“Brigitte Granville has written a spirited and learned defense of how macroeconomic ideas can defeat inflation with sound monetary policy and inflation targeting. The success of these ideas is evident in persistently low inflationary expectations, which are now taken for granted. Yet Granville warns that monetary policy must not be overloaded because then its credibility may be undermined. Hers is a wonderfully and enlighteningly fresh look at inflation.”–Anders Åslund, senior fellow, Peterson Institute for International Economics

“Granville recalls the inflation of the 1970s, which, she fears, is in danger of being forgotten in the wake of the recent financial crisis and the ongoing recession. She covers a wide swath of macroeconomics and takes in the causes of inflation, the relation between unemployment and inflation, the Phillips curve, the role of expectations, and much more. I don’t know of any other book quite like this.”–John Driffill, Birkbeck, University of London

“Granville has read almost everything and has a good eye for the central issues. I liked this book very much.”–Thomas J. Sargent, Nobel Laureate in Economics

Brigitte Granville is professor of international economics and economic policy at Queen Mary University of London. Her books include Sovereign Debt: Origins, Crises, and Restructuring.

Remembering Inflation

By Brigitte Granville

PRINCETON UNIVERSITY PRESS

Copyright © 2013 Princeton University Press
All rights reserved.
ISBN: 978-0-691-14540-2

Contents

Preface…………………………………………………………..ixAcronyms………………………………………………………….xvCHAPTER 1 The End of a Mirage More Money Increases Inflation but Not
Employment………………………………………………………..1CHAPTER 2 Origins of Inflation Monetary, Fiscal, and Financial Links…..33CHAPTER 3 Ending Inflation Without Prolonged Recession Introducing
Credibility……………………………………………………….54CHAPTER 4 The Coordination of Monetary and Fiscal Policy………………93CHAPTER 5 Who Is Voting for Low Inflation and Why?……………………125CHAPTER 6 Monetary and Financial Stability Conflict or Complementarity…154CHAPTER 7 Inflation in an Open World Does That Change the Rules?………186CONCLUSION Adapting to Expectations…………………………………214References………………………………………………………..223Index…………………………………………………………….255

CHAPTER 1

The End of a MirageMore Money Increases Inflationbut Not Employment

This first chapter describes the learning trajectory that led economistsand policymakers to regard controlling inflation as a priority and to pursuethis goal of greater price stability more effectively. Starting from the finalthird of the twentieth century, the discipline of macroeconomics generatedadvances in the understanding of inflation that went on to have a powerfulimpact on the design of effective monetary policies to counter inflation. Atthe heart of these advances was the concept of the neutrality of money overthe long run as established by the classical school of economics: changesin the money supply affect nominal variables such as the general level ofprices but not real variables such as unemployment or output. Yet if moneyis neutral in the long run, this is not always the case in the short run. Realshort-term effects can be observed to result from changes in the supply ofmoney. This duality has been well described by Robert Lucas (1996: 664):

This tension between two incompatible ideas—that changes in moneyare neutral unit changes and that they induce movements in employmentand production in the same direction—has been at the center ofmonetary theory at least since Hume wrote.

Lucas is referring here to David Hume’s seminal essays Of Money, OfInterest, and Of the Balance of Trade, first published in Political Discourses(1752). The fundamental importance of Hume’s contribution lies in hisattack on the prevalent mercantilist school of thought and his advocacyof free trade—which had a direct influence on Adam Smith—and alsobecause in these three essays Hume articulates the key principles of theclassical school of economics. As a result, his work has been the wellspringand catalyst for most debates and controversies in monetary economics tothis day. His economic ideas have been incessantly pored over by academiccommentators. For our purposes, it is worth picking out from this vastliterature Joseph Schumpeter’s examination ([1954] 1997, 276–334) of theadvances in the understanding of “value and money” during the seventeenthand eighteenth centuries. More recently Carl Wennerlind (2005)not only offered a brilliant tour of the literature but also made his owncontribution by resolving one of the most contentious controversies surroundingHume’s work—namely, whether Hume misapplied the quantitytheory.

In brief, in Of Money Hume is credited with formulating the positionthat money is neutral in the long run—meaning that only the price levelwill be affected by changes in the quantity of money—but not in the shortrun. As a result, there is a time lag between an increase in the quantity ofmoney and its effects on the price level. In Of Interest Hume drew from hisanalysis of the work of his contemporaries and predecessors the conclusionthat interest rates are more a symptom of wealth than its cause, andthat the rate of interest is determined by the demand for loans and thesupply of savings rather than solely by changes in the quantity of money(Schumpeter, [1954] 1997: 331–32). In Of the Balance of Trade Hume setsthe framework of the monetary approach to the balance of payments bylinking the money supply, trade balance, and price level. His price-specieflow adjustment mechanism describes an automatic balance of paymentsadjustment process: an increase (decrease) in the money supply leads toan increase (decrease) in prices, which discourages (encourages) exportsand encourages (discourages) imports, resulting in an outflow (inflow) ofmoney that eventually decreases (increases) the price level back to its originalposition. There is therefore a “natural balance” of trade between nations.Hume’s automatic flow mechanism of international trade denied any needfor governments to interfere with this “natural balance” and thus directlyopposed the position of the mercantilists.

The above quotation of Lucas evokes three centuries of controversyamong thinkers on political economy and practitioners of the moderndiscipline of economics. Successive theories have been developed to makesense of the ever-changing nature of the world economy; and ideologyhas never lain far below the surface of the resulting debates and disputes.Every time a “new” crisis shakes the world, the previously prevalent theoriesare called into question, and the old ideological battle reemerges betweenthe partisans of laissez-faire on one side and, on the other, advocates of a”managed” economy in which fiscal and monetary policy is used to tackleeconomic downturns. Each cycle of controversy in economic thought generatesideas that are more or less ephemeral (depending on the timing andintensity of the next crisis) and produce illumination or obfuscation. Progressis conditional on how much economic history is remembered—whileremembering also that history does not repeat itself. Most controversiescan be resolved by maintaining a clear view of the distinctions betweentime periods—current, short, or long; or, put another way, some phenomenaare valid either in the short or the long run—but not both. In this way andby keeping in mind also that the validity of new analysis is contingent oncurrent conditions, a unified theory can be attempted.

This chapter focuses on one particular episode in the history of macroeconomiccontroversy—namely, how a set of economic ideas shifted the generalconduct of monetary policy that had prevailed since John Hicks’s interpretation(1937) of John Maynard Keynes’s The General Theory of Employment,Interest and Money (1936). This “new” thinking about inflation and monetarypolicy reacted against the contemporary orthodoxy because the prevailingtheory had proved to be unsatisfactory in analyzing the changing nature ofthe economy.

Keynes’s Revolution

Keynes’s General Theory too had changed the way policies were conducted.It had this effect by designing a model to express “the world in whichwe live,” and in doing so attacked the prevailing orthodoxy—the classicaltheory. His perception was that “classical” economics did not providea satisfactory interpretation of the 1920s and 1930s and therefore wasunable to offer policies to cure unemployment. Keynes’s thinking was informedby his lifetime involvement in public policy debates—for him,economists should base policy advice on observed circumstances—andhis experience of the events of the 1920s and 1930s. The perception ofdisorder and the high unemployment rates that characterized the Britisheconomy in the interwar years led Keynes to think that market forcesalone were not enough to restore full employment and that state interventionwas needed. This ran contrary to the principles of classical economistswith their tradition of laissez-faire based on the idea that the economywas self-adjusting.

Keynes’s prescription to actively use monetary and fiscal policies tocounter the cycles of recession and booms, together with his preference fordiscretion rather than changes in rules, initiated a revolution in economicthinking. While corresponding with George Bernard Shaw about Marx’sDas Kapital, Keynes announced in January 1935 (1979, 42):

To understand my state of mind, however, you have to know that I believemyself to be writing a book on economic theory, which will largelyrevolutionize—not I suppose, at once but in the course of the next tenyears—the way the world thinks about economic problems. When mynew theory has been duly assimilated and mixed with politics and feelingsand passions, I can’t predict what the final upshot will be in itseffects on action and affairs. But there will be a great change, and, inparticular, the Ricardian foundations of Marxism will be knocked away.

Keynes’s high expectations of the impact of his ideas in the General Theorywere vindicated. Following the year of the book’s publication and manyyears after that,

The discussion that went on was of two kinds, the first concerned withthe relationship between Keynes’s theory and orthodox theory, the secondwith the interpretation, internal development and presentation ofKeynes’s own theory. The two discourses overlap, since the question ofwhether the General Theory was a revolutionary break with classical theoryor a rearrangement of its pieces concerned both critics and followers.(Skidelsky, 1992: 593–94)

Even if, according to Davidson (2007), some of his most prominent followersnever actually read the book nor really comprehended it, and despitewhat in reality was a blurred line between the classical and Keynesian camps(as Hicks [1937: 147] pointedly remarked, most of the economists classifiedby Keynes as “classical” “find it hard to remember that they believed intheir unregenerate days the things Mr. Keynes says they believed”), therecan be no doubting the revolutionary effect that Keynes himself foresaw.Keynes’s “work of genius” (Samuelson, 1946: 190) was revolutionary inlinking the monetary side of the economy to the real side—output andunemployment. In other words, a core message was that “money is not neutral”(Keynes, 1933: 411).

This led to a new orthodoxy called Keynesian economics developed overthe two decades following WWII. As explained by Keynes’s biographerRobert Skidelsky (1992: 621):

[T]he version of Keynesianism which came out of the debates followingthe publication of the General Theory was by no means whollyKeynes’s…. Perhaps Joan Robinson was right to call it “bastard Keynesianism.”But only in that form could the Keynesian Revolution surviveand grow.

And for two postwar decades this new orthodoxy seemed to work in themain Western industrial countries: price stability was achieved in the1950s, while the steady expansion of output continued into the 1960s. Butthen, in the late 1960s, prices began to rise. Keynesianism no longer appearedto offer all the answers, and was challenged by a new would-beorthodoxy—monetarism.

To understand the coming of the monetarist counterrevolution, it isfirst important to review why and how Keynes came to differ from theclassical theory. One episode is of primary importance in this discussion:while Britain was slowly recovering from the First World War, WinstonChurchill announced in the budget speech that he delivered as Chancellorof the Exchequer on April 28, 1925, the return of the pound sterling to thegold standard at its prewar exchange rate of $4.867. Due to the war, thegold standard had been suspended in Britain and by most other members.Members were allowed to leave the gold standard in case of shocks (war,financial crises, and terms of trade), but the assumption was that when theyreturned to the gold standard this would be at the preshock parity (Bordoand Kydland, 1992).

The literature on the gold standard is vast and has been beautifully surveyedby scholars such as Bordo (1981), Bordo and Schwartz (1984), andEichengreen (1995, 1996). It will suffice here to pick out points that areparticularly relevant to our subject of developments in thinking about inflationand—by extension—monetary policy. The start of the gold standardin Britain has been dated either to 1717, when silver specie disappearedfrom circulation, or to 1821 when the Bank Restriction Act was lifted. Inother industrialized countries the demonetization of silver occurred between1870 and 1880, marking the start of the international gold standard.

The main objective of the monetary authorities was not price stability, asin today’s world, but rather to preserve the convertibility of the domesticcurrency into gold. The movements of the price level were regulated by thetotal supply of gold, which determined the money supply and price level ofevery country participating in the system. An increase in gold productionrelative to output due to new discoveries or better mining techniques led,with a lag, to a rise in the money supply and prices, just as a slowing downor a decrease in the gold supply relative to output implied stable or even decreasingworld prices. For instance, during the period 1879 to 1896, whenthere were only a few gold discoveries, average annual inflation rates (calculatedusing national product deflators) in Britain and the United States fellinto negative territory (respectively -0.58 percent and -1.08 percent), whilefrom 1897 to 1913, a time when new sources of gold were discovered inAustralia, Canada, and South Africa, they rose (respectively 0.88 and 1.99percent) (Barsky and Bradford DeLong, 1991: 816, table 1). The volatilityof the price level during the period 1820–1913 is seen in figure 1.1 and intable 1.1, with high short-term volatility measured by the coefficient ofvariation.

To ensure convertibility, each member fixed a “rule.” In Britain the rulewas set by the Bank Charter Act of 1844 (Peel’s Act), which guaranteed theequivalence between sterling and gold by maintaining a fixed par betweengold reserves and note issue. All members’ central banks pegged their localcurrency to a fixed quantity of gold at a fixed price using gold reserves tostabilize gold prices in the local currency, and it was at this fixed price thattheir currencies were freely converted to gold. All members’ currencies werelinked internationally through their tie to gold. In Britain between 1870and 1914 (and in 1925–31), one pound sterling and one dollar were respectivelyfixed to 113 and 23.22 grains of gold, therefore the dollar was equalto 113/23.22, or $4.867 per pound. The price of gold was (and is) quoted inounces, with an ounce of gold equaling 473.5 grains (table 1.2); the price ofone ounce of gold was fixed respectively at £3 17s. 10^1/2d. and $20.67, thistoo gives the exchange rate of $4.867 per pound.

To maintain the convertibility of the pound sterling into gold at a fixedprice, the Bank of England would use its discount rate (the so-called bankrate)—raising it to prevent gold outflows and decreasing it in case of inflows,with the consequences of tightening or loosening credit accordingly,affecting demand and the price level. These changes in the bank rate wouldalso influence capital flows, with higher rates reducing capital exports fromLondon and increasing investment in London (Williams, 1963: 514). Thedirectors of the bank based their decision on the proportion of gold reservesto liabilities (which was monitored on a daily basis), on movementsof the European exchanges (because these acted as an indicator for likelyreserve changes), and on the governor’s discretion—which was guided bythe overall economic circumstances both at home and abroad (Ferguson,2001: 159). For the rate to be effective it had to influence market interestrates, ensuring that the bank rate “constituted the opportunity costof funds at the margin for market participants” (Dutton, 1984: 177). Thebank rate on its own seems to have had little effect on money marketinterest rates, as in the 1850s the Bank of England had seen its share inthe financial sector considerably reduced relative to a growing number ofjoint stock banks. Until the 1910s, the bank influenced market rates eitherby exchanging bills or by borrowing from the commercial banks (Eichengreen,1996: 29).

At the end of WWI, the case for an immediate return to the gold standardat the prewar parity was made by the members of the “Cunliffe” committee(appointed in January 1918 under the chairmanship of the governorof the Bank of England—Lord Cunliffe). The return to gold was seen asthe way to reestablish a market framework in which British industry andfinance would prosper again (Booth, 1987). The Cunliffe committee wasconstituted mainly of bankers, apart from the Cambridge economist ArthurPigou (1870–1957), and its report was presented in December 1919.Their conclusions—subsequently approved by the Committee on the Currencyand Bank of England in 1925, and on which Churchill based hisdecision—were that

[b]efore the war the country possessed a complete and effective goldstandard. The provisions of the Bank Act of 1844, operated automaticallyto correct unfavorable exchanges and to check undue expansions ofcredit (Paras 2 to 7). (Sayers, 1976: 7:58, appendix)

The Cunliffe Report extended the Humeian price specie flow model. Thefunctioning of the gold standard rested on the classical theory of automaticmonetary adjustments, and such adjustments were now understood to becaused not only by the trade balance but also by fluctuations across the entirebalance of payments (Eichengreen, 1995: 34–35; 1996: 26–27).
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