No 28 Inflation: It's Causes and Effects
Introduction
This short explanation of Inflation is based on the Marxist analysis of capitalist economics. It is the first of a series of topical events under the heading Questions of the Day and is written in a simple and easily understandable form.
In future editions we shall deal with Unemployment and its causes; the role of Trade Unions; Rent, Interest and wages and other related economic subjects. We shall also cover the political field and the role of the Socialist Party of Great Britain (S.P.G.B).
The presentation of these subjects from the Socialist point of view will remove the misconceptions, prejudices and the mystic association with these subjects.
The Socialist party of Great Britain was formed in 1904 and reconstituted in June 1991. Our Object and Declaration of Principles have remained unchanged since 1904 and form the structure of the Party's case. Had we rewritten these today the wording would have been slightly different but the conditions of capitalism to which they reply have remained unaltered.
March 1992
Reprint April 1992
2021 Preface
The article below was written by our late Comrade Hardy who, along with other sound Socialists, was expelled from the Socialist Party in May 1991 for continuing to take political action in the name of The Socialist Party of Great Britain as required by the SPGB's OBJECT AND DECLARATION OF PRINCIPLES.
Hardy had been a student of Professor Edwin Cannan at the London School of Economics in the early 1920's who impressed on Hardy clarity in writing and not to be swayed by economic fashion. Hardy was a life-time Socialist and Marxist. In a lecture he gave just before his death he wrote:
"It only needs to add that getting rid of inflation is not the answer. Capitalism without inflation, as in the nineteenth century, no more solves working class problems than does capitalism with inflation, as in the years since the end of the Second world war".
Knowing which way the wind was blowing at Clapham, Hardy wrote a series of articles for publication by the reconstituted Socialist Party of Great Britain. Many were published as "Questions of the Day". These are freely available on our web site.
Unfortunately the digital version of his paper was mislaid and has only recently come to light. Although the article was written 30 odd years ago its arguments still remain sound and valid.
We are publishing the article again because inflation is now back again in the news - although inflation never went away. Predictably workers are erroneously being blamed again for inflation as they were in the 1970s when a Labour government tried to force on trade unions a wage restraint.
A recent example of blaming workers for inflation was an article by the economist Sean O'Grady published in THE INDEPENDENT under the heading "Ministers fail to grasp basic economics" (October 04 2021).
O'Grady stated that wage increases cause inflation and can only rise if productivity does. He tells workers to accept a lower standard of living and not to struggle for better wages. It preaches economic abstinence and political quiescence.
The analysis of inflation that Marx gave in his lecture to the General Council of the First International win June 1865, which was published after his death as a pamphlet, VALUE, PRICE AND PROFIT, completely demolished O'Grady's argument.
Marx showed that increased wages do not push up the general price level of commodities but does lead to a generalised reduction in the rate of profit. Workers, then, should ignore economists like O’Grady and struggle for higher wages and better working conditions when trade circumstances allow.
And he reminded workers:
"By cowardly giving way in their everyday conflict with capital, they would certainly disqualify themselves for the initiating of any large movement"
However, as Marx noted, workers are only dealing with effects and not causes. They are struggling in a system that is weighted in favour of the capitalist class. He said that the working class should set out to "abolish the wages system".
The wages system only exists as labour power is a commodity. When commodity production and exchange for profit is abolished in socialism and is replaced with the production of useful goods and services meeting human need, prices, including wages, will no longer be necessary.
Workers have no alternative but to democratically and politically organise for the abolition of capitalism and the establishment of socialism: the common ownership and democratic control of the means of production and distribution by all of society.
Inflation: It Cause and Effects.
Prices have been rising in this country for over half a century and are now about thirty-five times what they were in 1938. It is therefore not surprising that many people believe that it is normal and necessary for prices to go up. They are wrong. There is no need for prices always to rise. The government and the Bank of England could, if it wished, reduce prices or keep them more or less stable (provided of course that it knew how to do it).
After the inflation of the Napoleonic wars the government reduced prices by about a half and then maintained prices up to 1914; the price level in 1914 was almost exactly the same as it had been in 1850. After the inflation of the 1914 war prices were reduced between 1920 and 1925 by about a third. So the decision after the 1939 war to continue with inflation in peace-time was a departure from previous practice.
Several questions call for answers. By what means could the government control the price level? Why do governments sometimes raise prices and at others reduce them? And who gains and who loses?
Taking the last question first, it is obvious that anyone whose total income fails to increase as much as prices (or whose income falls more than the fall of prices) will be worse off. This happens to some workers and to some of the people who live on income from owning property. But incomes can, and do, move up or down independently of changes in prices. This will be seen from the following examples of movements in the average wages of the working class.
Between 1920 and 1925, when the government reduced prices, average wages fell more than prices so the workers in work were worse off.
Between 1873 and 1883 wages and prices both went down but the fall in prices was more than the fall in wages and the workers in work were better off.
Between 1900 and 1910 wages and prices both went up, but prices by more than wages, so workers in work were worse off.
Between 1900 and 1937 wages and prices both went up, but wages more than prices so workers in work were better off. The same is true of wages and prices between 1945 and 2008. Now prices are rising faster than wages.
The reason why wages can change independently of price changes is that other factors influence wage movements, the most important being whether the employers are making profits or losses and the effectiveness of trade union organisation.
A special case concerns borrowers and lenders. When prices are rising the lender, in terms of purchasing power, receives less than is indicated by the rate of interest. For example, if the lender lends £100 for a year at 10% and prices rise by 10% during the year, the £110 the lender receives at the end of the year will buy no more than the £100 would buy at the time of the loan was made; the lender has, in effect, lent the £100 at no interest.
When prices are rising lenders therefore stand out for a higher rate of interest, but experience has shown that interest rates tend to rise less than the rate at which prices are rising. So, periods of rising prices are of benefit to borrowers, like governments, at the expense of lenders. Conversely periods of falling prices tend to be of benefit to lenders at the expense of borrowers.
There has long been a body of opinion holding that inflation, with its higher prices, should be adopted as government policy, because, or so its advocates believe, it leads to greater production and reduces unemployment.
Sir Ralph Hawtrey, a Treasury official who wrote extensively about financial and economic problems, summed it up in 1923 in his CURRENCY AND CREDIT:-
"inflation itself is popular in business circles because it brings high profits, and is recommended because it means active trade, and therefore increases production" (page 231).
The MacMillan Committee (Committee on Finance and Industry) in its Report in 1931 also wanted higher prices. It argued that the prevailing depression having been caused or at least accompanied by falling prices they way out was to raise them. They recommended that steps be taken to push up the wholesale prices of the "principle foodstuffs and raw materials entering into international trade" (Paragraphs 266 and 285), and proposed to do this by means of agreement "to lower the international value of gold in terms of wholesale commodities".
The value of gold, like the values of other commodities cannot be altered by agreement of governments because value is determined in production. Wholesale prices have certainly risen in over half a century of inflation but it has not ruled out depressions; for example the depression beginning in 1979, the later depression which began in 1990 and the more recent one of 2009, all three showing unemployment above 2.5 million.
It may nevertheless be true that at least some business men and women look favourably on inflation in the belief that it will raise the prices of goods they sell more than the prices of the materials they have to buy and the wages they have to pay and thus increase profits.
The method by which past governments raised, lowered or stabilized the price level was by regulating the amount of currency (notes and coin) put into circulation by the Bank of England. Under what was known as the gold standard the Bank of England was bound by law to give notes in place of gold or gold in place of notes on the fixed basis of about a quarter of an ounce of gold for each £1. Prices were in that way tied to gold. Furthermore beyond a limit of £18, 450, 100 of notes which could be issued without gold backing, the Bank had to buy and hold in its vaults gold for every additional note issued.
That does not mean that every increase in the amount of notes and coin in circulation would raise prices. It would raise prices only if it was in excess of the amount required by the volume of transactions to be dealt with. If production increased the amount of necessary currency would increase.
The way in which prices were reduced in 1920-1925 was by reducing the amount of currency in circulation, including the burning of £66 million of notes taken out of circulation.
Most economists including Karl Marx were in general agreement that prices were controlled by regulating the amount of notes and coin in circulation. Marx defined "excess" as an amount of notes and coin in circulation in excess of the amount of gold that would be in circulation if all the currency was gold (see CAPITAL VOL. 1. Chapter 111, Section 2c).
That was the position in the nineteenth century and up to the 1920's. Since then their sound theory has been rejected and replaced by what Professor Edwin Cannan derisively named "the mystical school of banking theorists", of which J. M. Keynes was a prominent member. According to Keynes: "The internal price level is mainly determined by the amount of credit created by the banks, chiefly the big five", and: "the amount of credit, so created, is in its turn roughly measured by the volume of the bank's deposits" (MONETARY REFORM by J. M. Keynes 1923, page 178).
If the banks determine the price level it is the banks who are responsible for inflation, as was shown by M. E. Robinson in his PUBLIC FINANCES (1932 page 129), with an introduction by Keynes.
The MacMillan Committee of which Keynes was a member, endorsed the theory that the bulk of bank deposits are not created by depositors but "arise out of the action of the banks themselves...by granting loans" (report 1931, Para 74).
Professor Milton Friedman was another member of the "mystical school". In FREE TO CHOOSE (1979, page 298) he and Rose Friedman declared the banks responsible for inflation because they: "can legally authorise a book-keeper to make entries on ledgers that are equivalent to pieces of paper" (i.e. of currency notes).
Another believer in this nonsense described it as the power to create untold wealth "by the stroke of a pen".
The banks do not create anything. Bank deposits are not assets the banks possess but merely a record of what they owe to depositors. The function of the commercial banks is simply that of borrowing from depositors and lending to borrowers.
The "mystical" of banking theory is not new. It was answered in 1865 by John Stuart Mill in his PRINCIPLES OF POLITICAL ECONOMY (Chapter XI)
Walter Leaf, Chairman of the Westminster Bank answered it in his BANKING (Home University Library 1926 page 102) with the statement:
"The banks can lend no more than they can borrow - in fact not nearly so much"
Professor Edwin Cannan answered it at some length in AN ECONOMIST'S PROTEST (1947, Pages 256-266).
The final answer to the theory is the enormous price rise of the past half-century or more. All three parties, Tory, Liberal and Labour, were committed in 1944 to maintaining a fairly stable price level. Every government since 1945 has not only declared its opposition to inflation but has spelled out the way in which it thought it could make this effective. Since the 1970’s Labour and Tory Governments have directed their efforts to "watching" the movements of several differently defined amounts of "money supply" or "money stock", meaning predominantly bank deposits (not "notes and coin" alone).
Their efforts have had no effect at all, for prices have risen every year; which stands in contrast to the century before 1914, by regulating the amount of notes and coin in circulation the monetary authorities did maintain a fairly stable price level.
It remains to understand why governments sometimes raise prices, sometimes lower them and sometimes seek a stable price level.
It has first to be emphasised that capitalism can function just as well or ill with rising prices, falling prices and stable prices. It has functioned in half a century of rising prices; it functioned under falling prices (a fall of 41% between 1920 and 1936) and it functioned with stable prices in the century before 1914.
When a government, faced with an emergency such as World war, has to decide which monetary policy to adopt their decision depends on how much or how little the ministers and their advisors know about monetary theory; which school of theory they favour and to what extent they are subject to pressure from sectional interests which stand to gain by one policy or another, such as the businessmen who favour inflation.
In three world wars (Napoleonic War, the 1914-1918 and the 1929-45 war) the government decided on inflation but it is not easy to understand what decided the issue. The one common factor is that under world-war conditions it was point-less to try to maintain the gold standard. The government had to get control of the gold standard themselves and prevent its export by banks and others, because in those war conditions no foreigner from whom they needed to buy materials would accept paper money in payment.
It is probable that in 1790 the government ministers did not realise that they could avoid inflation without the maintenance of the gold standard; simply by limiting the amount of notes and coins in circulation.
Why the government adopted inflation at the outbreak of the 1914 war is something of a puzzle. Professor Cannan found it so. In 1917 he wrote:
"Before the war no fairly orthodox authority would have admitted that the British government in any future war would have endeavoured to pay its way in inconvertible paper. The past was supposed to have shown the fallacy of the plan" (AN ECONOMIST'S PROTEST, page 110).
All that Cannan could offer by way of an explanation was that "war seems to deprive people of their reasoning faculties".
By 1939 the theories of Keynes and other members of the "mystical" school of banking theorists had gained acceptance in government circles so that they were ignorant of the relationship between the amount of currency and the price level.
Keynes himself did not favour inflation generally and in his HOW TO PAY FOR THE WAR (1940) he counted on the avoidance of inflation during the war. The government apparently considered it could hold down prices by price controls and by subsidised food and other materials in spite of inflation.
Why the Labour Government, after the 1939-1945 war, decided on peace-time inflation this breaking away from 19th century tradition is not hard to understand. The gold standard and the policy of a stable price level were developed when London was the world’s financial centre and Britain was the world’s leading manufacturer and exporter.
It suited importers and exporters and bankers to have a stable price level. But when Britain’s world position steadily declined a policy of higher prices, balanced as it had been by a decline in the foreign exchange rate of the £ from, $4.86 to 5.87 became more attractive. The Attlee Labour Government was, on paper, opposed to inflation but a Report of the National Executive Committee to the 1944 Conference committed them to the proposition:
"If bad trade and general unemployment threaten...we should give people more money, and not less to spend".
They were also committed not to return to the Gold Standard.
Several theories have been offered by economists and others who reject the valid theory of Marx and Cannan to explain inflation. They range from the very common explanation that it is higher wages that push up prices, to the simple moralistic argument that inflation is the result of people's greed.
They are both easy to answer. If rising wages cause prices to rise how is it that between 1850 and 1914 average wages rose by ninety per cent while the price level rose by only 2 per cent from an index of 100 to 102? That rise of wages took place because the growing trade unions were able not only to secure the benefit from increased output per worker but also to secure a certain amount of gain at the expense of profits.
As for greedy, the argument must lead us to conclude that people have been excessively greedy from 1938 to 1991 but not at all greedy between 1850 and 1914 (or only 2% greedy). And that between 1920 and 1925 when prices were reduced by 30% people were not only not greedy at all but filled with benevolence to their fellows.
It is reasonable to accept that the Labour Government in 1945-1951, having swallowed the mystical nonsense of the Keynesian bank loan theory of prices, knew nothing about the real cause and effects of inflation, but even they cannot have been so misguided as to suppose that a tiny additional revenue from increasing the currency would be sufficient to pay for the vastly greater increase of expenditure forced on them by inflationary higher prices.
In the above outline of the cause and effects of inflation we have been dealing with capitalism and the monetary policies Liberal, Tory and Labour governments have adopted in Britain during the past two hundred years. Capitalism has to have a monetary system –notes and coin in circulation and banks and other financial institutions. Under capitalism the products of industry are what Karl Marx described as "commodities", that is to say they are produced for sale, not directly for consumption.
In socialist society "commodity production" will cease. Goods will be produced directly and solely for consumption. There will be no capitalist class, no rent, interest and profit, no wages and no prices.
As Marx and Engels put it in THE COMMUNIST MANIFESTO, the abolition of capitalism will involve the "abolition of buying and selling". All members of socialist society will have free and direct access to what is produced. Whatever problems socialist society may have to deal with, money and prices will not be among them.