PROPHETS of inflation have not been lacking in this country ever since the devaluation of the dollar and the inauguration of the government spending program in 1933. Perhaps in the now not distant future they will receive their meed of tardy, and melancholy, honor. Inflation does seem rather obviously in the offing. But the assertion that the storm will inevitably burst upon us is even yet not completely convincing. There is no doubt, however, that most energetic government measures will be necessary to forestall the danger. These will not be pleasant, either to Congress or the population at large. The vital question is whether or not we have the resolution to see them through. If not, we can count confidently on sufferings much greater than those involved in the heavy taxation urgently required if the danger is to be avoided.

Discussion of the prospect of inflation in the United States is not inappropriate in a review dealing with international relations. The eyes of economists and business men everywhere are on us because of the size of our gold holdings and because of the extent to which economic recovery is a factor in general world recovery. Indeed, under present conditions one can say more correctly that gold is attached to the dollar than that the dollar is attached to gold. The question, then, whether there will be inflation in the United States is of direct concern to all the nations of the world.

In discussing inflation we are encountered at the start with an unfortunate indefiniteness of meaning. If inflation is defined as any expansion of the circulating medium, either absolutely or in comparison with the volume of production and trade, it is already with us and is waxing daily. If, however, we take realized price increases as our sole criterion there is need for some discrimination. Unless we regard as a price inflation any rise in the price level above its momentary status, we are at a loss to give the term a precise significance. Yet to regard it in that light is to give it merely casuistical import. In the course of business cycles, under gold standards of the traditional type, there have been more or less regular fluctuations in price levels which necessarily involved a recovery of prices from the low point reached in the course of any given cycle. Such would not, in ordinary usage, be regarded as inflation.

Over and above these short cycles in the gold price level there have been constant longer swings. Perhaps fortuitously, these swings in the past century have run for approximately twenty-five years before changing direction. The upward phase can properly be regarded as an inflation, during which the general price level has, from time to time, been multiplied two, three or fourfold relative to its status when the upward movement began.

Finally, we have had unambiguous inflations in countries which have abandoned the gold standard and abused the power to issue currency. These countries have suffered not only an absolute rise in prices but also increases in paper prices relative to prices measured in gold, even when the latter have themselves been moving upward. Sometimes such inflations have been movements that were little, if any, greater than those of the major upward swings in prices expressed in gold, on which they have often been superimposed. Sometimes they have been movements of all but infinite scope. The essentially determining factor has been the degree of restraint or recklessness shown by the fiscal authorities.

Now the rise in prices in this country since 1933 has so far not exceeded the limits of an ordinary cyclical recovery. In early 1933 prices in gold were extremely low on any normal basis. In fact, they were as low as authentic records have ever shown. It was rather generally agreed at the time that a reversal of the sharp downward price trend, which had been in process for several years, was essential to our economic health. The Administration at Washington more or less explicitly set as its goal the restoration of the price level of 1926. That level has not yet been attained. If prices should now cease to rise, or even if the level of 1926 should be surpassed by not more than say 10 percent, we shall not have had inflation in any alarming sense. The question is whether we now are having a mere price recovery or whether this is the beginning of an indefinite upward trend.

The price movement so far has not only been within the limits of cyclical recovery but has borne all the earmarks of a normal cyclical advance. Raw materials and foodstuffs have, as is usual in such cases, played the leading rôle. The improvement in their price has only approximately cancelled the relatively great fall which they suffered during the depression. The sharp increases in the prices of a comparatively limited number of agricultural and mining commodities, specially affected by shifts in demand or supply, will probably not be sustained in the face of larger prospective supplies. At the moment of writing, prices have in several instances already slumped, momentarily at least. Though there have been advances in the prices of more fully wrought commodities (attendant upon wage increases recently put into effect), it would be premature to conclude that all this is the inception of an unending and vicious spiral, and that, instead of being a mere cyclical phenomenon, it is the harbinger of substantial and possibly extreme inflation.

The history of inflations, nevertheless, shows that the virus takes hold slowly. The absence at present of any marked evidence of the disease therefore does not give any assurance that the poison is not present in our economic system. The great postwar inflations abroad were not sudden affairs, but were in each case the climax of a steady augmentation of the means of payment over a period of years. The rise in prices was at first negligible in proportion to the increase in the means of payment. It continued to be relatively slight up to the point where popular opinion shifted over from a desire to acquire cash balances to a desire to spend them. Once this point had been reached, prices rose at a much faster rate than the rate of increase in the means of payment and showed a tendency to continue an upward course even in the face of a contraction of the total supply of money. This is readily explicable. The first reaction in the face of possible inflation is one of vague apprehension and a desire for "liquidity." At first there is little more than a desire to be free to act as seems best in some unforeseen eventuality. Only when vague apprehensions are converted into a specific fear of devastating loss in the purchasing power of monetary hoards does net disbursement begin. Then the inflation manifests itself plainly in an upward surge of prices. The process is cumulative, since the shortening interval between disbursements tends to accelerate the rate of monetary turnover. If the period for which wage and other payments are made is shortened, the tendency may be speeded up. Such action is taken in an effort to counteract losses in purchasing power between payments; actually, it is a potent factor in furthering the rise which it is designed to offset.

The hope is sometimes expressed that a buyers' strike would develop in case prices rose too high, and that this would help to prevent a runaway inflation. This hope seems barren. When prices have once begun to rise substantially, people are more concerned to obtain goods before prices rise still further than they are to bring about a fall in prices by a spontaneous boycott.

Thus the inflationary process is inherently unstable, and if it is to be kept at all in hand it must be subjected to strong controls well before the necessity for these becomes apparent in the price structure. Strong controls can be exerted only if the authorities dominating the supply of money are themselves strong. The significance of this statement in the case of the United States today is that the Treasury must without delay attain a position in which it can take, or permit, action to restrict the supply of money. Only so can it be the master and not the slave of circumstance. Whatever may be said for the spending policy of the government as a means of priming the pump at the depth of depression, and no matter what defense can be made for the inflationary form of borrowing which was adopted, there simply is no question that once recovery got under way it became urgently necessary to adopt a pay-as-you-go policy. Today we have a degree of business activity which, if precedent can serve as guide, we cannot expect to maintain for any extended period. It is imperative, then, that we do not longer delay in putting the ship in shape to ride out any weather.

We find cause for concern today more in the conditions underlying prices than in the prices themselves. It is not current but future prices that we must consider. What is most needed at the moment is a lively apprehension in governmental circles of the great probability of inflation and the will to take forehanded measures now rather than palliatives later on.

The prospect of inflation can be appraised on the basis of: (a) the existing monetary situation; (b) the potentialities of monetary expansion on the assumption that governmental borrowing from banks is brought to an early close; and (c) the potentialities of monetary expansion on the assumption that governmental borrowing of this inflationary type continues.

The present monetary situation is disquieting. In June 1929, at the peak of the boom, adjusted demand deposits of all member banks of the Federal Reserve System amounted to $16,324,000,000. At the depth of the depression, four years later, they had fallen to $12,089,000,000. From that date to the present there has been an uninterrupted rise. This rise brought the total at the end of 1936 to $21,647,000,000, or 33 percent above the 1929 level. Since production and, presumably, sales of commodities are now about what they were in 1929, while wholesale prices are not yet as high, these figures indicate that the rate of deposit turnover is still relatively low. This conclusion is confirmed by more direct estimates. Any widespread fear that inflation was imminent would almost certainly result in a monetary turnover considerably greater than that of 1929, and the further upward movement of prices would be markedly stimulated. The increase in deposits, moreover, has been accompanied by a more than corresponding augmentation in the volume of cash in circulation outside the banks. The advance from the June 1929 figure of $4,026,000,000 to $5,846,000,000 at the end of 1936 is an increase of 45 percent.

The volume of bank deposits is of course very largely a reflection of borrowing. But this is chiefly not business borrowing, which normally rises and falls with business activity, but borrowing by the Government through the sale of government securities to the banks. This is the procedure on which all modern inflations have been based. Unlike borrowing from the investment market, it adds directly to the money supply. The proceeds of these sales of securities are transferred to the recipients of government payments and become their property without any counterclaim of the bank against the holders of the deposits. There is no possibility of a reduction in the volume of these deposits unless the Government begins to repay its debt or unless the banks dispose of a sizable part of their holdings of government securities to private individuals. The prospect that the banks can do this on any large scale without depressing the price of bonds to the point of endangering their own solvency is practically nil.

The holdings of government or government-guaranteed securities by member banks of the Reserve System have more than tripled since 1929 ($4,155,000,000 on June 30 of that year compared to $13,545,000,000 at the close of 1936), and the end of the process is not yet in sight. The recent purchases of government bonds by the Reserve banks permitted the member banks to dispose in this way of a small fraction of their holdings. This involved a shift of member bank assets out of government securities, which cannot be counted as reserves, into deposits with the Federal reserve banks, which do constitute reserves. This process therefore multiplied the inflationary effect by adding to the reserve balances of member banks.

The measures adopted in 1933 and 1934 to increase the available reserves of the banks made it easy for them to buy government securities at low interest rates, and the persistent government spending greatly in excess of income has eventually led to a situation in which the banks have no alternative to absorbing further government securities as long as the Government continues to put them out. Demand deposits will correspondingly increase; and, if present reserves and reserve requirements should prove inadequate or inconvenient, they would assuredly be altered under government pressure.

Summing up the immediate situation, we may note that the total volume of means of payment is now much larger than ever before, that it is growing fast, and that there has not been and is not likely to be a corresponding increase in the volume of production. Unless the rate of monetary turnover can be kept down, the current monetary structure is therefore likely to produce a substantial increase in price levels.

Let us now turn to the potentialities of future monetary expansion, on the optimistic assumption that governmental borrowing will be brought to an early close. We come here to the problem of excess reserves. Excess reserves had their origin in the purchase of government securities by the Federal Reserve banks. But for the past several years, until the recent support of the government bond market began, practically no credit has been extended by the Reserve banks to the member institutions either by redis-counting or by open market operations. The growth in reserves in this later period has been almost entirely associated with phenomena over which the Reserve banks had no control, in that they could not refuse to accept cash deposits from member banks. The more important of these phenomena were: (a) the devaluation of the dollar and other currencies; (b) the consequent great expansion in the output of new gold and the persistent drift of gold in enormous volume to the United States; and (c) the Government's silver purchases, with the accompanying issue of redundant silver certificates available directly, or through the currency they displace, as reserve money.

We need deal only with the gold situation. Devaluation raised the dollar value of gold by approximately 70 percent; but the devaluations here and abroad were not accompanied by a proportionate (if any) increase in mining costs. Gold mining, in consequence, became a highly remunerative industry. Abandoned mines again became profitable; then began an intensive search for new supplies; and the output of gold was enormously stimulated.

South Africa, the leading producer, took advantage of the opportunity to shift from higher to relatively low-grade ores. Though new mines there are being opened, no very great expansion of production has as yet occurred. Russia, however, has made tremendous advances and Canada has moved forward rapidly. Indeed, nearly all the parts of the earth where gold is available have increased their output greatly. India has released part of its ancient hoards. Probably, too, the Spanish Government, which possessed very large stocks of gold, has disbursed considerable amounts in payment for urgently needed war materials.

From an annual figure of about 24,000,000 ounces in 1932, gold production has risen to something more than 35,000,000 ounces in 1936. And the trend is still sharply upward. The increase of stocks in central bank reserves, or other repositories of monetary gold, has exceeded the total great accessions to gold supplies arising from new production. The United States has been, and still is, receiving gold at a rate about equal to the current output of the whole world. The currency value of the Government's present monetary gold stocks is at present not far short of twelve billion dollars, or nearly three times what it was in 1929.

In an effort to prevent the very great expansion of bank credit which the continued accession of gold would normally involve, the Federal Reserve Board has doubled the reserve ratios required of member banks.[i] More recently the Treasury has been following the policy of keeping imports of gold from entering the banking system at all. To do so it has had to borrow to secure funds to buy the gold and has thus added to its deficit at an average rate of approximately $100,000,000 a month. For this outlay it gets no spendable quid pro quo whatever but merely puts the gold back underground in expensive vaults. The Treasury cannot follow this policy for any extended period. The only alternative is to return to the old policy of having the Reserve banks absorb gold imports. The excess reserves of member banks will thereby be increased; and a still further increase in reserve requirements (for which new legislation will be necessary) would be the only way of avoiding an additional inflationary stimulus.

The banking system could carry the gold without any net cost provided the banks were permitted to expand credit on a mere 1:1 ratio. The Treasury, on the contrary, is now sustaining an unadulterated loss. The banking system, therefore, is clearly the appropriate place for the gold. Not only should the Treasury refrain from buying any more gold, but instead of borrowing it should disburse (in certificate form) the gold which it already possesses, always on condition that the reserves required of member banks are stiffened correspondingly.

Even with the raising of reserve requirements on May 1, 1937, to the present legal limit, excess reserves are now not far from a billion dollars. If we add bank holdings of government securities to the reserves we get a sum approaching 100 percent of the present volume of demand deposits. In these circumstances serious consideration should be given to adopting the plan for 100 percent reserves against demand deposits. Bank holdings of government bonds might be deposited in trust with the Reserve banks in partial fulfilment of the requirement, and the present reserves would practically cover the remainder. The Government, instead of borrowing, could then spend the gold in its possession, and it could borrow, if it must, directly from the Reserve banks without any subsequent pyramiding of credit. This procedure, moreover, would insure that member banks would retain, at the present low interest rates, the government bonds which they now hold. There would be no further need to flood the market with money in order to hold interest rates at inflationary low levels, in the effort to ward off threats to the solvency of the banks now associated with a rise in interest rates and the correlative decline in the capital value of the banks' bond holdings.

What if the law remains unchanged? The existing excess reserves of the member banks will support an increase in the volume of means of payment, without any extension of credit by the Reserve banks, of from four to five billion dollars. Continued imports of gold will steadily expand the potential volume of means of payment unless the Treasury persists in absorbing gold -- a policy still more dangerous because of its effects on the budget. If the Reserve banks are called upon to extend credit to support the government bond market, member bank reserves will be still further increased. Even with an early balancing of the budget it will be difficult, therefore, to prevent a very sizable inflation.

The objection may be raised that a sharp rise in prices in this country, unaccompanied by a similar movement abroad, would increase the ratio of our imports to our exports, would drain off gold in support of the exchange, and would thus reduce the base of credit and hold inflation within comparatively narrow limits. This objection will occur in particular to those who think that the present gold imports are a reflection of a dollar undervalued in the exchange markets.

After the change in its gold content in 1933-34, the dollar doubtless was undervalued for a time. But the subsequent lowering of the exchange value of the gold bloc currencies, the prior deflation in the gold bloc countries, and the sizable price increases here have probably completely cancelled that undervaluation. Commodity imports into the United States are now running considerably ahead of commodity exports, and the ratio of imports to exports is steadily rising. This is strong, if not conclusive, evidence against the theory that the dollar is undervalued in the exchange markets. Gold is being sent here not primarily as a balancing item in the total of international transactions but rather because there is nowhere else for it to go. The United States is the only important country where the seller can now dispose of gold at a fixed price, without initiative on the part of the buyer. It may soon be impossible to maintain dollar exchange rates by offering gold, since the monetary authorities of the countries of strong exchange may refuse to take it.

We are apparently moving rapidly away from the age-long attitude of an indefinitely expansible demand for gold to a situation in which gold is a drug on the market. It is being dumped on us because no other competent buyer is willing to take it. So long as we maintain our present gold-buying policy -- and the repercussions that would mark its abandonment are unpleasant to contemplate -- we shall probably continue to receive gold. We are, nevertheless, in a period of uncertainty with respect to the use of gold as money and cannot apply former criteria to the present situation. Almost anything may happen to the value of gold and, if foreign countries continue to show their present reluctance to absorb it, the exchange value of the dollar may decline regardless of our willingness, even eagerness, to export gold. Inflation might then readily develop in this country, quite independently of the movement of prices abroad. Even if inflationary governmental borrowing ceased, the inflation could then proceed to the limits set by our present reserve legislation, without being checked by the disparity between price movements here and abroad.

But it is futile to discuss how to limit inflation while governmental deficits continue to pile up and the Government is forced to rely on the banks for loans. Under these circumstances there are no restraints which will not be overridden. Monetary history reveals many cases of great inflation where gold reserves in the possession of the monetary authorities were of greater value than the total circulating medium, including demand deposits, at the low value to which the monetary unit had then fallen. The possession of gold has never been a safeguard against any degree of inflation whatsoever unless the gold was used to reduce, or otherwise restrict, the volume of fiduciary means of payment. Under our present procedure, the volume of means of payment is primarily conditioned not by gold but by the Government's deficit. The situation is still within control. But for eight years now we have been running a deficit of the order of $2,000,000,000 annually, most of it covered not by borrowing from savers but by recourse to a method which is merely a refinement of printing money on the presses. We are gambling on the long continuation of high business activity and on the continued receipt of taxes at not less than the present level. If the gamble fails, indefinite and even uncontrollable inflation is by no means out of the question.

We must not forget that a large proportion of government revenues are collected on incomes earned anywhere from one to two years before the taxes accrue. In a rapid upward movement of prices, receipts would therefore automatically decline relative to even the most essential expenditures. The most heroic taxation might then fail to cover current deficits. The situation would be out of hand.

Today the mere hope of a balanced budget is not enough. We must tax, tax heavily, and tax immediately. The dispute as to whether the best way in the future would be to lower exemptions in the income tax or institute a sales tax should be solved, for the current emergency at least, by having resort to both methods. Both are needed, and needed now. Early in his first administration President Roosevelt remarked that liberal governments have often been wrecked on the rocks of loose fiscal policy. We are now within sight of those rocks, and they hold a much greater menace than the President contemplated. The only sane procedure is to make certain at once that revenues more than cover expenditures, and thereby stop inflation at its source.

[i] The gold, in the form of certificates, would ordinarily flow to the Reserve banks in exchange for reserve credit and would increase the ability of member banks to extend credit by about five times the amount of the gold influx, even if the Reserve banks allowed no secondary expansion.

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  • FRANK D. GRAHAM, Professor of Economics in Princeton University; author of several works on monetary problems
  • More By Frank D. Graham