12. The Inflation Genie
Inflation is a dirty word in economics. Nobody likes to see the things they buy get more expensive. Plenty of people (and a lot of today’s economic policy makers) remember the 1970s, the great decade of inflation. The bouts of hyper-inflation in Venezuela, Zimbabwe and even Weimar Germany loom large in the popular imagination as a marker of failing states.
But when enjoyed in moderation, inflation is not such a bad thing. In fact, I want to contend that inflation is quite a good thing, within limits. It helps the economy to adjust to shocks; it can smooth out monetary crunches; it steadily erodes the burden of debt; and it stacks the economy in favour of the risk-takers who drive economic growth. Inflation helps to gear the economy towards change and growth; if the pound in your pocket is slowly losing value, standing still is not a good option. More than anything else, a little inflation can help an economy to find its real productive limits; it is only when wages and prices are rising that businesses and investors are really forced to operate at their limits. There are, of course, serious downsides to inflation, but my guess is that they probably only outweigh the benefits when annual inflation is close to double figures. In an economy like Britain’s, which has strong institutions for moderating inflation, a bit more inflation would be a good thing*.
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Let’s start by taking a look at the history of inflation in Britain. You might be surprised to learn that inflation didn’t really exist in Britain — certainly not in the sustained, year-after-year way it does today — until around the 1940s. With a few exceptions, prices remained surprisingly steady throughout the industrial revolution and the rapid growth of the Victorian era. After the 1940s, inflation became a routine fact of life, averaging just under 5% per year on average since then; goods are roughly 45 times more expensive today than in 1940. This inflationary period has also been the fastest period of real economic growth (yes, that’s after adjusting for inflation) in British history. The chart below shows the 750-year view of inflation.
There are three noticeable bouts of inflation on the record before the 1940s. The first, known as the Price Revolution, took place between about 1540 and 1650, and was linked to an influx of gold and silver into Europe from Spanish conquests in the Americas. Because gold and silver were the main currencies used, having more of them made each coin less valuable. The Price Revolution increased prices in Britain by around 4 times over in 120 years, and may have contributed to the development of capital investment, by forcing people with money to find productive uses for their wealth.
The second bout, between around 1800 and 1815, coincided with the Napoleonic wars, and were largely reversed by deflation soon after peace broke out. This bout of post-Napoleonic deflation triggered a painful economic downturn, and led to the infamous Corn Laws.
The third bout, from 1918 to 1921, was triggered by the end of the First World War and the painful adjustments that followed. It triggered Britain’s horrible 1920s, the country’s worst macroeconomic decade since the Industrial Revolution, and was partly reversed by the deflationary policies of then-Chancellor Winston Churchill. As with the Napoleonic inflation, the deflation proved far more painful than the inflation.
Each of these three bouts of inflation either fizzled out or reversed eventually, but the burst of inflation triggered by the end of the Great Depression and by World War II became pretty much continuous. As the table below shows, inflation has slowed down a little since the 1990s — no doubt related to the Bank of England getting independence and a 2% inflation target in 1997 — but it has been a pretty constant fact of life since World War II.
A couple of details are worth pulling out of the table: first, note that the much-maligned 1970s actually saw GDP per capita grow by 1.9% per year despite all the inflation, which is pretty healthy by historical standards; second, note that Thatcher’s monetarist policies in the 1980s actually produced higher inflation than any decade bar the ’70s (some of this down to taming high inflation at the end of the ’70s, but the late ’80s “Lawson Boom” also played a role).
Why did inflation become an annual fact of life post-World War 2, after centuries where it was the exception rather than the rule? The simple answer is about currency. Throughout most of history before World War 2, currencies were mostly linked to gold or silver — there could generally only be as much money as there was gold or silver available. And because the supply of gold and silver tends to be limited, the overall amount of money in the economy couldn’t rise by much. This meant prices couldn’t rise much; if you raise the price of everything without any more money being available, you have a big problem.
After World War 2, Britain was part of the new Bretton Woods currency system. Although Bretton Woods aimed to control currency fluctuations between nations, it effectively made the US dollar, not gold, the basis of the system, which meant the world’s supply of currency could increase. When Bretton Woods collapsed in the 1970s, the UK switched to a fully floating currency, allowing even more scope for increasing the amount of currency.
There’s an obvious question that jumps out of this historical analysis: did the advent of inflation cause the post-war economic miracle? The correlation is obvious — the period after the 1940s, where annual inflation became the norm, where the supply of currency could increase, was also the fastest period of growth in British history. But causation is a different matter, and I have no evidence to claim inflation caused this growth. The second half of the twentieth century saw rapid technological progress in many parts of the world, and it is hard to argue for an alternate reality in which that did not lead to economic growth. I believe moderate inflation can increase and unlock economic growth in the right circumstances, but it certainly does not cause economic growth on its own.
What we can say with some confidence, though, is that deflation — the opposite of inflation, where prices fall — can have a serious negative impact on economic growth. The 1920s, in which Britain (led by Chancellor Winston Churchill) forcibly deflated its economy, the worst decade in the country’s modern economic history. Between 1918 and 1928, real GDP per capita shrunk by 8%, accompanied by serious social unrest. The decade was known as the Roaring Twenties in fast-growing America, but Britain’s deflationary attempt to keep the pound strong caused a huge amount of pain**.
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So why do I think inflation is often a good thing?
The harms caused by inflation — particularly very high inflation — are well understood. Having to raise prices and wages all the time can be expensive and inefficient. It can create winners and losers — those with savings in the wrong place or non-indexed pensions can lose dramatically. It weakens currencies, and tends to be the most visible symptom for countries suffering currency or debt crises. Inflation creates uncertainty that can act as a severe brake on investment and agreeing business contracts — who wants to agree to a long-term deal when they aren’t sure what the value of a pound will be in a year’s time? Economies work by using currencies and prices, and if those prices are constantly changing, the economy is likely to work less well. Inflation is also a persistent phenomenon: the spiral of workers demanding higher wages and firms then further putting up prices to pay the wages is hard to break. This is why it is often referred to as the Inflation Genie: because it is hard to put back in the bottle.
But the benefits of inflation, like genies, are pretty significant too, and it’s worth spelling them out. Some of the benefits are also pretty well understood, but some of them are too often underrated in my experience.
First, inflation helps the economy adjust to ups and downs, particularly in changing wage levels. Sometimes, people’s wages need to fall to help their industry stay competitive. But economies tend to have a “nominal stickiness”: people don’t like to see their wages fall in actual cash terms. If you have a little inflation, you can reduce real wages while holding nominal wages flat. The reduction isn’t as obvious and seems to be more acceptable to people, but in economic terms it is still a reduction. This “flat cash” approach has been used extensively by the UK Government over the last decade to gradually reduce Government spending without announcing actual cash cuts.
Second, inflation erodes debt burdens in the economy over time. Debts are normally fixed in cash terms, so if there is inflation, the debt gets smaller over time. This is part of a pattern where higher inflation generally hurts savers and rewards borrowers over time, by making savings (borrowings) worth less. This is usually a good thing for economic growth, because borrowers tend to be the people who are taking risks and investing in the things (businesses, capital machinery and technology, consumer spending) which make the economy grow. It is an especially good thing after financial crises, where the economy is stunted by very high levels of debt (which makes businesses less likely to invest and people less likely to spend).
Third, and relatedly, inflation forces savers and investors to look for more productive uses for their money. Inflation punishes people holding on to cash or low-return assets (the value of cash literally goes down over time) and encourages people to find higher rates of return so as not to lose their money. Higher rates of return generally come from riskier, more growth-enhancing investments, such as backing innovative companies or investing in new technologies. An economy directing more of its capital to productive, growth-enhancing ventures is likely to grow more quickly.
Fourth, keeping inflation at a moderate level can help to smooth out monetary crunches in the economy. Recessions often occur and persist because everyone stops spending their money at once, for a whole range of different reasons. As a result, less money flows to businesses, and on to people’s wages, and so the economy begins to shrink. One of the main remedies for this is to make extra money available, so it keeps flowing around the economy. An economy that is aiming for (or tolerating) a bit more inflation is likely to be more able to respond to and smooth out these monetary crunches quickly.
Fifth, and perhaps most peculiarly to the current British economy, the price level matters much more in a service-based economy. The productivity of a service, such as consultancy advice or a haircut, is more influenced by its value than how many are produced. And for most services, the value roughly corresponds to its price — what a customer will pay for it. Britain produces more services than it consumes (by exporting more services and importing more goods), so if the relative price of services falls, that is bad for the British economy. And that is exactly what has happened in Britain since 2008; as the chart below shows, consumer prices have increased twice as fast as the price charged by service businesses***. This may well have made many service sectors — the strongest parts of the modern British economy — less productive and weakened the economy.
When you take all of this together, the effect of moderate inflation is to keep the economy close to — or perhaps a little above — its full productive potential. That is true in a dynamic as well as a static sense — if there are productivity gains to be had from the riskier investment or uptake of technology, inflation is more likely to flush them out, because it increases the cost of standing still. Of course, inflation cannot magically erase the productive limits of an economy; if you push an economy too far beyond its limits, the result is only much more inflation, and no extra growth. But without tolerating a bit of inflation, it’s hard to find out where those limits are, especially in a service-based economy. There is a risk to running the economy well below its capacity just as there is a risk to running over-capacity.
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So what does this mean for how we should run the economy today? My argument has probably been a little glib: inflation is a *good thing*, until it reaches a certain level, when everyone knows it becomes a *bad thing*. What level of inflation should we be willing to tolerate?
Based on the historical record, my sense is that inflation between 3% and 5% is a healthy place to be, and gives the economy every chance to find its limits. This is more inflation than we have at present; our target is 2%, and the Bank of England has done a pretty good job of meeting this since it became independent. But the more important point is that, if in doubt, we should err on the side of more inflation. A bit too much inflation is generally better than a bit too little — remember how much worse the 1920s look in hindsight compared to the 1970s. The inflation genie may be hard to get back into the bottle, but there are much worse things to be stuck with than a genie.
Notes and explainers
*If you need a quick primer of what inflation is: Inflation is the price of things rising, and therefore a pound (or your currency of choice) becoming worth less. These are one and the same thing; if prices rise, your pound can buy less stuff. There are two main ways inflation can happen. One: the economy overheats, so that overall demand is more than can be supplied, which drives the price of things up. Two: the amount of currency increases (e.g., because the Government printed more money) without any increase in supply in the economy, which reduces the value of the currency and drives prices up. In practice, the demand-outstrips-supply and the extra-currency issues interact with each other, but it’s helpful to highlight the difference between an overheating economy and an oversupply of currency.
**By contrast, Britain had a relatively good 1930s while the USA suffered the Great Depression, in part because of Chancellor Neville Chamberlain’s push to raise prices and build homes.
*** If this seems confusing, it’s worth remembering that many service businesses sell to other businesses, not to consumers. The Consumer Price Index, our main measure of inflation, only measures the prices consumers pay, not the prices of business-to-business trade.