How to Stop Inflation

January 8, 1951

Overnight, without any serious consideration of past experience, present facts, theory, or consequences, the economy has been put into the straitjacket of price control. This has happened because most people still do not understand that price control creates far more problems than it “solves.” It has happened because, in spite of the Niagara of books, pamphlets and editorials in the last ten years, most people still do not understand what inflation really is, what causes it, and what can cure it.

Fortunately, the problem of inflation is in at least some respects much simpler than it is commonly thought to be. There are not a hundred different causes. There is only one: an increase in the volume of money and credit in relation to the volume of goods. When people have more dollars to bid for the same supply of goods, they will bid prices up. Putting the matter another way: just as each individual bushel of wheat will exchange for less, other things being equal, when the supply of wheat is increased, so each individual dollar will exchange for less, other things being equal, when the supply of dollars is increased.

At the end of 1939 the combined total of demand deposits and currency outside banks was $36,194,000,000. At the end of May of 1950 it was $109,700,000,000. In other words, the supply of money in the pockets and bank accounts of consumers and other buyers had more than tripled.

It was said and commonly believed in the second world war that prices were high because of the “shortage of goods.” This was not true then, and it was certainly not true after the war, when prices went higher still. The cost of living right at the end of the second world war, in August 1945, was 29.3 percent above the 1935–39 level; the cost of living in May 1950 was 68.6 percent above that level. The wholesale price index rose from 105.7 in August 1945 to 155.9 in May of 1950. This was certainly not because goods were scarcer in May of 1950 than during the war or in the prewar period. On the contrary, the official index of industrial production in May of 1950 was 95 percent higher than in the prewar period 1935–39.

Why were prices so much higher in spite of the fact that goods were so much more abundant? The answer lies in the volume of currency and demand deposits, which was not only three times as high in May of 1950 as in the 1935–39 period, but $12,000,000,000 higher than at the end of July of 1945.

A similar explanation must be given for the rise in prices since the outbreak of war in Korea. It is not due to a greater “shortage of goods.” The index of industrial production, in fact, has risen from 195 in May to 214 in November. But in that period there has also been an increase of some $5,000,000,000 in demand deposits. The secret of the rise in prices, in other words, is that more money has come into existence to buy even the increased supply of goods.

Even sophisticated bankers and economists get confused about this subject because the causation often seems to be the other way round. It is not always the increase in the money and credit supply that comes before the rise in prices. Often (and this happened after the outbreak of the Korean war) it is the price rise that comes first. But what most people overlook is that unless an increase in money and credit followed immediately, the price rise could not be sustained.

A typical chain of causation is this. War breaks out. Manufacturers and speculators think that the demand for certain goods is going to increase, making them higher in price. Therefore they begin to buy and hold them immediately. But to buy and hold them at a higher price they need more credit. This is usually forthcoming from the banks as a matter of course. If the banks refused this credit, however, or were not allowed to expand their total volume of advances, or if interest rates were raised to a point that discouraged this further expansion, no substantial general rise in prices could be sustained. The rise in the price of war goods would be offset by declines in other commodities.

Inflation is a monetary and credit phenomenon—and nothing else.