Everybody knows that consumer prices in Australia, Britain, the U.S. and other countries have risen rapidly over the past year, and most investors know that they’re presently increasing at rates unseen in decades. But seldom does anybody ask: what is inflation? What, ultimately, causes it? And because they don’t ask these questions, the crucial one escapes them: have the world’s central banks and governments focussed overwhelmingly upon one of inflation’s possible effects (rising consumer prices) and thereby ignored its underlying causes (governments’ interventionist monetary policies and the profligate fiscal policies they accommodate)? Like arsonists who join the bushfire brigade, have central banks created the very problem they purportedly seek to ameliorate?
In this article, I
- Contrast the current and previous mainstream definitions of inflation;
- Plot the course of inflation (according to today’s meaning) in Australia over the past century and the U.S. since 1800; and
- Identify and analyse the two causes of inflation in the U.S. (according to the conception that’s become outré).
The current mainstream ignores what the previous orthodox conception identified as inflation’s ultimate causes. As a result, today’s conventional wisdom emboldens governments to create ever more inflation. Central banks like the Reserve Bank of Australia don’t fight inflation. Quite the contrary: they create it and fan its flames.
A brief history of two conceptions
What is inflation: “rising consumer prices” (which, crudely, is the crux of the contemporary and Keynesian conception) or “too much money or credit” (the heart of classical, monetarist and Austrian School approaches)? The history of its definition is highly revealing (see in particular Justin Lahart, “Using a Dictionary to Define Inflation Can Spell Trouble,” The Wall Street Journal, 14 May 2011).
From the mid-19th century until the publication of its Eleventh New Collegiate Dictionary (2003), Merriam-Webster defined inflation as the consequence of printing too much money. The second edition of its New International Dictionary (1934) was particularly noteworthy. It defined inflation as a “disproportionate and relatively sharp and sudden increase in the quantity of money or credit, or both, relative to the amount of exchange business. Such increase may come as a result of unexpected additions to the supply of precious metals … ; or it may come in times of business activity by expansion of credit through the banks; or it may come in times of financial difficulty by governmental issues of paper money without adequate metallic reserve and without provisions for conversion into standard metallic money on demand. In accordance with the law of the quantity theory of money, inflation always produces a rise in the price level.”
But in 2003, reflecting the usage that decades previously had become prevalent, Merriam-Webster amended its definition to “a continuing rise in the general price level,” which is only “usually attributed” to an “overabundance of money and/or credit.”
The CPI in Australia and the US over the past century
Using data compiled by the Australian Bureau of Statistics, Reserve Bank of Australia and Federal Reserve Bank of St Louis, Figure 1 plots 12-month percentage changes of the Consumer Price Index (CPI) in Australia and the U.S. since the June quarter of 1922. In Australia, CPI has increased at an average rate of 4.01% per year; in the U.S., the mean is 2.97% per year.
Figure 1: Consumer Price Index, 12-Month Percentage Change, Quarterly Observations, Australia and U.S., 1922-2022
The series are correlated (r=0.59); as a result, the history of consumer prices in both countries comprises five key episodes:
- Falling prices at annualised rates of up to 10% distinguished the early years of the Great Depression;
- CPI zoomed to all-time highs (annualised rates of 20% or more) during the Second World War and (in Australia) the immediate post-war years (the “first Great Inflation”);
- CPI’s rise reached or exceeded 15% per annum during the 20 years (U.S.) and 25 years (Australia) from the mid-1960s (the “second Great Inflation”);
- Relative price stability characterised the decade to 1965 and the quarter-century after 1995;
- Since last year, CPI in both countries has surged at rates unseen since 1990 (Australia) and 1982 (U.S.).
“The appropriate target for monetary policy in Australia,” says the RBA’s web site, “is to achieve (an annualised rate of growth of the Consumer Price Index) rate of 2-3%, on average, over time. This is a rate … sufficiently low that it does not materially distort economic decisions in the community … This approach to monetary policy in Australia commenced in (1992-1993).” Since that time Australia’s CPI has increased at an average annual rate of 2.5%. For this and other reasons, during most of these years the RBA has a respected, even lauded (albeit mysterious to the general public) institution.
Using this target’s mid-range as a rule of thumb, Table 1 and Table 2 list the intervals over the past century during which the CPI’s annualised rate of growth in Australia and the U.S. has continuously exceeded 2.5%. These tables rank these intervals according to their average rate of consumer price inflation; by this standard, the current bout ranks #7 in Australia and #5 in the U.S.
Table 1: Consecutive Quarters during which Australian CPI’s 12-Month Rate of Change Exceeds 2.5%
These intervals are slightly more numerous in Australia (16) than the U.S. (13); and they have been slightly longer in this country (mean duration of 15.9 quarters) than the U.S. (14.5). Yet consumer price inflation during these intervals has been somewhat higher in the U.S. (mean of 5.1% per year) than Australia (4.6%), and the CPI’s peak during these intervals has been higher there (7.6% per year) than here (7.3%).
Table 2: Consecutive Quarters during which U.S. CPI’s 12-Month Rate of Change Exceeds 2.5%
The first “Great Inflation”
“Inflation is soaring, Wall Street is skittish and the supply chain is clogged. Empty store shelves dominate dinner table conversations. The new president is in hot water, his approval rating at just 30%. A recession seems likely.” Sound familiar? Yet as David Oshinsky writes (“How Previous Generations Handled Inflation Crises,” The Wall Street Journal, 29 July 2022), “the year is … 1946.”
The rapid military build-up in Australia, the U.S. and elsewhere during the Second World War, and again during the Korean War, triggered what Oshinsky dubs “the First Great Inflation.” Astonishingly, and unlike anything that occurred before or since, America’s Gross National Product (GNP) doubled from $100 billion in 1940 to $212 billion in 1945; as a result, mass unemployment, the scourge of the Great Depression, suddenly disappeared and acute shortages of labour emerged. In the first half of 1942 alone, the U.S. Government ordered close to $100 billion of goods and services – more than the entire economy had ever produced during a single year. In order to create this output, more than 17 million jobs suddenly materialised – equivalent to almost 13% of the country’s population – and wages soared.
For governments, the problem was no longer (as it had been in the 1930s) to find enough work for people to do: it was finding enough people to do the huge amount of work to be done. For households, the major concern (apart from the lives of family members in the armed forces) was finding enough to buy. Vastly greater military production necessitated restricted civilian consumption – which forced governments to ration most consumer goods and impose strict wage and price controls. As a result, CPI’s annualised rate of increase in the U.S. decelerated from 12.7% in January-March 1942 (when the controls commenced) to 1.2% two years later. The deceleration in Australia was even more marked: from 10.7% in the September quarter of 1942 to 0.4% in the December quarter of 1943.
Military victory in 1945 commenced the painful reversion from wartime back to peacetime economy. Having accumulated $140 billion of savings (equivalent to an astonishing 66% of the country’s GNP), Americans were willing and able to spend big. Bowing to intense pressure from the public, Congress, businesses and trade unions, President Harry Truman allowed wage and price controls to expire. But factories couldn’t transition instantly to civilian production; demand for consumer goods thereby greatly exceeded their supply and prices skyrocketed. Indeed, in March 1947, CPI’s 12-month rate of increase reached its all-time maximum of 19.7%.
In Australia, rationing and wage and price controls took longer to lift – but a roughly similar set of circumstances, together with a sudden spurt of government military expenditure and booming commodity prices during the Korean War, pushed the Australian CPI’s annualised rate of increase to 23.9% in the December quarter of 1951.
The second “Great Inflation”
The longest interval of consumer price inflation commenced in Australia in March 1964 and in the U.S. two years later. In this country, CPI’s rate of increase continuously exceeded 2.5% until September 1991 – that’s 111 quarters and almost 28 years. America’s second Great Inflation lasted almost as long (80 quarters and 20 years).
Determined to expand the U.S. war effort in Vietnam without affecting his costly Great Society agenda (which his successors criticised from opposition but then extended once elected), under President Lyndon Johnson government spending zoomed, the budget deficit began to balloon (see Figure 5 below) and the economy to overheat. Similar developments, particularly following the election of the Whitlam Labor government in 1972, occurred in Australia. As a result, consumer prices rose, at first slowly and then not so slowly (in the U.S., from 1.3% in 1965 to 5.5% in early 1969).
The next president, Richard Nixon, charted a new course. During his election in 1968, he opposed mandatory wage and price controls. Yet on 15 August 1971 he imposed a 90-day freeze for the first time since the Second World War. He also announced a change of far greater importance: the U.S. abandoned the Bretton Woods financial system that for more than a quarter-century had pegged major currencies to the $US and guaranteed to foreign central banks its convertibility to gold at a fixed price. But news of the wage and price freeze, being much more comprehensible to the general public, dominated the headlines.
In his second term (he was re-elected in 1972), Nixon abolished the controls, then re-imposed them (his successor, Gerald Ford, axed them permanently in 1974). Amid the confusion, ranchers and farmers hesitated to send beef and produce to market, prompting shoppers to pick grocery stores clean. At the same time, the combination of drought and gross economic mismanagement in the Soviet Union led to a severe global shortfall of grain. Alas, Washington had signed a trade deal that allowed the Soviets to buy millions of tonnes of American wheat on credit and at below-market prices – which they did, and which produced severe shortages and skyrocketing prices.
Then came the decade’s the first energy crisis. Cheap oil, increasingly from the Middle East, had long been a pillar upon which Western and particularly American prosperity rested. In 1973, however, Arab members of the Organisation of Petroleum Exporting Countries (OPEC) imposed an oil embargo (primarily upon the U.S.) in order to punish it and other countries for supporting Israel during the Yom Kippur War. Oil’s price per barrel quadrupled and long queues formed at petrol stations.
Also in 1973, the Watergate scandal forced Richard Nixon to resign the presidency. Jimmy Carter, elected in 1976, fared no better. Like Nixon, Carter succumbed to a massive oil shock (the revolution in Iran in 1979 caused the decade’s second energy crisis). When he left office early in 1980, CPI’s annualised rate of increase approached 15%. In Australia during the March quarter of 1975, CPI peaked at 17.7%.
In mid-1979, Carter sacked half of his cabinet and several top officials. Among the replacements was a new head of the Federal Reserve. Presidents Kennedy and especially Johnson had pressured the Fed, usually successfully, to “stimulate” economy through low interest rates and a loose supply of money. Serving briefly under Carter and then for eight years under Ronald Reagan, Paul Volcker was cut from very different cloth. His senior thesis at Princeton University castigated the Fed’s post-WWII policies’ failure to curb inflation: “a swollen money supply presented a grave inflationary threat to the economy. There was a need to bring this money supply under control if the disastrous effects of a sharp price rise were to be avoided.”
As the Fed’s Chairman, Volcker launched a single-minded campaign to crush rising prices. Ignoring pleas from the administration, Congress and the press, short-term rates in the early 1980s hit 20%. Unemployment also rose, followed by two deep recessions, but consumer price inflation plunged from 13.5% in 1980 to 3.6% in March 1983.
What Ultimately Causes Inflation?
According to today’s mainstream, inflation is an increase of the general level of prices (such as the Consumer Price Index or one of its variants). What, says today’s conventional wisdom, causes CPI to rise? Several things at any given point in time and different things over time – but leading orthodox economists seldom assign governments’ policies a prominent place on the list. If anything, they reckon, government intervention – including central banks’ policies – tamps inflation and deregulation exacerbates it. Investopedia is typical: “central banks of developed economies, including the Federal Reserve in the U.S., monitor inflation. The Fed has an inflation target of approximately 2% and adjusts monetary policy to combat inflation if prices rise too much or too quickly.”
David Oshinsky, too, is thoroughly conventional. “The first Great Inflation,” he says, was “triggered by supply chain shocks and compounded by the lifting of wage and price controls. So was the second Great Inflation. The distinguished economist Alan Blinder summarised the reasons in three words: food, energy and decontrol. “These three shocks alone,” (Blinder) wrote, “can account for all of the acceleration and deceleration of inflation in that period.”
Oshinsky emphatically exonerates the Fed from any blame: “it has a mandate to raise interest rates to slow down the economy, and this week’s second consecutive, unusually large rate hike signals its determination to keep inflation in check.” To the mainstream, it’s an article of faith: central banks combat inflation; they certainly don’t cause it. Oshinsky’s confidence in interventionist policymakers’ ability to control and manage inflation has perhaps been bruised but certainly remains unbroken: “the current economic picture is certainly gloomy … But we are far from the worst economic woes of the past. If our policy makers are both lucky and wise, we may yet avoid adding another chapter to the unsettling story of America’s Great Inflations.”
Cause #1: Interventionist Monetary Policy
What is inflation? According to the now unorthodox definition, and in Milton Friedman’s famous words, “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” What causes inflation? Friedman has stated that “there is one and only one basic cause: too high a rate of growth in the quantity of money.”
Today’s mainstream mostly emphatically rejects it, but its predecessor accepted that, in a monetary regime of the kind that has existed since the First World War, the central bank is the primary creator of money. Consequently, it’s the ultimate manufacturer of inflation.
Figure 2: Changes of the Fed’s Total Assets, Annualised Percentage Change per Five-Year Period, 1914-1919 to 2018-2022
Figure 2 plots a crude but revealing summary indicator of the now-unorthodox conception of inflation: the rate of growth (expressed as the annualised percentage change per rolling five-year period) of the total assets on the Federal Reserve’s balance sheet since its formation in 1913. Its balance sheet has swelled at an average rate of 10.7% per year. (Largely because Australia had no dedicated central bank until 1959-1960 (the Commonwealth Bank conducted quasi-central banking activities until then), it’s not possible to compile an Australian counterpart to Figure 2.)
There’s a crude relationship between the Fed’s total assets’ rate of growth and CPI’s subsequent rise. The Fed’s first five years of existence included the Great War; at one point during these years, its assets rose at an annualised rate of 50%. Growth then plunged below zero during the disinflationary Depression of 1920-21, and remained very low throughout the 1920s.
The Fed became highly interventionist – that is, inflationist – after the Roosevelt administration took office early in 1933. By the end of that year, its balance sheet was growing at an annualised rate of 10% per year; by 1935, its growth exceeded 20% per annum and remained at this level for the next decade. At the end of the Second World War, however, growth decelerated sharply, reached 0% by 1951 and remained 2% or less until 1963. From the next decade, reflecting the Great Society and other interventions of the era, the Fed’s balance sheet’s growth accelerated – reaching a rate of 11% per year by 1979. Paul Volcker’s tough monetary medicine halved the rate of growth to 5% by 1984, and it fluctuated between 5-10% per year until the GFC.
The GFC prompted the Fed to launch the most extensive and frenzied intervention in its history: during the five years to June 2013, its balance sheet’s annualised rate of growth approached 60% per year. It’s true that its subsequent operations caused its balance sheet’s rate of growth to fall slightly below zero (that is, shrink); equally, however, since then it’s expanded at rates that exceed anything except those attained during the two World Wars, Great Depression and GFC.
Figure 3: The Federal Reserve’s Total Assets, Half-Yearly, Trillions of $US, CPI-Adjusted, 1914-2022
Figure 3 plots the Fed’s assets in constant (2022) dollars. From its formation until the eve of the GFC, they grew – and thus, by the previous definition, inflation rose – at a compound rate of 5.5% per year; since the GFC, it’s risen 15.8% per year; as a result, its compound average growth rate (CAGR) from 1914 to 2022 is 6.8% per year. By the previous definition, the Fed hasn’t merely created inflation almost continuously; during wars, depressions and crises it has greatly accelerated its inflationary tendencies.
Figure 3 shows that, post-GFC, the Fed is an incomparably larger beast than it was pre-GFC. So does Figure 4, which plots the assets on the Fed’s balance sheet relative to U.S. GNP. (Both Gross Domestic Product and GNP measure the total market value goods and services produced during a defined period. GDP measures the goods and services produced within the U.S., whether by its citizens or non-citizens, or American or foreign-owned businesses. GNP measures the goods and services produced by U.S. citizens and businesses domestically and abroad, and provides the basis of national accounts data in Historical Statistics of the United States. For that reason, I use it here.)
Before the Great Depression, the Fed’s assets comprised no more than 7% of America’s GNP. During the Great Depression and Second World War this percentage trebled to ca. 20%. From June 1945 until June 1983, it fell almost continuously – to just 5% in the latter year. Its size relative to the overall economy remained quite stable until the GFC, and then exploded to a then-unprecedented high of almost 25%. The shrinkage of Fed’s balance sheet and the rise of GNP decreased the Fed’s relative size below 20% by the eve of the Global Viral Crisis – and then the frenzied intervention during the GVC boosted it to a new all-time high above 35%.
Figure 4: The Federal Reserve’s Assets as a Percentage of U.S. GNP, Half-Yearly, 1914-2022
Cause #2: Profligate Fiscal Policy
Today’s mainstream exonerates central banks and their monetary “stimulus” as manufacturers of inflation; it also largely – but not completely – excuses governments’ fiscal “stimulus.” Investopedia encapsulates today’s conventional wisdom: “expansionary fiscal policy by governments can increase the amount of discretionary income for both businesses and consumers … The government could also stimulate the economy by increasing spending on infrastructure projects. The result could be an increase in demand for goods and services, leading to price increases.”
By the previous (and now outré) conception, governments’ central banks, private banks and treasuries co-operate to create inflation. The central bank creates money and credits some portion of it to the treasury and another portion to private banks; the treasury, in turn, spends the money and the banks lend it – and, in the process, demand rises relative to supply and thereby lifts the CPI. Simon White (“Inflation: A Play in Three Acts,” Bloomberg Markets Live, 11 August) puts it well: “runaway inflation (like today’s) is almost always preceded by large government borrowing financed by the central bank.”
Figure 5 plots a crude measure of the U.S. Government’s fiscal interventionism – its budget deficit as a percentage of GNP – since 1914. The average is a deficit equivalent to 3.0% of GNP. On only one extended occasion – during the low-inflation 1920s – did it run budget surpluses – which it used to repay a significant portion of the debt it had accumulated during the First World War (for details, see Why we need a “good” depression). Colossal deficits occurred during the First and Second World Wars. And the huge deficits incurred during the GFC and GVC have greatly exceeded anything outside the world wars.
Figure 5: U.S. Government’s Budget Deficit, Percentage of GNP, 1914-2022