The Start of Inflation as We Know It
In the 1930s, John Maynard Keynes built a new theory of inflation that sought to reckon with the proletariat’s recent and explosive entry onto the stage of history.
“The laws of economics, it’s often forgotten, are like the laws of engineering. There’s only one set of laws and they work everywhere.” That remark, which Larry Summers delivered more than thirty years ago in connection with the economics of the postcommunist transition countries, remains one of his all-time greatest hits.
It’s fun to laugh at the naivete of such ideas. But that kind of ahistorical thinking can have morbid real-world consequences, and in the great inflation debate of the past two years, I believe it did — above all via the widespread delusion, echoed by Summers and many other prominent economists, that the US economy was at risk of a return to the intractable inflation of the 1960s and 1970s.
To properly explain why that view was a delusion, we need to go back further in time, to the Great Deflation of 1929–1933, when John Maynard Keynes and his colleagues at Cambridge University were turning their attention to the question of what determines the price level. It was then, in the early 1930s, that Keynes finally abandoned the ancient Quantity Theory of Money, as I discussed in this previous article.
In 1934, the new trend of thought at Cambridge was summarized by Richard Kahn, Keynes’s closest collaborator, in a letter to a colleague: “In the view of Keynes and his followers the [Quantity] Theory of Money has ceased to exist,” Kahn wrote. Far from being an essentially monetary phenomenon, “how prices behave . . . depends on how wages behave, and that in turn depends on how Trade Unions behave.”
That addendum about trade unions will surely raise eyebrows today. But at the time, Kahn’s remark was neither more nor less than conventional wisdom.
Accompanying the profound reconstruction of economic theory that took place between the world wars — a ferment that birthed Keynes’s General Theory along with the entire field we nowadays call macroeconomics — was a widely shared though often unspoken background assumption: that the forward leap taken by the working class in its political and industrial organization as a result of World War I had permanently altered the dynamics of the macroeconomy, including inflation.
The theme is reflected in the future Nobel Laureate John Hicks’s landmark 1932 treatise The Theory of Wages, a four-hundred-page tome whose second paragraph begins: “The historical fact which dominates the wage-history of the present century — both in Britain and in other countries — is the growth of Trade Union power and the development of State Regulation of Wages.”
Interspersed with equations and diagrams, Hicks’s book included a long historical section recounting “The Rise of the Trade Unions,” of which the key development, in Hicks’s analysis, was the emergence of national industry-wide collective bargaining backed by an effective strike weapon, a trend that came to fruition in many industries during and after World War I.
By taking wages out of competition among domestic firms within the same industry, industry-wide bargaining strengthened the unions’ power even as it softened employer resistance to their demands (since higher wage costs could now be passed into prices without too much risk to the competitive position of any one firm).
These changes began to visibly impinge on the inflation process during and after the war. Prior to 1914, it had been regarded as axiomatic by economists that in times of inflation, wage increases lag behind price increases, reducing the share of income going to labor. This “wage lag” hypothesis was probably already folk wisdom by the time it was documented empirically by Wesley Clair Mitchell, the founder of the National Bureau of Economic Research, in a 1908 econometric study of US Civil War–era inflation.
Mitchell attributed the Civil War wage lag to the fact that “in the 60s . . . the labor market of the United States was one in which individual bargaining prevailed,” rather than collective bargaining. The “individual laborer is,” as Mitchell put it, “a poor bargainer,” and his weakness is compounded by exposure to “the competition of others with the same disabilities.”
But by 1923, Keynes, looking back on the more recent experience of World War I, could note that the famous wage lag no longer seemed to be operative, at least not to the same degree as before:
It has been a commonplace of economic textbooks that wages tend to lag behind prices, with the result that the real earnings of the wage-earner are diminished during a period of rising prices. This has often been true in the past, and may be true even now of certain classes of labour which are ill-placed or ill-organised for improving their position. But in Great Britain, at any rate, and in the United States also, some important sections of labour were able to take advantage of the situation not only to obtain money wages equivalent in purchasing power to what they had before, but to secure a real improvement.
The important question now, Keynes thought, was what was causing this new pattern of wage-price formation. “Was it due to a permanent modification of the economic factors which determine the distribution of the national product between different classes? Or was it due to some temporary and exhaustible influence connected with Inflation and with the resulting disturbance in the standard of value?”
Events almost immediately convinced him that the change was permanent.
In 1925 Winston Churchill, then chancellor of the exchequer, decreed Britain’s return to the gold standard at the old prewar exchange rate, a level now grossly overvalued given Britain’s changed postwar circumstances. It was well understood by Churchill and his treasury staff that the tight money and constricted exports the new policy entailed would, at least temporarily, induce an economic downturn. But it was their belief that the ensuing unemployment would soon enough force down the level of wages and, consequently, prices, until the domestic price level was low enough to be compatible with the higher foreign exchange rate. At that point growth would resume and unemployment subside.
Keynes was violently opposed to the decision. He warned that the government gravely underestimated the amount and duration of unemployment that would be needed to push wages down sufficiently for the policy to work as intended.
As things turned out, even Keynes was surprised by how slowly wages fell despite the swelling of unemployment, and how intensely workers resisted wage cuts: so intensely that an attempt by employers to cut pay rates for coal miners sparked the greatest outbreak of class warfare in Britain’s history, the 1926 General Strike, in which 1.7 million workers walked out and shut down the country for more than a week.
Reflecting on that episode four years later in his Treatise on Money, Keynes concluded that the novel wage-and-price dynamics he’d first glimpsed in the war-induced inflation of a few years earlier must have been more than just a one-off event:
It may be that in earlier periods the pressure of subnormal profits and the unemployment of factors of production may have operated more rapidly than they do now to achieve the objective of an income deflation. I believe that the resistances to a severe income deflation . . . have always been very great. But in the modern world of organized trade unions and a proletarian electorate they are overwhelmingly strong.
This vast but silent historical shift had consequences that would ramify around the world, throughout the rest of the twentieth century.