F O R U M : T H E D E AT H O F I N F L AT I O N ?

The Death of Inflation

are accepted without question as though ficult to judge by looking at the chart when
Roger Bootle
they were inevitable. Yet it is striking how inflation is rising or falling.)
recent a phenomenon persistent inflation The charts clearly bring out three
CONOMIC AFFAIRS ARE A MIXTURE OF is—and the psychology which goes with it. things. First, the remarkable long-run sta-

E the immutable and the ever-

changing. For analysts and com-
mentators the secret is to avoid
In the countries of the developed west,
there was no sustained inflation of mod-
ern proportions until after the Second
bility of the price level over hundreds of
years. Second, the frequency and extent of
price deflation right up to the 1930s.
getting the one confused with World War. There were occasional bursts Third, the remarkable extent of recent
the other. of high inflation (sometimes very high), inflation, without parallel in the whole
According to the dominant school of usually associated with wars (or the after- period. Although I have not come across
thinking in the subject today, the eco- math of wars), but they were not sus- any data on the price level going back
nomics of inflation falls into the tained. Moreover, the normal experience anything like as far for other countries,
immutable category. By contrast, I submit which these occasional bursts of inflation data going back over the last two cen-
that in the last decade and a half, major interrupted was not of continual moderate turies confirms broadly the same picture
changes have taken place in the relations for the US, Germany and France.
governing price and wage behaviour, and The recent history of inflation is, of
the constraints and issues facing policy- course, much more familiar. And again,
makers. Underlying all this, of course, although it is sharply different from the
some things are unchanged—“excessive” older historical experience of inflation
growth of demand will still produce infla- described above, it is broadly similar across
tion. But what is excessive? And how countries. After the Second World War,
much inflation will “excessive” demand inflation was moderate for nearly a quarter
produce? Is deflation a serious threat? of a century (apart from another bout of
These issues, I believe, are in the realm of war inflation associated with the Korean
the ever-changing. And they are changing conflict). It was starting to rise at the end of
now in a broadly favourable direction. the 1960s, but it really only took off in the
In short, the interaction between the 1970s under the combined impact of a co-
microeconomic conditions in the econo- ordinated world boom (which caused a
my and macroeconomic management is dramatic rise in commodity prices), the
leading us to a new inflation regime—a first oil price shock and the breakdown of
regime in which it will be possible to com- the international monetary system. A sec-
bine sustained low inflation, or even ond oil shock at the end of the 1970s
price stability, with high levels of capaci- brought a repeat performance.
ty utilisation and low unemployment. Following this experience, the 1980s
This is not to say that there are now clear were the decade of disinflation as central
blue skies ahead as far as the eye can see. banks and governments nearly every-
There are storms on the horizon but they where in the developed world strove to
are somewhat unfamiliar—the dangerous bring inflation down. And they broadly
interaction between low inflation, high inflation, but rather of fluctuating prices. succeeded, despite another hiccough at
interest rates and government debt; and The general price level could—and did— the end of the decade. Moreover, the
the possible re-appearance of inflation’s fall, sometimes for sustained periods. 1990s have so far continued this same
dark twin, deflation. The British economic historians, Sir trend. Inflation is now back down to
But already this talk of a change in the Henry Phelps-Brown and Sheila Hopkins, 1950s levels. (See Table I.)
inflation regime jumps the gun. Before constructed a price level series for Eng-
speculating on the future it is first neces- land from the thirteenth century to 1954. Fundamental Questions
sary to put the past into perspective. I have spliced recent British price data on and Fundamental Answers
to it, thereby bringing it up to date. I show Why the sharp change in the inflation
The History this series on a normal scale in Chart I, regime with the end of the Second World
To modern financial markets, persistent which brings out the broad trend dramat- War? Why this period of continual peace-
inflation, and the danger of a lapse into ically but suppresses much detail. This time inflation, sustained for fifty years,
high inflation, are just facts of life. They detail is revealed in Chart II, which is on without precedent in modern history?
a log scale. (This has the merit that a con- The answers to these questions provide
Chief Economist of the HSBC Group in London, UK. stant rate of inflation is shown as a line of the backdrop to the economic prospects
He is also a Visiting Professor at Manchester Business constant slope, whereas with an ordinary now before us.
School. His book, The Death of Inflation—Surviving
and Thriving in the Zero Era, has recently been scale a constant rate of inflation is shown The conventional view pins the blame
released by Nicholas Brealey Publishing. as a line of increasing slope, making it dif- for post-war inflation on the excessive
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 F O R U M : T H E D E AT H O F I N F L AT I O N ?

growth of the money supply. I will say what made them continue to adhere to not a mere unfounded prejudice; for
more about the role of money and mone- the discipline. The answer is certainly not more than two hundred years, it did give
tary policy in a moment. But the sophis- because they knew no alternative. After long-term stability to the price level, and
ticated version of this view goes deeper all, debasement of the coinage had been the economy prospered—even in times
than the mere monetary numbers—to the known about (and practised) since when prices were falling.
underlying cause of loose monetary con- ancient Greece. There must have been To put the matter starkly, the discipline
trol. This it attributes to the end of the some other reason. afforded by the Gold Standard was not
system under which monetary values Again, the British experience is inter- imposed but self-imposed, because of a
were tied to the supply of gold (the Gold esting. The gold content of the pound was set of beliefs about the way the economy
Standard) and its replacement by a sys- fixed in 1711 and was still at the same rate worked. And in the end, it was a change in
tem where monetary policy was governed when the link to gold was finally aban- that set of beliefs that killed it.
by central banks and governments, pur- doned in 1931. Moreover, the price level
suing objectives of their own choosing. was not that different either—only about Price and Wage Rigidities
Under the Gold Standard, the general 30% higher after more than 200 years. When Britain went back to gold in 1925,
level of prices was effectively tied to the Even so, the Gold Standard was suspend- getting prices (and especially wages) back
amount of gold in the system. Gold circu- ed for two intervals during this long peri- to the levels consistent with the old ster-
lated as coin and the amount of other cur- od—during the Napoleonic Wars, and ling-gold parity was extremely painful,
rency permitted to be issued was limited again during the First World War. In both more painful than it had been after the
by the amount of gold held by the central cases, Britain was on a paper standard. Napoleonic Wars, and more painful than
bank. If a boom developed while the sup- Paper money was printed out of all pro- most expected it to be in the 1920s. When
ply of gold remained fixed then a shortage portion to the supply of gold. And in both the 1929 Wall Street crash ushered in a
of money would ensue. This would lead to cases, the result was a significant burst of wave of deflation across the industrial
tighter credit conditions and higher inter- inflation. After both conflicts, however, world the same effect was evident every-
est rates, which would restrict spending. the British authorities decided to go back where. Prices and wages did fall but only
The opposite forces worked when an to gold, and at the same old parity—that painfully slowly, and nowhere near fast
economy underwent a recession. Thus the is, at the same value of the pound in terms enough to absorb the drop in aggregate
Gold Standard was self-stabilising. And of gold. This meant that the inflated level demand. So there were large falls in real
since the supply of gold in the economy of prices which had been sustained by the output. The result was intolerable misery.
was outside the direct power of the gov- increased supplies of paper money was no Once deflation was abandoned and
ernment, it was impossible for the gov- longer sustainable. In short, prices had to expansionary policies were pursued, the
ernment to sustain inflationary policies. fall to a level compatible with the limited result more or less everywhere was the
Sooner or later, a shortage of gold would stock of gold. So the wartime inflation same—big increases in output and big falls
bring about a reckoning. was followed by peacetime deflation. in unemployment, accompanied by hardly
Listening to the many critics of recent For other countries on the Gold Stan- any inflation. This is what broke the Gold
monetary management, you would think dard, it was a broadly similar (though Standard and stood in the way of its return
that the difference between the Gold shorter) story. They stuck with gold after the Second World War—people no
Standard and modern, administered through thick and thin—until the 1930s. longer believed that it worked, and with
monetary systems was a technological Why did the British authorities not resort good reason. Scarce wonder, therefore, that
one, namely that policy after the War
governments are was devoted to
Table I: Average Annual Inflation Rates in the G7: CPI, % (* = decade so far)
currently able to maintaining unem-
1950s 1960s 1970s 1980s 1990s* latest month
create money ployment at the low-
Canada 2.4 5.7 9.0 6.5 2.6 1.4
by printing notes est possible level,
France 6.7 3.4 10.3 7.4 2.4 2.2
whereas they were Germany 2.0 2.5 4.9 2.9 3.2 1.6 with scant concern
previously unable Italy 2.7 3.6 15.9 11.3 5.2 3.6 for the dangers of
to influence or con- Japan 3.1 5.8 9.1 2.5 1.5 0.0 inflation—a policy
trol the supply of United Kingdom 4.3 3.5 12.6 7.5 4.3 2.1 dubbed by Sir John
gold. This suggests United States 2.0 2.4 7.1 5.6 3.5 3.0 Hicks as the Labour
that a monetary Standard.
system based on gold provides automatic to debasement? Why did they, and other But this was not a case of modern, demo-
discipline, whereas a system based on countries, retain the Gold Standard for so cratic governments pursuing the easy way
paper provides no intrinsic discipline at long? And why did they twice go back to out, of governments unconstrained by the
all. Once the link to gold was abandoned, gold at the old parity? Gold Standard, behaving irresponsibly in
governments and central banks were able The answer surely is because the mon- pursuit of their own selfish, short-term
to pursue policy objectives, such as full etary authorities, both in Britain and else- goals. On the contrary, this was the policy
employment, with little regard for the where, believed in it. That is to say, they which seemed to make rational sense in the
inflationary consequences. believed in the desirability of a stable interests of the economy as a whole.
Yet this view completely misses the money and a stable long-term price level. Moreover, it was the policy urged by the
point. The central issue is indeed disci- And they believed that the Gold Standard new economic establishment, who now
pline and this is what the Gold Standard could deliver this without undue sacrifice, regarded as antediluvian the deflationary
provided. But the key question is what including undue sacrifice to themselves. precepts and prescriptions fervently
kept countries on the Gold Standard, Moreover, belief in the Gold Standard was believed by their equivalents only twenty
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or thirty years previously, just as their The entrepreneur gave way to the corpo- ● Competition from dynamic countries,
ideas are now derided by today’s econom- rate bureaucrat. principally in East Asia but also Latin
ic policy establishment. And for about a In Europe, huge swathes of the pro- America (and increasingly in Eastern
quarter of a century, this policy worked. ductive economy were owned by the Europe), operating with much lower cost
Ironically, what eventually caused the state, and run in pursuit of a variety of bases. This is bringing huge competitive
breakdown of the Labour Standard and of objectives—with profit maximisation pressure to bear on western producers.
the post-war policy consensus was a logi- some way down the list. Even in the pri- ● Privatisation of public enterprises,
cal extension of what had caused the vate sector, the influence of government whether by outright sale of public-sec-
breakdown of the Gold Standard—name- was often felt with a heavy hand. tor entities or by the introduction of
ly, the increasing imperviousness of prices With regard to employment, people market processes into the public sector,
and wages to demand conditions. When spoke of a labour market but in reality such as competitive market tendering
demand was slack, the rate of inflation, matters of wages and employment were and market testing.
never mind the absolute level of prices, not settled on any sort of market. In most ● The collapse of trade-union power,
hardly fell. If a shock occurred to the cost of Europe (although less so in North partly in response to the above forces,
level, the rate of price rise accelerated. In America), trade unions dominated the but in some countries partly arising
this way, the rate of inflation was ratch- wage bargaining process. Even where independently of it.
eted up. By the mid or late 1970s it had their influence was not felt directly, the ● Increasing price sensitivity by con-
reached intolerable levels. The regime had debate about wage levels was dominated sumers. This has arisen partly because of
to change. And change it did. by considerations of rights, fairness and the pressures that consumers are under
What had destroyed the Gold Standard comparability. In countries (such as Ger- in their role as wage earners, and partly
was the unacceptably high unemploy- many) where an effective tripartite struc- as a reaction to low inflation itself. The
ment costs of deflation in conditions ture (involving employers, unions and the result is to force firms to offer value to
where pay and prices had become insti- state) operated, it was possible to combine customers and to concentrate on getting
tutionalised and subject to producer these arrangements with a low rate of high volumes rather than high margins.
power. But in the
crises of the 1970s, The upshot is that
these self-same condi- Table II: Interaction Between Microeconomic firms now compete
Conditions and Macroeconomic Policy
tions then destroyed vigorously on price,
the Labour Standard, Period Micro Conditions Policy Regime Macroeconomic Performance and there is a constant
by producing unac- 19th century Price and wage Gold Standard Fluctuating prices, fluctuating stream of price reduc-
flexibility growth but deflation no
ceptably high rates of impediment to real growth tions (principally in
inflation. The denoue- Early 20th Some price and wage Gold Standard Fluctuating prices but deflation the high-tech area,
ment was a long peri- century flexibility but rigidities now a serious impediment to and in sectors closely
emerging growth
od of disinflation, 1945 – late Extreme downward Labour Standard Continual inflation but sustained
affected by low cost
accompanied in most 1960s inflexibility of wages growth with low unemployment supply from the
and prices
countries by high lev- dynamic countries) to
1970s Labour militancy, cost- Transition High inflation, weak growth,
els of unemployment. push culture and high unemployment offset the areas where
What makes the dominant inflationary prices are still going
psychology
future look so differ- up. This has begun to
1980s and Weakening of Discretionary Low inflation, still high
ent now is that these early 1990s inflationary psychology, disinflation unemployment but signs dent the inflationary
structural forces collapse of labour (monetary of marked improvements psychology which has
power and outbreaks targets) (US and UK)
which destroyed the of serious price dominated since the
Gold Standard and competition War. People are now
the Labour Standard The future? The return of price Discretionary Sustained growth accompanied starting to get used to
(and wage?) flexibility pursuit of very by low inflation
are collapsing, with low inflation or low inflation and this
dramatic conse- price stability is itself helping to keep
quences for both the inflation down.
world economy and These changes in
the policymakers charged with the inflation. In countries where it did not microeconomic conditions make it possi-
responsibility of managing it. (Britain and Italy), high and unstable ble for western economies to combine sus-
inflation was the natural result. tained growth and low unemployment
Changes at the Micro Level This system of inter-connecting blocks with very low inflation. What lies before us
We are used to speaking of “the market of producer power is now collapsing could be at least as good as the immediate
economy” as a way of describing the eco- under the combined assault of several post-war period, and possibly even a good
nomic system under which we, in all related forces: deal better. (See Table II.)
countries of the democratic west, have ● Rapid technological change, which is
lived. But in the years after the Second undermining established market posi- Doubts and Whispers
World War, the influence of markets was tions and ways of doing business, slash- However interesting these ideas may
severely attenuated. In many product ing costs and creating new products, be, many sceptics remain unconvinced
areas, a few firms in entrenched positions and establishing a mood of insecurity, that the inflation relationships have fun-
dominated. With secure conditions and not only for individuals, but also for damentally changed. What evidence is
cosy markets, their cost bases burgeoned. businesses. there that such changes have occurred?
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The experience of the last few years pro- up because they were so effective in rais- rate of inflation has remained more or
vides several sorts of evidence. Two exam- ing the devaluers’ growth rates (at the less unaffected. (See Chart IV.)
ples will have to suffice here. First, in the expense of others). The implication of my thesis, of course,
United States the economy has been in is that many central banks can indeed
continuous expansion for six years and A Short-Term Blip? relax their stance and aim for a higher
unemployment has fallen to just over 5%. Some people accept that real structur- level of economic activity without endan-
At various stages during this expansion, al forces have had an effect on inflation gering their objectives for sustained low
the Cassandras, basing their forecasts on but argue that these are one-off, short- inflation. However, with the notable
previously established relationships, have term factors whose influence will soon exception of the US Federal Reserve,
seen an inflationary upsurge around the fade, landing us back with the inflationary which has pursued a balanced policy by
corner, pointing to a succession of indi- tendencies of the past. But this strikes me giving due weight to the needs of eco-
cators which supposedly heralded disas- as totally lacking in historical vision and nomic expansion, central banks are still
ter—the unemployment rate, commodity imagination. With regard to the possibil- obsessively on their guard against the
prices, the gold price, the money supply, ities opened up by the revolution in com- danger of the inflationary genie breaking
the bond market. And they have all been munications technology we have so far out of his bottle. Having seen inflation
wrong. It is particularly noteworthy that only scratched the surface. return to very low levels, their next trick,
in recent years the core rate of inflation Meanwhile, the advance of the dynam- I suspect, will be to use the next recession,
has hardly budged from just under 3% as ic economies in the East has a very long whenever it comes, to edge inflation
unemployment has fallen and maintained way to run. Eastern Europe is only now down still further, to reach the central
its lower level. (See Chart III.) setting out on this path and there is still bankers’ Holy Grail—price stability.
It is true, of course, that in Europe the vast untapped potential in Russia. Weak- If there is an inflationary threat on the
unemployment picture is much more ening of labour power may not have horizon it comes, in my view, not from
gloomy. Even so, the inflation story is much further to run in North America, monetary policy but rather from fiscal pol-
much the same—inflation lower than but it still has a lot further to go in much icy. In many countries in the west (not
almost anybody forecast. In Germany it is of Europe. One-off they may be, but it will least in Canada) the accumulated level of
down to about 1.5%, and the signs are be a one-off spread over decades to come. government debt is huge in relation to
that the economy could readily stand a GDP. The interest payments on this debt
faster rate of growth and a lower rate of make up a large proportion of government
unemployment without producing higher spending. In some cases they exceed the
inflation. current public deficit—that is, all of cur-
Second, several European countries rent government borrowing (and more) is
which suffer from high unemployment to finance interest payments on the out-
rates have managed to achieve and sus- standing government debt. This poses a
tain low inflation rates in the face of potentially serious stability threat for the
developments that would have been future.
expected to push inflation higher. The At the moment, governments nearly
most spectacular examples are in those everywhere are making strenuous efforts
European countries which either with- to contain their budget deficits and this is
drew from the Exchange Rate Mechanism helping to restrict the growth of aggregate
(ERM) or devalued in 1992-93. When demand. But the process needs to go fur-
their currencies fell, market and profes- ther and to be sustained for many years
sional opinion was at one—the result for the public finances to be put back on
would be higher inflation which would a stable footing and to fend off what could
soon wipe out the competitive gains, leav- be a serious inflationary threat for some
ing no lasting legacy except higher infla- countries in the medium term.
tion and higher interest rates. They were While this fiscal consolidation is con-
wrong. Inflation rose only modestly, leav- tinuing, the proper role of monetary pol-
ing the devaluers with clear competitive Dangers of a Policy Reversal icy is to be supportive of economic expan-
gains. Will the policymakers throw away our sion to help bring public deficits down
Indeed, this has caused a complete hard-gotten gains and allow (or even further. This means a policy of sustained
reversal of view among the supporters of directly stimulate) a further burst of low interest rates, not rates high enough
monetary union in Europe. They used to inflation? This is what bond markets in to fend off an imaginary inflationary
argue that it was perfectly acceptable to most western countries seem to fear. That threat in the immediate future.
give up the opportunity to use exchange is why they set the yields on long-term
rate changes within Europe because debt at such high levels. But contrary to The Role of Central Banks
such changes were effectively useless, market folklore (and one strand of cur- To what extent is low inflation solely the
except as ways of differentiating Euro- rent intellectual fashion), the markets are achievement of central banks? The con-
pean inflation rates. After 1992-93, how- not always right. Indeed, they have been ventional view is that monetary policy is
ever, they complained about “competi- consistently too pessimistic about infla- just about all that matters. Accordingly,
tive devaluation” and argued that the tion. The bond market has undergone see- countries get the inflation rates which
opportunity to have exchange rate saws of optimism and pessimism about their central banks (or governments,
changes within Europe had to be given the inflation outlook, but the underlying where central banks are not independent)
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choose. But this view surely puts central dent to follow the money supply blindly. tions. Had central banks chosen then the
banks too much in the driving-seat of On the contrary, it would be downright inflation rates which they choose now, the
events rather than as their victims. It dangerous. western economies would have been
implies that the high inflation of the Consider a concrete example. Could the thrown into a devastating recession.
1970s was “chosen” and that central world’s central banks have chosen to
banks choose now to tolerate inflation in achieve the low rates of inflation that are Conclusion
the 1%-3% range rather than establishing now common in the developed west dur- Every generation of economic thinkers
price stability. ing the 1970s? The answer surely is that has a searing experience which colours
It is more helpful, I believe, to see infla- had they been prepared to be tough attitudes for a lifetime. The thinking of the
tion as the result of an interaction enough, even if they could not have pre- current generation of economic policy-
between policy actions (including actions vented the initial rise in the price level makers was moulded by the inflation and
by the central bank) and impulses arising instability of the 1970s, just as the previous
from the economy—on both the demand generation was obsessed with keeping
and the cost side. These impulses con- unemployment down and consequently
strain the choices which central banks failed to give due attention to the inflation-
can make. The limitations on central ary problem building up under their noses.
banks can be summarised as follows: But economic conditions can change. The
● They cannot directly control microeco- changes afoot in the world today are undo-
nomic conditions in the economy. These ing the rigidities and inflexibilities which
conditions influence the nature and accompanied capitalist development for
direction of economic shocks and how most of this century. Of course, it will still be
the economy reacts to them. Accord- possible for countries to run high rates of
ingly, they influence the sort of inflation inflation through budgetary and monetary
regime that is realistically achievable. mismanagement. But there will be few infla-
(See Table II.) tionary shocks emerging from the cost side
● Central banks do not have control over of the economy requiring suppression
inflationary expectations, even though through restrictive macro policy. Indeed,
their actions can have a significant there will be a continuing supply of shocks
influence over them. which reduce the price level. And when an
● There is dynamic interaction between inflationary shock does occur, it will be eas-
factors operating directly on the price ier to contain and offset it by restrictive pol-
level, inflationary expectations and the icy. The result will be that it will be possible
rate of growth of the money supply. to run the economy at higher levels of
Accordingly, it is not even true that cen- demand (and lower rates of unemployment)
tral banks choose the rate of monetary without engendering inflation.
growth, let alone the rate of inflation arising from the sharp increase in the Does this mean that central banks can
which is supposed to result from it. price of oil in 1973 (and again in 1979), drop their guard against inflation? No. It
they would have been able subsequently will always be necessary to be vigilant. But
This last point is particularly relevant to achieve the low inflation rates that we the balance of risks has now changed. As
with regard to the status of “the money enjoy now. And if they had been prepared the Bank for International Settlements
supply” as a cause of inflation, and the to be even tougher, they could in principle recently acknowledged, for the first time in
attitude both policymakers and the mar- have achieved a price deflation to offset two generations it is now right for central
kets take to it. The popular vision of the the previous inflation. banks to give serious weight to the risk of
money supply harks back subconsciously But to say that central banks could have deflation. Moreover, central banks must
to the old days of gold. Money is thought chosen this course of action both flatters beware that, in being over-vigilant against
to represent a stock of available purchas- them and wrongly condemns them at the supposed inflationary dangers, they may
ing power and when money grows faster, same time. Quite apart from the question unnecessarily hold back their economies,
inflation will supposedly follow. of what would have been politically feasi- thereby consigning them to high unem-
The truth is more complex. Sometimes ble, would it have been economically jus- ployment, and perhaps also to low growth.
faster monetary growth does indeed give tified for central banks to have behaved in That central banks should now have a
a message of this sort. But the modern this way? more balanced set of objectives and risks
money supply is an amalgam of several We can debate the details of whether before them, as opposed to the one-sided
different sorts of bank deposit which one particular country should have resist- and all-embracing task of bringing infla-
serve many different purposes, and the ed the inflationary forces more strongly, tion down, is a measure of success. That
public’s demand for this amalgam may or indeed, whether some other country success is partly, but only partly, theirs.
change substantially. So when the money should have resisted less strongly, but the They have been greatly helped by changes
supply increases, this may simply repre- really important point is that the costs of in the real economy which have worked
sent an increased preference for this sort resisting inflation had been raised by with the grain of anti-inflationary policy.
of financial asset. It is part of central events arising outside the central banks’ As a result, we now face a remarkably
bankers’ job to tell which sort of monetary sphere of competence, namely the attractive macroeconomic prospect. After
expansion is which. It certainly is not upsurge of oil prices and the (partly asso- everything that we have been through,
easy. But nor would it be cautious or pru- ciated) increase in inflationary expecta- this is a prize richly deserved.l
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