What Stops Inflation?

Not WIN buttons and not wage/price controls. But history does show ways to do it.


It would be a serious misconception for the American public to think that the inflation of the 1970s is unique to this decade or this nation. And it would be a sad mistake if successive administrations' misdirected efforts to beat down inflation were thus excused as well-meant attempts to solve what no one else anywhere else has had to solve.

The truth is that inflation has plagued many areas of the world at many times in history. Nearly everyone is familiar with the image of the German wheelbarrows-full-of-currency experience. Yet this is not the only instance of inflation of such drastic magnitude. Nor is it the only kind history has seen. Inflation hovering in the 8-10 percent range, as well as the feared double-digit and unthinkable triple-digit variety, have afflicted various peoples at various times.

And what came after the wheelbarrows? After all, present-day Germans don't do their shopping with such contraptions in tow. And what comes after 10 percent inflation? or 40 percent? or 350 percent? Must these escalate, to be banished, finally, only when they reach drastic proportions and only by whatever cured the notorious German inflation? Unfortunately, the answers to these questions are even less known than the facts of other peoples' and eras' experience of inflation. But in each case, the beast was tamed by some kind of monetary change. No inflation has ever been cured with WIN buttons or jawboning or wage and price controls. If we continue to rely on these, then we may be doomed to ever-higher levels of or ever-recurring inflation, until we too end up carting around piles of currency. The alternative is to learn from history what is the least-painful way out of our painful situation.

A few years after World War II the rate of price inflation in the United States appeared to be speeding up in a threatening way. There had been considerable currency inflation starting with the 41 percent devaluation of the dollar in 1934, further stimulated by a tripling of gold reserves during the next seven years, and finally owing to a tripling of the money supply during World War II. The dollar depreciated at an average of 5 percent a year between 1939 and 1951—which means it lost nearly half of its buying power over those years.

The commercial banks were loaded in the late 1940s with US government bonds, and the Treasury insisted that their market price be supported by the Federal Reserve. But doing so resulted in further currency inflation and deprived the Fed of its powers of credit control. After all, it could not simultaneously support the bond market and limit credit expansion. During the fall of 1950 price inflation reached an average monthly rate of nearly one percent. Something had to be done. In March 1951 the Treasury and the Federal Reserve reached an "accord" for which soon-to-be chairman of the Federal Reserve, William McChesney Martin, was in large part responsible. Bond supports were dropped and the currency inflation ended. The dollar's rate of depreciation slowed to one and two percent a year and did not speed up again until about 15 years later. There were, however, some disturbing omens starting around 1958.

At the time, all of this strongly reinforced my thinking that the United States should return to its former gold-coin standard. Nor was this an unreasonable hope. The Economists' National Committee on Monetary Policy—whose president then was Prof. James Washington Bell of Northwestern University and whose executive vice-president was Prof. Walter E. Spahr of New York University—enlisted the support of Sen. H. Styles Bridges of New Hampshire to present a bill in the Senate to put the United States back on the gold-coin standard. The committee also had the Opinion Research Corporation poll the public on its attitude toward a return to the gold standard. The survey showed that more Americans in 1954 favored the idea than opposed it.

It seemed quite likely that the Senate would pass Senator Bridges's bill, although no one believed that such a bill could get through the House. Still, passing the Senate would be progress: many bills take several sessions before becoming law. So a group of us journeyed to Washington to testify before the Senate Banking and Currency Committee. I gathered historical materials that clearly showed gold-based currencies, in a sample of 30 major nations, to be more reliable than paper-based ones.

Also, I began to gather material for a book on the resumption of specie payments, a subject that today sounds archaic. It usually means a nation's return to a gold-coin standard, but it can mean a return to a silver-coin standard or to a bimetallic standard. A obvious example is the American "resumption" or return to gold convertibility on January 2, 1879, following the Greenback inflation of the Civil War. But I soon unearthed dozens of other cases.

Since 1967 the dollar has depreciated at an annual rate averaging 6 percent, compared to 5 percent for 1939-51. Sooner or later the American public is going to grow weary of the paper-money, inflation-ridden life that it has been leading—which I liken to "pub crawling"—and decide that it wants a reliable currency again, that it wants to "get back on the wagon." Maybe this will happen in a few years time, as it did in Britain after the Napoleonic wars, or in France in 1926-28. Or to be pessimistic, maybe we'll lead an Andy Capp existence for several generations as we did during most of the 18th century, until we finally adopted the Constitution, which said, "No State shall…make anything but gold and silver coin a tender in payment of debts." And suppose we do choose to stabilize our currency again so as to have once more a dollar whose continuing value we can trust. Where do we turn for instruction? We should, of course, look at how other nations have done it in the past.

Most nations can halt the inflation that is afflicting them if they are willing to pay the price. The exceptions, like the Black Death inflation of the 14th century or the gold and silver inflation of the 17th century, are rare. Any nation that does not stop an inflation simply because it is politically painful to do so is essentially declaring bankruptcy. There is an old saying, "Nations do not go bankrupt and pay off, say 50 cents on the dollar; instead, they inflate the money supply and pay off in a 50-cent dollar." Historically, inflations have been dealt with in various ways, often depending on the type of inflation involved.

First, there is the mega-inflation, or complete disaster type, that winds up with a stabilization at a thousand to one, or a million to one, or even a trillion to one. The rate on the Continental dollar reached a thousand to one near the end of the American Revolution, and we still didn't achieve stabilization. It was the worst example of inflation in recorded history up to that time. Stabilization rates for the French assignats were also very high in the 1790s. In Brazil the present cruzeiro is a many-thousand multiple of the real of a century ago, and there is still no end to it. In Russia about 1924 the ruble (once worth 51 cents) was temporarily stabilized at 50 billion to 1. At about the same time, Germany stabilized its mark at the all-time record of a trillion to 1.

None of these nations ever declared itself bankrupt. But one may well ask at what point a government closes down the old "store" of value and starts over with a new one.

Second, there is the multiple or three- to four-digit type of inflation. Like the mega-inflation just mentioned, it too can do enormous economic damage. In this category would fall some of the inflations in colonial times, such as those in Massachusetts (11 to 1), or Rhode Island (26 to 1), or New Hampshire (34 to 1), or the one terminating in Guatemala in 1926 (60 to 1), or in France, 1914-28 (8 to 1), or again in France in World War II and after (40 to 1), or in Germany after World War II (at least 10 to 1).

These price inflations are not a great deal less damaging than the mega-inflations. What is the difference between being paid off by a bankrupt at the rate of 20 cents, or 10 cents, or 2 cents on the dollar and receiving virtually nothing? In every instance the person who trusted the money unit has lost most of his savings. Nonetheless, in Type II inflations there is a little hope left and thus some motivation to put out the inflation fire and save the remnants of the economic edifice before flames completely sweep it away, as in Type I.

Third, there is the more creeping variety of inflation. We had this kind during our Civil War, in the two World Wars, and since 1965, especially since 1971. It is the kind that Britain had in the Napoleonic period, in World War I, and likewise twice since then. But don't think for a moment that those are mild and relatively harmless. All of them, too, did terrific economic damage, causing losses to savers of half to four-fifths of their capital. But at least these inflations leave some hope of preserving the reputation of the money unit as well as some of its buying power—provided the people and their government take sufficiently prompt and drastic action. Often the people won't, or at least not enough of them sense the need to do so.

Their hesitation or seeming indifference sometimes rests on faulty economic thinking emanating from presumed authorities who state that the money unit has only a temporary ailment attributable to a bad trade balance or to excessive demand. These excuses were heard in Germany after World War I and are now being reiterated in this country. Or the inflation may be attributed to the refusal of the defeated enemy to pay reparations, as many believed in France in the 1920s. Or blame may be placed on the scarcity of coin and the "high price of gold," as in Britain in the early 1800s.

When people find it painful to face facts, they are highly ingenious rationalizers. But very very few inflations throughout history have not been caused primarily by an oversupply of money, usually paper money, and we will never come up with a remedy unless we focus our attention on that main cause of the affliction and not seek to blame or cure other pains, many of which are only side-effects of the principal cause.

So what are the alternatives before us? I am assuming (1) that it is inflation we are dealing with and must continue to deal with, that no deflation is going to spirit us from the scaffold at the last minute. I am assuming (2) that the presence of Eurodollars is not an insurmountable obstacle that only world cooperation can solve and no nation alone can overcome. I am assuming (3) that finally enough of us want badly enough to stop the currency inflation to keep the pressure on to stop it.

Let's look first at the concluding chapters of the catastrophic Type I inflations. We find the governments following one of three main courses of action. I shall touch on them in reverse order of my preference for them, saving the best for last.

The United States in the 1780s, France in the 1790s, Russia in the 1920s, and Brazil repeatedly created a new money unit with, say, a 10 to 1 or 100 to 1 ratio of the old to the new. This temporarily reassured the people and gave the government a brief respite before it started out on a new round of currency inflation. That is not a solution.

A few years ago Brazil came up with a new device so the government might continue to enjoy the profits and "freedom" of inflation and yet allow its citizens some measure of self-protection. The device is indexing, and it has attracted widespread attention in this country from those who think that stopping inflation is a vain hope. This, too, is a palliative, not a cure.

Finally, let's look at the better solutions employed. France eventually turned to bimetallism under Napoleon and so essentially did the United States under its Constitution adopted in 1789. Both were delayed reactions. Germany in 1923-24 first tried a way out that was reminiscent of John Law's economics—land was used as the collateral for the Rentenmark. But Germany quickly shifted to a mixed gold-bullion/gold-exchange standard. And Austria and Poland made a more direct transition to the same mixed gold standard. The late 1920s were the happiest and most prosperous years in central Europe between the wars.

Next let's examine the wind-up stages of the Type II inflations in which the money unit lost 80 to 98 percent of its value. Once again I'll give them in ascending order of desirability, although this time the choices are not as clear-cut as in Type I.

France under President Charles DeGaulle in 1958 knocked two zeros off the old franc to create a new franc whose value relative to the dollar became a once-familiar 5 to 1. At the same time he had the Parliament repeal a number of price controls and other regulations that stimulated price inflation instead of restraining it. But France did not make its new franc convertible into gold, and within a few years it was once again depreciating at a distressing rate.

Germany in 1948 literally "bit the bullet," virtually cancelling 90 percent of all money and bank accounts and at the same time repealing numerous price controls and other restraints on economic growth. But Germany did not—in fact, was in no position to—make the new mark gold-convertible. Nonetheless, the action unleashed a "miracle" economic recovery that has been one of the marvels of the 20th century. One should not, however, forget that during the first 20 of the last 30 years, the rate of price inflation in Germany was about the same as in the United States. Only in the last decade has ours speeded up. The German cancellation method required great courage and secrecy on the government's part and great self-discipline on the part of the German public.

Nobel Prize-winning economist Friedrich von Hayek has in the last few years attracted a good deal of attention by suggesting that governments should surrender their monopoly right to provide the nations' money. Actually, his suggestion is not all that new. With or without governmental approval, many countries have resorted to this on numerous occasions. When governments are irresponsible in maintaining the value of their money unit, some of the people, sooner or later, find ways to solve the problem.

For Europeans, the prime example is the use of cigarette money at the close of and after World War II. For historically minded Americans, it is the use of gold coins instead of fiat paper money (Greenbacks) during the Civil War, particularly in California. During an inflationary period in Poland in the 1920s when the future value of the zloty was in doubt, there was a bank in Warsaw that did all its business in American dollars. Likewise in Mexico in 1917, after a period of one unsettled government after another accompanied by successive issuings of fiat paper money pesos, the people, quite suddenly, within a few days' time, turned to using gold and silver coins. Shake the confidence of a people in their money, and this sort of thing can happen rapidly.

The Guatemalan peso lost most of its value in the first 20 years of this century because of chronic currency inflation. More and more the businessmen of Guatemala turned to using American dollars, until finally this second currency, in essence, officially replaced the discredited peso. The 1924 monetary reform proposal to create a gold-convertible unit, the Quetzal, equal to a US dollar, was put into operation in 1926. Old pesos were made convertible into Quetzals at 60 to 1. In short, the more trusted currency now became the official one.

Finally, a few Type II inflation nations readopted a gold unit, whether old or new. France in 1928 adopted a gold-bullion standard with a franc about one-fifth the value of the prewar franc in terms of 1928 dollars or sterling but one-eighth the value in terms of its 1914 purchasing power. In the latter 1920s Italy, Belgium, Rumania and a few other recent belligerents returned to some form of the gold standard. Occasionally it was the gold-bullion variety, but more frequently it was the fatally flawed version of the gold-exchange standard that came out of the 1922 Genoa Monetary Conference.


The Type III inflation nations, the ones suffering a 5 to 1 inflation or less, have chosen one or the other of two routes—drifting, or stabilizing with gold. The United States and Great Britain have been drifting for close to 40 years. Our inflation has picked up speed since we cut the last tenuous tie with gold in 1971. The 1978 dollar is worth only about 20 cents in terms of the 1933 one. At the last decade's rate of inflation—six percent a year on the average—the dollar loses half its remaining value every 12 years. Rates like this tend to speed up rather than slow down. If a nation drifts long enough, it lands in the Type II category, and beyond that lies the Type I abyss. Britain and the United States are already close to being in my Type II inflation category.

The other solution, virtually the only one used in the past, is a return to gold or silver convertibility. That is a quick way of restoring public confidence. At the close of the Napoleonic Wars and after World War I, Britain returned to the gold standard. So also did the United States after the Civil War and after World War I. A nation must, of course, be prepared to submit to the discipline that the gold standard imposes.

"Ah," I hear, "but times have changed." Technology has become increasingly complex, but have people changed in any basic respect? Their fears and desires remain much the same. Yet the public does at times develop some strong and lasting prejudices. The South Sea Bubble of 1720 in Britain, for example, left such a lasting bad impression that it delayed acceptance of the corporation as a form of business for about a century. Likewise, American political differences over the First and then the Second Banks of the United States made the thought of a central bank anathema for most of a century. When we did set up a central bank in 1913-14, we had to break it into 12 pieces and give it another name, the Federal Reserve System. The 1929-33 panic and depression has colored our economic thinking now for nearly 50 years and made most American and British economists more fearful of rare deflation than of the much commoner and more dangerous inflation. And finally, the followers of Lord Keynes have so poisoned the minds of a generation of students, many of them today's top policymakers of the nation, against a gold-convertible currency that there is little likelihood of getting it reconsidered for some time.

How then could we end the present price inflation and put a "capper" on it to keep it from starting up again? A proposal to return to a gold-convertible currency would arouse widespread opposition. Indexing is a clumsy Rube Goldberg device that does not get to the root of the problem. Knocking off zeros and creating new units solves nothing and is a transparent cover-up for drifting.

The most promising way out is the second-currency one. And it could lead us eventually to the many-times proven best money standard, the gold standard. In the last five years Congress has swept three barriers out of the way. In the fall of 1974 it passed a bill restoring the citizens' right to own and deal in gold, starting January 1, 1975. And in October 1977 it repealed its resolution of June 5, 1933, outlawing the gold clause in contracts. And in November 1978 it passed a bill to introduce gold coins of an ounce and a half-ounce in size. These could serve as a dual currency for those whose faith in the fiat paper dollar is waning.

Like the establishment of the Federal Reserve System, the creation of a dual gold currency could be an acceptable way to circumvent a widely held prejudice. Those who prefer fiat paper money could continue to do so and those favoring gold coins, gold-convertible paper, and gold banks could go that way.

But, one way or another, we have to return to a precious-metal-based currency if we are to banish inflation. History shows us there is no other really successful way.

Donald Kemmerer is professor of economics, emeritus, at the University of Illinois and president of the Committee for Monetary Research and Education. This article is adapted from his presentation at a CMRE conference.