How has inflation been fought in the past?

Inflation is damaging to the economy. Recent years have given the impression that public authorities knew how to keep it under control, but the current resurgence has revived old fears. The policy response will benefit from a look at how previous inflations have been tackled.

Inflation is a sustained rise in the prices of goods and services. It is a relatively new phenomenon in the long sweep of history and largely belongs to the 20^th and 21^st centuries.

Before then, there were occasional long periods of mild inflation. Examples include the last years of the Roman Empire, Tudor times in England, and even during the Napoleonic Wars in England – each of these were in the region of a few percentage points increase each year.

There are other occasions when there were some bursts of rapid inflation such as in the American War of Independence in the 1780s, the French Revolution in the 1790s and the American Civil War in the 1860s. In these examples, the rise was more than 100% per year. But widespread and high inflation belongs almost entirely to the last 100 years or so (Capie, 1986).

Figure 1: Long run inflation rate

Source: Bank of England

There is an obvious reason for that. Only when paper money became easy to produce – with some basic security measures – was a rapidly growing money supply possible. The fundamental explanation for inflation is an excess of growth in money over growth in output.

When and why did inflation appear in the past?

Some hints have already been given as to why inflation appeared when it did in the past. Rapid inflation was not, contrary to the assertions in many textbooks, a consequence of war. Indeed, in the 18^th century, Britain was at war most of the time without any inflation.

Rather, extreme examples of inflation have almost invariably been found in countries during civil war or something close to that. In these cases, the established government is trying to preserve the peace but may end up fighting the rebels.

Either way, it is spending to placate the opposition or spending on fighting. But with the country divided, the opposition is not paying tax and a gulf opens between spending and revenues. There is a resort to borrowing, and when the possibilities for that are exhausted, money is printed.

Money growth quickly expands at a rate that precludes any possibility of output growth matching it and inflation follows. And a key lies therein: weak governments give in to spending in excess of their income.

There were several examples of hyperinflation in the early 1920s – in Russia, Poland, Hungary, Austria and Germany. Then in the 1940s, Hungary, Greece and China all experienced hyperinflation, which reached staggering rates frequently in the thousands of percentage points per year. After 1950, examples can also be found – in countries such as Indonesia in the 1960s, Serbia in the 1990s and in much of Latin America and elsewhere in between these dates. All of these were cases of civil war or something very close to that.

But this also spread to most other countries. What had become a common occurrence as the 20^th century progressed was either an inability or an unwillingness on the part of governments to keep their spending in line with their ability to raise tax revenues.

In the case of civil war or serious social unrest, governments are largely unable to do so. But unwillingness to keep spending and income in line over time has become more common, even when governments are not facing such pressures.

So how was inflation tackled?

When countries adhered to a metallic standard – when money was determined in metal, usually gold or silver – it was difficult or even impossible for inflation to develop. The supply of money could not grow fast enough. But when such a standard was abandoned, as it was, for example, in Britain during the Napoleonic Wars, inflation appeared.

The cause was clear to contemporaries – the loss of the discipline of the standard. The solution was therefore a return to that standard. After that was achieved in England at the start of the 1820s, prices were stable for almost 100 years. But where that option proved, or seemed, too difficult to achieve, inflation continued.

In some cases when inflation had been ruinous, the solution was to start again with a new currency and some old principles. This was often the case in Europe after the First World War – the German Reichmark and the Russian rouble being two examples.

What was the approach after the Second World War?

After the Second World War, the new international monetary arrangements held to an attachment to the US dollar, with the ultimate anchor to gold. Currencies linked to the US dollar through their foreign exchange rate, and the dollar was based on gold.

But this system broke down under pressures at the end of the 1960s and the connection with gold was severed. The US government would not contain its spending. The world thereafter, and for the first time ever, was on a fiat standard, backed only by the word of government.

Strangely, in this period of the late 1960s and into the 1970s when widespread inflation had begun to develop, its cause had been forgotten. A sociological theory was being advanced. Inflation was said to be the result of large powerful labour unions that were able to demand ever-increasing wage settlements; or of large powerful monopolists – such as oil producers – which were able to put up prices. And, it as argued, these actions were responsible for inflation (Kaldor, 1985).

The solution that followed was for governments to impose wage and price controls. Such controls have been employed for many hundreds and possibly thousands of years and yet seem never to have worked. They certainly did not work in the 1970s when inflation reached its highest ever level in the UK – an annualised rate of 30% – and in many other countries.

When did an alternative solution appear?

A gradual acceptance took hold among policy-makers that excess money was indeed the root cause of inflation and, in the 1980s, attempts were made to bring it under control. This could be done by operating either on price (interest rates) or on quantity.

One approach was to control the quantity of money directly. This might be done by controlling narrow money (the monetary base) – that part of money under the central bank’s control.

Others argued that a broader definition of money was the measure that mattered and the relationship between narrow and broad money was not constant. Broad money had to be controlled via reserve requirements imposed on the banks (Griffiths and Wood, 1981).

A certain amount of success followed, insofar as inflation rates fell wherever these methods were used. But the pattern was mixed and there was dissatisfaction.

What came next?

During this period, it also became clear that political pressure on central banks had to be removed. The old story of governments wanting to spend led to pressure on central banks to provide the cash. Take away that possibility and central banks should be able to control inflation.

The government would decide on the rate of inflation that was acceptable and mandate the country’s central bank to achieve that rate. As a result, inflation targeting was introduced in the 1990s (although there were one or two examples in the late 1980s).

The argument was that with the inflation target announced, the central bank’s credibility would persuade people that the inflation rate would be achieved. Indeed, inflation generally fell around the world in the 1990s and the first decade of the 21^st century.

An element of good fortune emerged at this point as global economic output and global trade produced pressures of a beneficial kind. Central banks’ task became easier. But, unfortunately, the idea developed that announcing the inflation target itself was all that was required. Now governments could spend what they liked without worrying because inflation expectations had been firmly anchored.

Furthermore, the targeting of consumer prices took attention away from asset prices. While the consumer price index (CPI) or the retail price index (RPI) may remain steady, excess money can be flowing into asset prices – for example, housing or the stock market.

This can result in potential danger in the future. For example, it was the rise and collapse in asset prices– particularly housing – that led to the global financial crisis of 2007-09.

What happened in and after the global financial crisis?

The response to the global financial crisis was generally the correct one. There had been a scramble for liquidity and the need for central banks to inject money into the economy. They did this on a grand scale through measures called quantitative easing.

Many warned of the inflation that would inevitably follow. But even though the injection was incorrectly left in the system, and often increased, that did not happen. This was because broad money growth did not rise greatly.

It did not rise because the authorities had decided that the banks needed to be better capitalised and insisted that they raise their capital/asset ratios. That cannot be achieved without constraining bank lending and the outcome was that money growth did not take place on a scale that led to inflation.

What has been happening during the pandemic?

The notion that governments could spend freely and not worry about inflation has been coming under increased scrutiny with the most recent surge in government spending following measures taken to deal with Covid-19. Money growth has surged and inflation has risen sharply.

Much has been written about whether this is a consequence of supply shortages arising as a result of the pandemic, which in turn has led to individual prices rising. This is a reversion to an old fallacy and indeed the tautology that it was rising prices that caused inflation.

The facts are that in 2020 and 2021, money growth has been extraordinary and greatly in excess of output growth – and this has produced inflation. Money growth has slowed in 2021-22, but there will still be inflation to come. There is no escaping the fundamental role that money plays in the process (King, 2022).