There is No Alternative

by Claire Berlinski

  It is not hard to create inflation. All you need to do is increase the quantity of money in an economy, otherwise known as the money supply. The value of money, like the value of any other commodity, depends upon the relationship between the supply of that commodity and the demand for it. If the supply of money increases, its value will diminish. That is the very meaning of inflation.

  A government can pursue an expansionary policy—which often leads to inflation—in one of two ways. It can control the supply of money directly, through what is called monetary policy. For example, it can lower interest rates. This increases aggregate expenditure, because when interest rates are low, people save less and spend more. Investors invest more, because they can get cheap loans.

  Alternatively, it can use fiscal policy: By taxing less, or by spending more, the government directly increases aggregate expenditure, leading to an increase in output. The use of fiscal policy to combat unemployment is commonly associated with the economist John Maynard Keynes—this is broadly what is meant by the term “Keynesian economics”—and until the late 1960s, Keynesian policies were held to be the state of the art. No one likes inflation, but the assumption underpinning an expansionary policy is that at times of unusually high unemployment, a controlled rise in the inflation rate is a reasonable tradeoff for getting people back to work.

  Controlled is the operative word.

  The state of the industrialized world in the 1970s led to a crisis of faith in the Phillips Curve. Stagflation—high rates of inflation and unemployment—forced economists to develop a competing idea: the natural rate of unemployment. If unemployment fell below this natural rate, they speculated, prices would not rise in a stable and proportionate way. Instead, inflation would gallop.99

  Now why would that happen?

  In 1975, the economist Milton Friedman famously proposed this answer: At any given time, constraints placed upon the economy’s efficiency create barriers to full employment. These constraints include, for example, the degree to which it is easy to relocate to find work, the degree to which the price of labor is artificially elevated (by, for example, mandatory minimum wages or collective wage bargaining), and the degree to which options other than working—such as collecting unemployment benefits—seem attractive. If these constraints are not lifted, then no matter how high the rate of inflation, unemployment cannot be completely eliminated.

  Now suppose, said Friedman, that despite these constraints, the government, seeking to reduce unemployment below the natural rate, accepts the logic of the Phillips Curve and pursues an expansionary policy. This pushes up prices. Real wages fall, leading firms to increase their demand for labor, which is now cheaper. Employment rises. In the short run, the policy seems to work. Happy employees enter the marketplace; the government wins the election.

  The problem, said Friedman, is this: The workers agreed to supply their labor at Wage W assuming that prices would remain stable. But the workers aren’t stupid: They notice that prices are rising, and they notice that the real value of Wage W is falling. They expect that this trend will continue. They demand higher wages. When labor becomes more expensive, employers buy less of it. Unemployment returns to its previous level. You have therefore raised inflation and gained nothing.

  Now the government, which unlike the workers is stupid, again pursues an inflationary policy to correct unemployment. The workers respond by demanding higher wages still. This cycle continues, each time more rapidly. Voilà, skyrocketing inflation, and still no commensurate rise in employment.

  If you accept this analysis, you will conclude that policymakers cannot attempt to choose between high unemployment and high inflation. Instead, they should steer the economy toward a growth rate such that prices remain stable, and accept the level of unemployment consistent with this. This target is called the Non-Accelerating Inflation Rate of Unemployment, or NAIRU.100 To treat unemployment, the government should fix the underlying problem—the structural flaws in the economy that are increasing the NAIRU. Over the long run, argued Friedman, unemployment simply cannot be cured by pushing up the inflation rate, so there is no point in trying. What’s more, by stimulating runaway inflation, the government will serve only to raise the overall level of misery.

  During the 1970s, this argument looked extremely persuasive. Britain was suffering from acute stagflation. Thatcher’s predecessors—both Labour and Conservative—had attempted to control inflation through fiscal policy and by implementing wage and price controls.101 These efforts had failed. Moreover, wage and price controls were ideologically abhorrent to free-market economists. Thus did Thatcher determine• to target inflation, above all

  • through monetary policy, alone.

  It is important to stress that Thatcher viewed inflation not only as a problem, but, like socialism, an evil. And if inflation is evil, skyrocketing inflation is more evil still. But why was inflation so wrong? First, because it punishes the thrifty: If inflation is rising unpredictably, it is pointless to save. If you have not saved, to whom will you turn in your needy old age? You will turn to the government. Inflation, Thatcher believed, thereby encouraged citizens to adopt a dependent, infantilized posture toward the state.

  Moreover, inflation distorts price signals. If the cost of goods and services rises quickly and unpredictably, the information conveyed by prices becomes gibberish. Who can plan or invest when they have simply no idea what things will cost in a year’s time or ten? The price mechanism is the key to the free market. If prices fail to convey meaningful information, the market will not function efficiently. This is why monetarism, for Thatcher, devolved from a commitment to free markets. Just as contract law is necessary to ensure the smooth functioning of the free market, so, she held, was the control of inflation.

  If you believe, as Thatcher did, that free markets are morally ennobling, you must of necessity view inflation as no mere macroeconomic problem: It is, in fact, a moral problem. Thus did Thatcher describe inflation as an “insidious moral evil to whose defeat everything must be subordinated.” In her famous “The Lady’s Not for Turning” speech, she called the defeat of inflation her “prime economic objective”:Inflation destroys nations and societies as surely as invading armies do. Inflation is the parent of unemployment. It is the unseen robber of those who have saved. No policy which puts at risk the defeat of inflation—however great its short-term attraction—can be right.102

  Contractionary economic policies appealed intuitively to Thatcher, for they seemed consonant with a key Methodist value: thrift. The Keynesian idea that a government could make an economy grow by spending more money seemed to her not only contrary to common sense, but a serpent-in-the-garden species of temptation. That way lay the wickedness of profligacy. “For many years,” she said,we have been told that a little bit of inflation is good for you. Many economists assured us—indeed some still do so assure us—that inflation is necessary to maintain full employment, to facilitate growth and to keep the economy moving. The message was: spend your way to prosperity, and when the economy faltered, spend and spend again.

  Of course it was difficult for governments to resist such siren voices. Britain was among the first large economies in the West to pursue these policies. We learned a hard lesson—monetary expansion stimulates only a brief and temporary growth. Decay soon sets in. But such monetary expansion does have a permanent effect—albeit an unfortunate permanent effect. It raises the rate of increase of the price level. Inflation comes to stay.

  With the hindsight of this sad history, we can easily see how the inflation rate rose persistently throughout these decades. But more strikingly, the average level of unemployment has also risen. The average unemployment was less than 2 percent in the 1960s, 4.1 percent in the 1970s and 6.8 percent in 1980. Our higher inflations have merely brought lower growth and rising unemployment.

  The lesson is clear. Inflation devalues us all.

  But the erosion of the currency not only has insidious effects on the health of the econom
y; it also breaks a trust between the government and the governed. The fabric of faith on which so much of our life depends rests on the maintenance of money values. A reliable and safe currency is a central responsibility of government. Once the people lose their trust in money the freedom of men and women in society will be diminished or even, eventually, destroyed.

  That is why my administration has put the permanent reduction of inflation as its first economic priority. In a free society this can be achieved only by reducing permanently the rate of growth of the stock of money. We knew that the transition could not be painless and smooth. After these many years of inflationary drift the costs of recovery have to be paid.103

  A siren voice, decay, and ultimate destruction—we all know this story, although it is usually not a fable of fiscal policy. From the analogy to the Fall, it is obvious that redemption will require, as it always does, pain.

  Even less subtle was the language used in 1981 by her then energy secretary and future chancellor, Nigel Lawson, who publicly asked critics of the government’s tight money policy to “drop their high moral tone, because there is really nothing that is moral or compassionate in prescribing policies that would engulf this country in a holocaust of inflation.”104 His use of the word “holocaust” is noteworthy: Lawson is Jewish, and obviously no word conveys greater moral horror to a Jew. The use of the word in this context is grotesque, but at least it makes it quite clear just how much the Thatcher stalwarts hated inflation and why they were willing to bear any price to kill it.

  What Thatcher hoped to do, by maintaining strict control over the money supply, was return the economy to the point of zero—or at least low and stable—inflation. She imagined this would necessitate a slight period of higher unemployment, after which unemployment rates would return to their starting point.

  That is not what happened—at all.

  Within two years of Thatcher’s monetarist ministrations, British unemployment soared to rates exceeded in the twentieth century only during the Great Depression. A quarter of the British manufacturing industry disappeared—the largest drop in industrial output since 1921. Britain’s inner cities went up in flames.

  . . . The latest government figures show unemployment rising from 1.5 million to 2.5 million in 12 months . . . Joblessness among ethnic minorities is rising even faster, up 82 percent in one year . . .

  . . . four nights of what Home Secretary William Whitelaw describes as “violence of extraordinary ferocity” . . . Police are forced to withdraw . . . 150 buildings are burnt down . . . 781 police officers are put out of action . . . CS gas is used for the first time on the British mainland . . .

  . . . In Toxteth, unemployment has risen to 37 percent, climbing to 60 percent among young blacks, with 81,000 people chasing 1,019 jobs in Liverpool . . . the local careers office has information on just 12 vacancies to offer school leavers throughout the city . . .

  . . . New riots in Brixton are accompanied by a wave of disturbances the length and breadth of Britain. Southall, Battersea, Dalston, Streatham and Walthamstow in London, Handsworth in Birmingham, Chapeltown in Leeds, Highfields in Leicester, Ellesmere Port, Luton, Leicester, Sheffield, Portsmouth, Preston, Newcastle, Derby, Southampton, Nottingham, High Wycombe, Bedford, Edinburgh, Wolverhampton, Stockport, Blackburn, Huddersfield, Reading, Chester, Aldershot—all these and other towns and cities report riots . . .

  . . . Margaret Thatcher cancels a planned visit to Toxteth because her safety cannot be guaranteed.105

  Unemployment rose and rose and rose. Stores were firebombed and looted. Imagine this period with a soundtrack by UB40. You’ll recall the band, I expect, but may not know that the name stands for Unemployment Benefits 40, a form issued by the Department of Health and Social Security, otherwise known as DHSS, an acronym you’ll also recall if you’ve ever listened to Wham!

  WHAM!

  BAM!

  I AM!

  A MAN!

  JOB OR NO JOB, YOU CAN’T TELL ME THAT I’M NOT!

  . . . DHSS . . . DHSS . . . DHSS . . . DHSS . . .

  All the same, the inflation rate simply refused to come down and stay down. The government couldn’t even achieve the one goal that was supposed to justify this misery. When Thatcher was elected in May 1979, the retail price index had risen by 10.3 percent over the previous year. By early 1980, it had risen above 20 percent.

  By the spring of 1983, it had fallen below 4 percent. Much excitement ensued: Had she done it? Had she vanquished inflation at last? Alas, no. In late 1985, inflation began again to climb. In 1991, the retail price index rose 10.9 percent—higher even than the year Thatcher became prime minister. It is not a coincidence that this was her last year in power.

  Why didn’t it work? The answer is quite technical, and even a professional economist who has spent his life explaining these concepts to hung-over undergraduates would be hard-pressed to sum it up neatly. I know this for a fact, because I asked the Master of Balliol to try.

  CB: Why wasn’t it working?

  Andrew Graham: [Sighs] Oh, God. This is back to tutorials, isn’t it? I’ll try and do as best I can. It’s a long time since I’ve given an economics tutorial . . . this is an incredibly boring technical argument . . . Um, I wonder if I could put my hands on an article, that would be even better . . . [Gets up and rummages through files] What happened is that a whole load of money that had been going out through the banks suddenly came in through the money supply, and ended up counted in the monetary aggregates, whereas before it had been outside the monetary aggregates—and, um, uh, sorry, this is extremely inefficient of me—God, it’s amazing what kind of stuff I’ve got in here, how weird! Um, I could give you, I have more than enough stuff to read—I could probably give you a copy of that—getting warmer . . .

  CB: I can’t put a bunch of graphs in this book.

  AG: Don’t worry, don’t worry. It doesn’t explain it there, that’s annoying—um—There are targets for M3, which was a funny old thing we were supposed to measure in those days, and it was supposed to grow by between 7 and 11 percent in that year—

  CB: And M3 is?

  AG: Current accounts in banks, plus deposit accounts in banks, plus, that’s about it, plus cash—M3 is simply a technical number. It was supposed to grow between 7 and 11 percent, and it grew 17 percent.106 Next year it was supposed to grow between 6 and 10 percent and it grew 14 percent.

  CB: And how do you explain the discrepancy?

  AG: The abolition in the same year of the corset. The banks had not been allowed to engage in various forms of lending. So what had been happening was companies had been lending direct to one another, and company lending didn’t count, since it’s not part of the bank lending, so it just didn’t appear in the bank figures . . . At the same time as Thatcher and Keith Joseph were trying to hold down the quantity of money, they changed the way the quantity of money was being influenced and took off this administrative control.

  Let me rephrase this. Monetarism sounded simple in theory but in practice proved confusing. This does not mean the theory was wrong, but it does mean that no one quite understood how to use it.

  The heart of the technical problem is this: To control the money supply you have to measure the money supply. To measure the money supply, you have to define what you mean by money. Coins and bills with the Queen’s face on them are obviously money. So you measure those. What about the contents of savings and checking accounts? Yes, that’s money too. What about bananas? No, not money, definitely not. Treasury bills? Well—actually that one’s tricky; you could argue it both ways.

  The contents of a PayPal account?

  Mardi Gras beads?

  Mexican pesos?

  Mexican pesos after they’ve been taken from the mattress where they’ve resided for the past five years and converted to British pounds?

  If not, why not?

  In principle, as long as you use a consistent definition of money, you should be able to measure the growth of the money supply over time�
��if people are using money, as you’ve defined it, in a consistent way.

  But while it was using an unchanging definition of money, Thatcher’s government was changing the way money was used. The abolition of foreign exchange controls and the deregulation of the banking sector were key free market reforms, obviously, and both led to a radical change in the way people used money as the government defined it. Corporations that had previously lent money to each other directly to bypass cumbersome bank regulations began using banks—which were now, as intended, more efficient—to facilitate these transactions. Stuff (to use the term of art) that had not previously been defined as money went into the banking system, where it was defined as money. This severely skewed the government’s efforts to measure the money supply, in a meaningful way, from year to year.

  AG: It’s just like—imagine that you’ve got a particular marketplace. Prohibition in the ’30s. You’re using all your official statistics on sales of alcohol, but alcohol sales are banned, so it looks pretty low. But plenty of alcohol sales were going on in the ’30s in the black market. Take off the controls, suddenly your shops are selling the alcohol, which was previously being sold by bootleggers. The banks in this case are the shops. Suddenly all this money-lending comes back to the banks, because banks are the efficient way to do it, and the black market is the inefficient way to do it. So it comes back into the banks and it suddenly counts as money.