Inflation through the ages

These charts are from a clipping of a Wall Street Journal reprint of an article in Forbes magazine’s March 1, 1975, issue.  I saved the article because I thought it was so interesting, and I still think it is interesting.

The price index was compiled by an Oxford economic historian named E.H. Phelps Brown from records of prices of food, cloth and fuel in Oxford, England, over the centuries.  It shows that inflation is not a normal state of affairs.  Prices have fluctuated around a base level except during two periods of history, the 16th century and the 20th century.

Phelps Brown also compiled a record of wages in both money terms and real terms – not just what a carpenter at Oxford was paid, but what he could buy with his wages.  The record showed that, in modern times, wages go down as well as up.  During the 16th century, the wages of an Oxford carpenter doubled in terms of pennies, but fell by two-thirds in terms of what he could buy.  It was not until 1880 that Oxford carpenters regained the lost ground.

Click on Measuring Worth for the U.S. Consumer Price Index starting in 1774 and continuing into the present.  In 2009, the CPI dropped for the first time since 1949 and is expected to fall again this year.

Monetarist economists, such as Milton Friedman, explain inflation as “too much money chasing too few goods.”  This fits the facts as outlined in the chart.  In the 16th century, Europe was flooded with the gold of Mexico and Peru following the Spanish colonization of the New World.  The newly-wealthy Spaniards bid up prices not only in their own country, but across Europe including Oxford, England.  In the 20th century, governments went off the gold standard, which meant they were free to issue as much money as they wished.

Many smart people, including Karl Marx, have advocated a gold standard as a means of keeping inflation under control.  This hasn’t always worked.  New discoveries of gold, including the California, Australia and Klondike gold rushes of the 19th century, have increased the money supply and generated inflation.  But any new gold strikes on that scale are unlikely.  Just as we’ve probably reached the age of Peak Oil, we’ve probably reached the age of Peak Gold.

A gold standard would create a different risk – the risk of deflation – if the amount of gold in the world was fixed, but the world’s economic output continued to increase.  You would have too little money chasing too many goods.

Most living people have experienced inflation, but not deflation, which can be just as disruptive or more so. If you’re a debtor – as most Americans are nowadays – you don’t want deflation, because you’re paying back your lender in dollars that are worth more than when you borrowed them.  Historically economic depressions and deflation go together.

Entrepreneurs generally need to borrow money to get started, and so they don’t mind a little inflation (but not too much).  Bankers, on the other hand, insist on stable currencies, even at the price of a little deflation (but not too much).

Ideally, according to monetarists, there should be a money supply expanding at exactly the same rate that the economy as a whole expands.  This would be impossible in practice, because nobody can know how fast the economy is expanding until after the fact.  So monetarists advocate increasing the money supply at a constant rate – say 2 percent a year – which is consistent with the long-term growth rate of the economy.

Keynesian economists think you can use the money supply as a kind of thermostat.  You turn up the money supply a little when the economy is cooling off, turn it down a little when the economy is overheating.  This might work.  The problem is the human bias toward keeping the economic thermostat too high.

I don’t know enough about economics to referee between monetarists and Keynesians, but I don’t think anything in human affairs can be explained by a single cause.  Prices can be driven up by governmental policy, competition or scarcity.  As the supply of oil and other non-renewable resources pass their peak, prices will increase for goods and services that require those resources.  When this happens, contracting the money supply or going to gold won’t bring prices down and may risk deflation.

Many years ago I asked an eminent monetarist at the University of Rochester whether the OPEC oil embargo contributed to inflation.  He said, no, the embargo may have caused prices to go up, but it didn’t increase inflation because inflation is defined as an increase in the money supply.

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