In 1963, Milton Friedman and Anna Schwartz wrote "Inflation is always and everywhere a monetary phenomenon." The thrust of this statement is that inflation is caused by unsound monetary arrangements — not by those who are raising prices or asking for higher wages, and not by oil speculators or by dealers in foreign exchange. This statement was made at a time when blame was being placed for inflation on groups in society.
This statement focuses attention on the monetary role in inflation. It suggests that to have sound currency arrangements and avoid inflation as well as deflation, a society has to have sound monetary arrangements. This is true. Squelching businessmen who raise prices or instituting wage and price controls does not address the role of the central bank in inflation.
The statement raises three deeper questions:
- Why does a society not have sound media of exchange (monies) via its monetary system?
- What arrangements will provide sound money?
- What must the society change in order to get to sound money or monies?
In answering these questions, we discover that inflation is always and everywhere a political phenomenon. A monetary authority produces inflation, and its authority is political. What it does regarding money is political. With one political arrangement, money may be stable. With another, deflation may be produced. With yet another, inflation may be the consequence. A society’s inflation and deflation cannot be understood or addressed without understanding its political forces.
Friedman and Schwartz were not the first to focus on the monetary authority. Henry Hazlitt said the same at an earlier date, December 22, 1947: "The basic cause of inflation, always and everywhere, lies in the field of money and credit." Many observers and economists throughout history have noticed the link between inflation and money. They are correct. However, it is still necessary to dig deeper to understand the nature of the monetary authority and how it is behaving. In doing that, we encounter many and varied political forces that can produce many and varied results. A limited government with a limited power to issue money can produce a stable money. A government with little or no revenues that issues its own notes that it makes legal tender may produce inflation. A government that has an independent central bank mandated to produce stable prices might get stable prices, whereas a government that has a central bank mandated to subsidize socialist enterprises may get inflation. There are innumerable possible arrangements, each with its own set of incentives, and each producing different inflation results. And if we ask why we observe these different arrangements and incentives, we come back to politics.
And, if I may digress briefly, we also encounter the fact that political authority and monetary authority interact with people in the society. There is an interplay of the expectations of people with actual events. What happens to prices depends on how people react to events that occur, what they expected to occur, and how their expectations change. If, for example, severe problems once again surfaced at several big banks in America, or if by chance members of the FED were to make certain kinds of remarks, or if the FED behaved one way instead of another, the people in America and outside might decide they wanted to hold more euros or more gold than dollars; or they might decide that problems had come to a head and it was time to hold more dollars. Hoarding of goods might begin, or abate.
It is a fact that if Paul Krugman should happen to write an article that forecasts hyperinflation, he may trigger hyperinflation himself; this depending on unobservable expectations locked up in people’s minds and depending on innumerable other statements and events that may occur if he should make such a statement and their effects. But while the future holds many surprises, the behavior of people is predictable enough that we sometimes can foresee outcomes. Sometimes the political arrangements are such that things can move on and end in only a few predictable ways.
The observation that inflation is a political phenomenon is not new. Let us choose an early and excellent treatise, the one written in 1817 by the Count Destutt Tracy. We can learn from him. His Treatise on Political Economy contains a chapter on money in which, preceding Menger by some decades, he discusses how gold becomes money. He speaks of how a sovereign robs creditors and aids debtors by using his authority to reduce the metal content of a currency unit like a livre or a louis or a dollar. A government that is a debtor has an incentive to use its authority in such a way. However, overly used, it ends up disturbing the economy to such an extent that the government loses revenues. (At that point, a currency reform may come about.) He then speaks of the paper money that is flooding Europe. He writes
"In effect the government, which has only created it to liberate itself, makes in the first place enough to extinguish all its debts. It is commanded to be received, people are disposed to do it; it circulates with facility, it is in every one’s hands concurrently with silver. It appears even at first to increase the activity of commerce, by multiplying capitals."
The political authority finds the paper money, unbacked by silver, useful for expenditures too:
"Afterwards the same authority uses the same mean[s] for its ordinary expenses. It observes necessarily less economy, conscious of resources always ready. It embarks in enterprizes, either of war, politics or administration, of which it would not have dared to think, knowing well that without this facility they would surpass its abilities. The paper is then greatly multiplied."
Destutt’s theory recognizes that the over issue of paper money unbacked by metal causes prices to rise, and he describes these effects in detail. Inflation, he sees, is a monetary phenomenon. Central bankers of the world today know this, and they usually acknowledge it. Government officials know this too, but they usually do not acknowledge it. They usually pin the blame elsewhere. They want to have the inflation tool at their disposal and they don’t want people to recognize that they are using it for their "enterprizes, either of war, politics or administration."
I return to the three main questions. Why does a society not have sound money arrangements? A society will usually have a state or a sovereign. When it gives that sovereign the authority to produce and control money at its own discretion or without further checks, that sovereign has an incentive to inflate.
The U.S. experience is interesting. The Constitution does not give the U.S. government the authority to do anything other than coin a dollar with a fixed weight of metal. Nevertheless, the national government has completely circumvented that restriction. This shows how powerful the incentive is for a government to inflate. Even a constitutional political arrangement that limits the government power to issue money proved powerless to prevent this outcome. The incentive arises from two sources: government and people in society. Government may want to issue money so that it can carry out its aims. People in society may support government programs offered by government to them that promise them benefits without costs.
In view of this, what arrangements will provide sound money? The government can have no power whatsoever over money. This will limit its ability to borrow in large quantity while not taxing. This prevents it from achieving its aims without taxing. It prevents it from offering large programs without levying large taxes. That is a necessary condition and a sufficient condition to foster monetary arrangements that will be as sound as can be attained. Monies will then be produced privately, and competition will assure that people will choose the monies that they prefer.
This prospect cannot be realized if people want big government while not paying for it now. If people will not pay for a war or a social program by raising taxes now, then the government has to borrow. If it attempts to borrow in any quantity, it quickly finds that, if it does not levy taxes, its borrowing costs rise steeply. To get around this, it then has an incentive to control money and inflate. In other words, there cannot be sound money and a low-taxing big government simultaneously. Any political arrangement that is biased toward deficits and taxing in the future rather than now will be biased toward inflation.
This brings us to the third question, which is what changes to make to get to sound money. The government sometimes does this itself through currency stabilization measures, but these typically happen after there has been a severe inflation or hyperinflation. The usual course of events is that severe deficits result in severe inflation and an eventual reform of the currency. Many people suffer badly, and finally the government itself suffers so much that it reforms the currency. This terrible outcome is very hard to avoid because it takes major, major political changes to avoid it. The people have to restrict government spending and borrowing, but that means constitutional changes that are all but impossible to obtain. It also means serious changes in wealth redistributions and government promises, and these are also politically infeasible. If these cannot be done before the situation moves into severe inflation, then eventually the breakdown of the economy will create a new political situation wherein some reforms will be enacted and a new system established.
Inflation is not only a monetary phenomenon. Inflation is a political phenomenon. What is more, inflation is intractable because it is a political phenomenon.
Inflation has gone on now in most countries for decades. It is moving into a new stage in the U.S., a more virulent stage. The U.S. government is running a deficit this year that is, as a percentage of its expenditures, about as large as several Balkan countries that experienced hyperinflation after World War I. The U.S. had large deficits during World War II, and that set off a substantial post-war inflation. Another such inflation is baked in the cake.
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.