John Steele Gordon: The Inflation Temptation

[John Steele Gordon is the author of An Empire of Wealth and a frequent contributor to COMMENTARY.]

... With the world economy now contracting rapidly and the banking systems in many countries in serious disarray, inflation is not a problem at the present. Indeed, deflation was the primary worry last fall as the financial crisis, heating up since Bear Stearns collapsed in March 2008, exploded with the bankruptcy of Lehman Brothers in September. To combat the recession, the Federal Reserve has been aggressively pumping liquidity into the banking system and the government has been spending deep into deficit.

With the Federal Reserve increasing the money supply by trillions of dollars by buying up federal bonds in open-market operations and a federal deficit that will be in the trillions this year and probably next year as well, is inflation destined to be an inevitable sidekick to recovery?

That is certainly a significant possibility. And a frightening one. Inflation is among the most devastating economic forces imaginable. It reduces the purchasing power of ordinary people, impoverishes those who have struggled to save money by destroying the value of their savings, and causes a crisis of faith in the viability of the currency. For that reason, it is universally understood that the Federal Reserve has a very tricky balancing act over the next few years. Once the American economy recovers, the Fed is going to have to move quickly but delicately to remove the excess liquidity from the system without doing so in a way that causes interest rates to rise too quickly. That would cause the economy to descend once again into the maw of recession. Still, if it acts prudently and wisely, the Federal Reserve has both the power and the ability to prevent inflation from roaring to life as the economy recovers.

But will its senior personnel have the political will and financial skills to do so? Don’t count on it. Indeed, there are reasons the political class in Washington is thirsting for a revival of inflation. For one thing, inflation would increase some tax revenues, such as from capital gains, considerably without Congress having to vote to increase taxes. And because the national debt is denominated in dollars, inflation would also reduce the national debt as a percentage of GDP, thereby seeming to make that debt more manageable.

Inflation therefore is not only a demon, but one that sometimes bears a superficially charming and attractive aspect. That may be especially true for the current administration and the current Congress, which would like to claim they can spend far more public money and reduce the deficit simultaneously.


To understand what inflation is, one first has to understand what money is. Money is a commodity—something that can be bought and sold in a marketplace, just like pork bellies, legal services, or West Texas sweet light crude. What makes money different is that it is the sole commodity universally accepted in exchange for every other. In a barter economy, only someone who needs apples is going to accept apples in payment for the commodity he trades away. But in a cash economy, everyone accepts money and then uses it to go buy what he wants.

Coins made of precious metal were the first true money, introduced in the kingdom of Lydia, in what is now Turkey, around 650 BCE. Because their face value was always set slightly above their bullion value (the difference is called “seigniorage”), coins were not melted down and thus had no other use than as a medium of exchange. Paper money, at first representing precious metal on deposit in a bank or treasury, was introduced in China in the 9th century and in Western Europe at the turn of the 18th. Today, most money is nothing more than electronic blips deep in the bowels of vast and interlocking computer systems. When you pay for coffee and a newspaper with a debit card, some blips are subtracted from your account and added to the seller’s.

But while today’s money is insubstantial in the extreme, it is still a commodity. And thus it will rise and fall in price according to the dictates of the law of supply and demand, just like any other commodity. But because money is a very special commodity, there is a special name for a fall in its value: we call it inflation....

The United States went off the gold standard during the Civil War, returning only in 1879. The North was able to raise about 89 percent of its wartime financing needs through bond sales and taxation, but resorted to printing $450 million in so-called greenbacks—fiat money that was not redeemable in gold—to finance the rest. The inevitable resulting inflation in the North over the course of the war was about 75 percent.

The South, with its far less developed and cash-poor economy, could raise only about 46 percent of its needs through borrowing and taxation and had no choice but to print money to finance the rest. The result was catastrophic for the Southern economy, which suffered an inflation of more than 700 percent just in the first two years of the war. As the currency became increasingly worthless, hoarding, black markets, and shortages of basic commodities spread. The Southern economy began to collapse, as did the Southern war effort along with it. It wasn’t just Grant and Sherman who doomed the Confederacy.

Both the First and Second World Wars were accompanied by bouts of inflation as the Federal Reserve System (established in 1913 as the nation’s central bank) facilitated the government’s borrowing needs by keeping interest rates low. Inflation was over 17 percent in 1917 and 1918 and over 15 percent in 1919 and 1920, until the recession that began that year cooled the economy and brought the inflation to an abrupt end.

Price and wage controls in World War II kept the lid on inflation for the duration of the conflict. But with the end of the war and popular pressure that the controls be removed, the immense pent-up demand for consumer goods unavailable during the war caused inflation to explode. Inflation was only 3.31 percent (calculated on an annual basis) in June of 1946, when the controls were ended. It was 9.39 percent in July, and by the end of the year it was 18.13 percent. Inflation reached almost 20 percent by the following March, before subsiding as supply and demand equalized. As the economic dislocations of the war faded, so did the war-induced inflation.

During much of the 1950s and early 60s, inflation was only rarely over 2 percent a year. But when President Lyndon Johnson tried to fight the Vietnam War and to fund the Great Society at the same time, inflation began to creep up as federal borrowing increased. The Federal Reserve, as it had in World War II, kept interest rates low to facilitate this borrowing.

But the Fed’s means of facilitating this federal borrowing was to buy up federal bonds, which restricted their supply in the marketplace and thus kept down the interest rate the federal government had to offer to sell them. That, in turn, increased the money supply. As the bonds moved onto the Federal Reserve’s balance sheet, the Fed credited banks’ accounts accordingly.

The economy as a whole, so robust in the early ’60s, began to falter, but inflation kept increasing regardless. Under Keynesian economic doctrine, this was supposed to be an impossibility, and so a new word had to be coined, in 1970, to denote it, stagflation.

In 1971, President Nixon, unable to control the falling price of money, tried to control the rising price of everything else by freezing wages and prices. This had been tried before, of course—in 301 CE, the Emperor Diocletian had imposed wage and price controls in an attempt to stem the inflation then raging in the Roman Empire. The tactic didn’t work for Diocletian and it didn’t work for Nixon, who abandoned the attempt in 1972 as the inflation raged on....

The Fed, with its policies over the past year, has set itself an immensely complex task—a task it must not fail, and yet one so difficult that success is by no means assured. The Fed will have to prevent an inflationary spiral when such a spiral is exactly what many elected politicians may want (but will not admit they want). It is for this very reason that the Federal Reserve was designed as an entity whose decisions could be made independent of direct political pressure. The Fed’s independence is subject to constant testing, and never has it been more important for its leadership to pass the test.

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