Commentary Magazine

The Inflation Temptation

The risk-taking New York real estate developer William Zeckendorf loved to say he would “rather be alive at 20 percent than dead at the prime rate.” But in 1980, four years after his death, the prime rate itself stood at 20 percent. Inflation that year reached a staggering 13.5 percent, by far the highest rate in American history (save wartime or the immediate aftermath of war).

It took a rough recession, induced by the Federal Reserve under its then-chairman Paul Volcker, to break the back of that inflation. Volcker’s measures caused a horrific jump in unemployment, which peaked at 10.8 percent in November 1983. But when the recession ended, the inflation did not return, and the world entered into a period of monetary stability, prosperity, and economic growth unparalleled in history.

For nearly 25 years, with only two shallow and brief recessions, the world grew richer and richer. The Dow Jones Industrial Average, under 1,000 in 1982, reached 14,000 in October 2007. In 1982, it had taken a net worth of $82 million to make it to the Forbes 400 list. Twenty-five years later, it took over a billion. And most of the fortunes on the list had been created during that time.

With the world economy now contracting rapidly and the banking systems in many countries in serious disarray, inflation is not a problem at the present. Indeed, deflation was the primary worry last fall as the financial crisis, heating up since Bear Stearns collapsed in March 2008, exploded with the bankruptcy of Lehman Brothers in September. To combat the recession, the Federal Reserve has been aggressively pumping liquidity into the banking system and the government has been spending deep into deficit.

With the Federal Reserve increasing the money supply by trillions of dollars by buying up federal bonds in open-market operations and a federal deficit that will be in the trillions this year and probably next year as well, is inflation destined to be an inevitable sidekick to recovery?

That is certainly a significant possibility. And a frightening one. Inflation is among the most devastating economic forces imaginable. It reduces the purchasing power of ordinary people, impoverishes those who have struggled to save money by destroying the value of their savings, and causes a crisis of faith in the viability of the currency. For that reason, it is universally understood that the Federal Reserve has a very tricky balancing act over the next few years. Once the American economy recovers, the Fed is going to have to move quickly but delicately to remove the excess liquidity from the system without doing so in a way that causes interest rates to rise too quickly. That would cause the economy to descend once again into the maw of recession. Still, if it acts prudently and wisely, the Federal Reserve has both the power and the ability to prevent inflation from roaring to life as the economy recovers.

But will its senior personnel have the political will and financial skills to do so? Don’t count on it. Indeed, there are reasons the political class in Washington is thirsting for a revival of inflation. For one thing, inflation would increase some tax revenues, such as from capital gains, considerably without Congress having to vote to increase taxes. And because the national debt is denominated in dollars, inflation would also reduce the national debt as a percentage of GDP, thereby seeming to make that debt more manageable.

Inflation therefore is not only a demon, but one that sometimes bears a superficially charming and attractive aspect. That may be especially true for the current administration and the current Congress, which would like to claim they can spend far more public money and reduce the deficit simultaneously.


To understand what inflation is, one first has to understand what money is. Money is a commodity—something that can be bought and sold in a marketplace, just like pork bellies, legal services, or West Texas sweet light crude. What makes money different is that it is the sole commodity universally accepted in exchange for every other. In a barter economy, only someone who needs apples is going to accept apples in payment for the commodity he trades away. But in a cash economy, everyone accepts money and then uses it to go buy what he wants.

Coins made of precious metal were the first true money, introduced in the kingdom of Lydia, in what is now Turkey, around 650 BCE. Because their face value was always set slightly above their bullion value (the difference is called “seigniorage”), coins were not melted down and thus had no other use than as a medium of exchange. Paper money, at first representing precious metal on deposit in a bank or treasury, was introduced in China in the 9th century and in Western Europe at the turn of the 18th. Today, most money is nothing more than electronic blips deep in the bowels of vast and interlocking computer systems. When you pay for coffee and a newspaper with a debit card, some blips are subtracted from your account and added to the seller’s.

But while today’s money is insubstantial in the extreme, it is still a commodity. And thus it will rise and fall in price according to the dictates of the law of supply and demand, just like any other commodity. But because money is a very special commodity, there is a special name for a fall in its value: we call it inflation.

For the two and a half millennia that money has been in use, it has almost always been an increase in supply, not a decrease in demand, that has caused inflation. Often it was government that was responsible. As the loot garnered in conquest ebbed, Roman emperors found themselves hard-pressed to pay their bills. They resorted to debasing the coinage, until by the 3rd century CE, the silver denarius was mostly copper, with only a wash of silver.

The Roman people were not fooled, and they began demanding more and more coins in exchange for the commodities they were selling. In that century, inflation rose about 1,000 percent and the Roman economy—and the empire with it—came close to collapse. The Chinese emperors likewise were often short of funds and resorted to printing more and more paper money until it inflated into worthlessness. The Ming Dynasty ended the printing of paper money in 1455.

But inflation is not always the fault of government. In the 16th century, the flood of precious metal into Europe from the new Spanish empire in the New World caused prices to rise by about 400 percent over the century.

As paper money began to be used in Europe in the 18th century, the problem of printing too much of it soon arose. During the American Revolution, Congress, having no other options, printed money called continentals until “not worth a continental” became a standard phrase in the American lexicon for the next hundred years.

That is why Alexander Hamilton, the first secretary of the treasury, wanted to establish a central bank modeled on the Bank of England: to take the power to print money away from politicians. He knew that if that power was under the control of the government, it would, “under a feeble or too sanguine administration . . . be liable to being too much influenced by public necessity.”

While Hamilton’s Bank of the United States and its successor, the Second Bank of the United States, were soon killed, the federal government left the printing of banknotes to state-chartered banks. These notes—there were thousands of different issues by the time of the Civil War—were subject to a rough and ready test in the marketplace. If people doubted a bank’s ability to redeem its notes, they were quickly discounted or refused altogether.

Great Britain went on the gold standard in 1821. The gold standard makes inflation effectively impossible, because it allows people to turn in banknotes and bank balances in exchange for gold if they sense that a government is allowing the money supply to increase too rapidly.

The Bank of England promised to buy or sell unlimited quantities of pounds sterling for gold at the rate of three pounds, seventeen shillings, and ten and a half pence per ounce of gold. Most major countries followed suit as the 19th century progressed. In the United States, Congress set the value of the dollar at $20.66 per ounce.

The United States went off the gold standard during the Civil War, returning only in 1879. The North was able to raise about 89 percent of its wartime financing needs through bond sales and taxation, but resorted to printing $450 million in so-called greenbacks—fiat money that was not redeemable in gold—to finance the rest. The inevitable resulting inflation in the North over the course of the war was about 75 percent.

The South, with its far less developed and cash-poor economy, could raise only about 46 percent of its needs through borrowing and taxation and had no choice but to print money to finance the rest. The result was catastrophic for the Southern economy, which suffered an inflation of more than 700 percent just in the first two years of the war. As the currency became increasingly worthless, hoarding, black markets, and shortages of basic commodities spread. The Southern economy began to collapse, as did the Southern war effort along with it. It wasn’t just Grant and Sherman who doomed the Confederacy.

Both the First and Second World Wars were accompanied by bouts of inflation as the Federal Reserve System (established in 1913 as the nation’s central bank) facilitated the government’s borrowing needs by keeping interest rates low. Inflation was over 17 percent in 1917 and 1918 and over 15 percent in 1919 and 1920, until the recession that began that year cooled the economy and brought the inflation to an abrupt end.

Price and wage controls in World War II kept the lid on inflation for the duration of the conflict. But with the end of the war and popular pressure that the controls be removed, the immense pent-up demand for consumer goods unavailable during the war caused inflation to explode. Inflation was only 3.31 percent (calculated on an annual basis) in June of 1946, when the controls were ended. It was 9.39 percent in July, and by the end of the year it was 18.13 percent. Inflation reached almost 20 percent by the following March, before subsiding as supply and demand equalized. As the economic dislocations of the war faded, so did the war-induced inflation.

During much of the 1950s and early 60s, inflation was only rarely over 2 percent a year. But when President Lyndon Johnson tried to fight the Vietnam War and to fund the Great Society at the same time, inflation began to creep up as federal borrowing increased. The Federal Reserve, as it had in World War II, kept interest rates low to facilitate this borrowing.

But the Fed’s means of facilitating this federal borrowing was to buy up federal bonds, which restricted their supply in the marketplace and thus kept down the interest rate the federal government had to offer to sell them. That, in turn, increased the money supply. As the bonds moved onto the Federal Reserve’s balance sheet, the Fed credited banks’ accounts accordingly.

The economy as a whole, so robust in the early ’60s, began to falter, but inflation kept increasing regardless. Under Keynesian economic doctrine, this was supposed to be an impossibility, and so a new word had to be coined, in 1970, to denote it, stagflation.

In 1971, President Nixon, unable to control the falling price of money, tried to control the rising price of everything else by freezing wages and prices. This had been tried before, of course—in 301 CE, the Emperor Diocletian had imposed wage and price controls in an attempt to stem the inflation then raging in the Roman Empire. The tactic didn’t work for Diocletian and it didn’t work for Nixon, who abandoned the attempt in 1972 as the inflation raged on.

If you need a yardstick to measure the difference between the 1970s and 1980s in terms of inflation, consider the national debt. It rose by a factor of 2.4 in nominal terms in the 1970s, from $370 billion to $909 billion. It rose by 3.5 times in the ’80s, from $909 billion to $3.2 trillion. But so great was the inflation in the ’70s that the national debt actually fell as a percentage of GDP, from 39.16 percent to 34.5 percent. As inflation waned in the 1980s, the debt as a percentage of GDP soared, from 34.5 percent to 58.15 percent, despite the far more robust growth of the economy.

Though it was barely mentioned in the 1970s, the growth of the national debt became a major political issue in the next decade, thanks far more to the decline of inflation under President Reagan than to his other political priorities.


The balance sheet of the Federal Reserve has already more than doubled just since last September, rising from $900 billion to $1.9 trillion. With its new commitments to buy even more federal bonds in open-market operations and help take the so-called toxic assets off the books of the nation’s commercial banks, the balance sheet could easily reach $4 trillion, a staggering 30 percent of GDP. This represents a huge increase in the money supply relative to the goods and services available in the marketplace and thus a huge potential source of inflation when recovery begins and the velocity of money—currently at near record modern lows—increases.

Of course, what the Fed buys it can sell. It can return the federal bonds and mortgage-backed securities to the marketplace, soaking up excess money in the process as the economy improves and inflation begins to tick upward. If it does this too quickly, however, it will endanger the recovery. That is what happened to Japan during the “lost decade” of the 1990s; its central bank prematurely tried to head off inflation, only to see the still-weak Japanese economy tank, which then forced the central bank there to backtrack. The Fed is acutely conscious of the Japanese example, and fearful of repeating it. Nonetheless, removing the excess liquidity from the system will be a necessary action if a major inflation is to be avoided.

But will the Fed act? There will be very great political pressure for it not to do so. This pressure will come first and foremost from the White House, in order to help finance President Obama’s huge projected deficits as he pursues an agenda that has little to do with economic recovery, despite the President’s rhetorical attempts to link the two.

But it will also come from Congress, which gives lip service to price stability, but also always likes low interest rates and easy credit for the short-term political benefits they yield. Any large-scale sale of federal bonds by the Feds would inevitably cause a rise in interest rates as the supply in the marketplace increases, driving down the price of such bonds. This will tend to push up other interest rates in the bond market and other interest rates in general.

This is no small matter for the federal budget in the next few years as well. Even the White House, with its rosy scenario of the economic future, predicts massive deficits for the next decade. The Congressional Budget Office and most private forecasters have produced far less sanguine predictions of federal borrowing needs. Thus any increase in interest rates for new federal bonds would greatly increase the cost of this new borrowing, crowding out other spending or further increasing the deficit. Interest on the debt might well amount to $850 billion a year by the middle of the next decade, making it the single biggest line item in the federal budget.

There will also be pressure from Wall Street. When the Fed begins to unload the $300 billion in purchases of longer-term federal bonds that it began making in late March, that will add to the supply of those bonds and the result could be, in the words of one Wall Streeter, “the mother of all bond bear markets.” Unwinding the Fed’s investments in other areas, such as mortgage-backed securities, will also be difficult to do, as this would tend to increase mortgage rates, a move that would be furiously resisted by the real-estate industry and Congress alike.

And the President, the Congress, and Wall Street will all oppose anything that might slow the recovery, which any large reduction in the Federal Reserve balance sheet is bound to do. The Federal Reserve Board and its chairman, Ben Bernanke, are going to have to show some real backbone to stand up to the howls from both Capitol Hill and the White House as they seek to reduce the balance sheet. And they will need to navigate a very narrow path between the Scylla of moving too quickly—and thus stalling the recovery—and the Charybdis of moving too slowly, igniting a massive bout of inflation.

That massive bout would be ugly. Inflation is a vicious circle. As prices rise, employees and their unions demand higher wages, driving up prices still further, causing more wage demands. As the value of dollar-denominated assets, such as bonds and money market funds, declines, lenders demand higher and higher interest rates to compensate, driving down the value of those assets still more, which then drives up interest rates again. Assets that are seen to have value independent of the dollar, such as gold, rise dramatically in price as people flee the dollar—which removes capital from the marketplace. Short sellers on the world’s currency markets would pound the dollar down still further, deepening the spiral.

The spiral could turn into hyperinflation (by definition, more than 100 percent a year). In Weimar Germany in 1922 the highest denomination banknote was 50,000 marks. A year later the highest was 100 trillion marks. By that time prices were doubling every two days and it took 4.2 trillion marks to buy a U.S. dollar. The savings of the German middle class were wiped out.

The U.S. dollar is the world’s reserve currency. Many vital commodities, such as oil, are traded in dollars. And American bonds are held abroad by the trillions. Thus foreign pressure to preserve the value of the dollar would be intense, to put it mildly, if a serious inflationary spiral began in the United States. So a Weimar-style hyperinflation of the dollar is very unlikely. But even a repeat of the 1970s would be devastating for the long-term interests of the country, and, because we now live in a thoroughly globalized economy, for the world as well.

The Fed, with its policies over the past year, has set itself an immensely complex task—a task it must not fail, and yet one so difficult that success is by no means assured. The Fed will have to prevent an inflationary spiral when such a spiral is exactly what many elected politicians may want (but will not admit they want). It is for this very reason that the Federal Reserve was designed as an entity whose decisions could be made independent of direct political pressure. The Fed’s independence is subject to constant testing, and never has it been more important for its leadership to pass the test.

About the Author

John Steele Gordon writes frequently for  COMMENTARY. His own economic history of the United States, An Empire of Wealth, was published in 2004.


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