of about one-quarter ounce for each £1. Except for marginal variations the value represented by Bank of England notes could not be different from the value of gold. Bank of England notes "were as good as gold" and were everywhere accepted as such. Now there is no convertibility, and in effect no restriction on the note issue.

A two-way fallacy

The man largely responsible for the adoption of inflation as government policy (they now call it "reflation") was the economist J.M. Keynes. Yet he did not knowingly and intentionally advocate inflation as a long-term policy. (There were some people who did just that.) What Keynes did was to say that if certain other things were looked after it was no longer necessary formally to restrict the note issue.

“Thus the tendency of today  . . . rightly I think is to watch and to control the creation of credit and to let the creation of currency follow suit, rather than, as formerly, to watch and control the creation of currency and to let the creation of credit follow suit.”

Professor Cannan promptly warned that the doctrine was basically unsound and would open the door to inflation. See Economic Journal, March 1924, and Cannan's An Economist's Protest, 1927, pages 370-384. Keynes's views won the day and came to be accepted by the Tory Party and Labour Party and by the trade unions, not only as monetary theory but because Keynes put them forward as part of his popular "full employment" doctrine.

This doctrine was formally set out by the Tory, Labour and Liberal wartime government in 1944 in the White paper Employment Policy. It was cautiously phrased but was immediately followed by a more crude interpretation drawn up by the Labour Party in Full Employment and Finance Policy. Here it was laid down that if unemployment threatened "we should at once increase expenditure, both on consumption and on development – i.e. both on consumer goods and capital goods. We should give people more money and not less to spend. If need be we should borrow to cover government expenditure. We need not aim at balancing the budget year by year."

It is the Labour Party version that has been followed by Tory and Labour governments, particularly in the past decade. It has included hoping for a much lower level of unemployment than even Keynes thought possible –and part of the belief has been the idea that increased spending increases production –something which events show to be true, if at all, only for a short period.

The fallacy of the theory is well illustrated from the period 1965-72. In that period annual consumer spending jumped from £22.943m. in 1965 to £39.263m. in 1972, an increase of 70 per cent. In the same period registered unemployment jumped from 360,000 to 943,000 and production went up by only 17 ½  per cent. The principal result was that prices rose by 47 per cent.

The policy is still being operated. One of the few forecasts about the present Labour government that has proved correct was that made by the late Richard Crossman, former minister in a Labour government, that the rate of inflation would be increased (Times, 12th Sept., 1973).

There are two ways in which currency depreciation can be operated, the direct way used by the German government in the 'twenties and the more indirect way used in Britain. Professor F.W. Paish summarised them:

“In some countries it [the Government] might simply print more notes and use them to pay for its expenditure. Nowadays, in such a country as Great Britain, the government would borrow from the banks, printing more notes to enable the banks to maintain their cash reserves.” (Benham's Economics. 1967, p. 465)

The additional notes and coin get into circulation through the joint-stock banks (Lloyds, NatWest, etc.) which bank with the Bank of England.

These banks withdraw notes and coin from the Bank of England and in turn the additional notes and coin reach the individuals, shopkeepers and employers who make withdrawals in that form from their deposits with the banks. The note issues are set out in the Bank of England's Weekly Return. In the week ended 24th July 1974 there was an increase in the notes in circulation by £52,193,306 tot a total of £5,098.767,831.

Many economists and politicians would be happy to see inflation going on indefinitely in the belief that it keeps unemployment down. But whatever happens with moderate inflation, even they cannot ignore that when inflation gets to the point that money falls into "general disrepute", unemployment multiplies. In Germany in 1923, unemployment was 4.2 per cent with another 1 2.6 per cent partially unemployed. Within the year it had jumped to 28.2 per cent and 42 per cent respectively, representing together over 5 million workers in receipt of unemployment pay and an unknown larger number not receiving relief. At this point the German government called a halt by replacing the notes by a new gold-backed currency.

Realisation of this danger here has induced some politicians and economists to call for the limitation of the note issue. In 1968 the Editor of The Times (15th October) described the idea that price rises could be checked "by printing fewer notes" as a "crude error". Now the Editor, Mr. Rees-Mogg, has been converted and is urging a return to the gold standard (Times, 1st May 1974).

But at the same time they are fearful that the drastic action of entirely stopping the increase of the note issue would, as in 1 920, bring prices down but be accompanied by a big increase in unemployment. So the line taken by one group of economists is to call for a gradual reduction in the rate at which inflation is increasing. Professor A.A. Walters of the London School of Economics is urging that such a slackening should be spread over three years (Money and Inflation, Aims of Industry 1974. and Times, 23rd July 1974).

It only remains to point to the difference between Marx and other economists. Marx was simply describing how capitalism operates, with inflation and without it. He was not saying, as did Cannan, that it is better to run capitalism without inflation, or saying like Keynes that a "full employment" policy will improve and save capitalism.

In Marx's view capitalism inevitably produces unemployment and crises. For him the task of the workers is to abolish capitalism and replace it with Socialism, in which problems of prices, inflation, crises and unemployment will not exist.