Three cheers for inflation?

Economist and economic historian Nicholas Crafts is back in the public eye with a new pamphlet for CentreForum. Those with long memories of his previous controversial stances won’t be surprised to know this pamphlet does not take a mainstream approach to economic history or economic policy, instead praising part of the 1930s and calling for more inflation.

The two are linked because he splits Britain’s economic record in the 1930s in two, arguing that in the second half of the 1930s higher prices helped fuel a strong economic recovery:

Over fiscal years 1932/33 and 1933/34 the structural budget deficit was reduced by a total of nearly 2 per cent of GDP as public expenditure was cut and taxes increased, the public debt to GDP ratio stopped going up while short term interest rates stabilized at about 0.6 per cent. Yet, from 1933 to 1937 there was strong growth such that real GDP increased by nearly 20 per cent over that period.

In the early 1930s, fiscal consolidation without a compensating boost from monetary policy was not conducive to recovery and ran the risk of prolonged stagnation in a difficult world economic environment which had little to encourage business investment and exports. The potential parallels with today are readily apparent.

As now, in the 1930s interest rates were reduced to an extremely low level, leaving little scope for further economic boosts from shaving fractions of a percent off them. Yet what really matters is not the headline interest rate but the real interest rate, i.e. after allowing for inflation. So if you can’t cut the headline rate much more because it is already so close to zero, you can instead cut the real interest rate by upping prices. As Crafts argues,

The key to recovery was the adoption of credible policies to raise the price level and in so doing to reduce real interest rates by raising the expected rate of inflation. This provided monetary stimulus even though, as today, nominal interest rates could not be cut further. Fiscal stimulus was not a factor in the UK recovery until after 1935 when rearmament began…

A close approximation to the successful 1930s policy would be to commit to a price-level target which might entail an average rate of inflation of about 4 per cent for three years. Crucially, this would have to be clear and credible so that the inflation was fully anticipated by the public and it would work by reducing the real interest rate.

It is a provocative argument and one which comes with one additional advantage: higher inflation eats away at the value of accumulated debt, both government debt (the cause of so much political debate and strife) and also the less talked about but still important large levels of private debt that burdens huge swathes of the population.

Of course inflation is not exactly a policy without costs, economic or political. Eating into the savings of pensioners in particular is never popular. However, it’s not only a provocative but also well-argued case from Nick Crafts which is well worth a read in full.



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