Chapter 4: Inflation rots the fabric of a nation, but it does wipe out debt.

Inflation is an addictive drug.

At first it is very stimulating; with falling unemployment and greater prosperity, but like any other drug you need larger and larger doses to produce the same result. People begin to understand what is happening, they demand higher wages and prices are raised in anticipation of higher costs.

Inflation may not be caused by the money supply increasing but it cannot happen without it increasing.

“A Government can live a long time by printing paper money. That is to say, it can by this means secure the command over real resources, - resources just as real as those obtained by taxation. The method is condemned, but its efficacy, up to a point, must be admitted. A Government can live by this means when it can live by no other. It is the form of taxation which the public find hardest to evade and even the weakest Government can enforce, when it can enforce nothing else.”

The above words were written by J M Keynes in his book entitled “Monetary Reform” in 1923. He went on to give evidence of the diminishing returns to a government who pushed the debasement of the currency too far, as in the hyper inflations in Europe after the First World War. He was arguing against a return to the gold standard and particularly against a return to the pre First World War value of gold in pounds sterling. His recommendations were broadly to manage the money supply in much the same way as we do now.

In Britain in early 2006 the official rate of inflation was quite low, 1.9% on the CPI (Consumer Price Index) and about 2.5% on the old measure the Retail Price Index; but this ignores the double digit rate of inflation in house prices and wage inflation running nearer to 4%. However, 2.5% of a gross national product of about one thousand billion pounds is a useful 25 billion pounds, which has been created out of thin air - created not by the government in the form of printed currency but by the private clearing banks in the form of new loans leading to new deposits. Looking at the rate of wage inflation instead of the artificially contrived RPI, the annual figure is nearer 40 billion pounds of new money injected into the economy by the private clearing banks in one year.

If you understand that the act of creating new money is mainly of benefit to those who create it and robs those who save, you may wonder why the creation of new money has been effectively privatised and is no longer the prerogative of the government. New money created in the form of currency note and coin is still reserved to the government, but new currency is a very small part of the annual increase these days. Most of the new money first appears to fund loans of one sort or another. Mortgages, credit card debt, hire purchase, and all the turmoil in the company take over market. This is electronic money. It costs nothing to produce, not even printing costs.

The losers are those with savings held in bonds or savings accounts and those on fixed annuities. Most of these are not wealthy, so the inflation tax is falling on those least able to bear it. Such an unjust levy would be bad even if it were imposed by the government as an alternative to taxation. It is many times worse when it is imposed by private banks for the benefit of the rich.

A money supply which can be increased by private enterprise is not only unjust to the vast majority of the people; it is also very difficult to control. In Britain at present the creation of new money is controlled to a limited extent by varying short term interest rates in the form of Minimum Lending Rate (MLR). MLR is reviewed each month by the Monetary Policy Committee (MPC) chaired by the Governor of the Bank of England. The MPC was charged by Gordon Brown with the task of keeping the rate of inflation, as measured by the Consumer Price Index (CPI) at an annual rate of 2% in December 2003. The question of whether this is a sensible target is the subject of a later chapter.

Lenin said:

“The surest way to destroy a nation is to debauch its currency.” And:

…” the concentration of capital and the growth of their turnover is radically challenging the significance of the banks. Scattered capitalists are transformed into a single collective capitalist. When carrying the current accounts of a few capitalists, the banks, as it were, transact a purely technical and exclusively auxiliary operation. When, however, these operations grow to enormous dimensions we find that a handful of monopolists control all the operations, both commercial and industrial, of capitalist society. They can, by means of their banking connections.”

If wages increase because of bargaining power in the hands of private and state employees or if prices increase because of lack of competition or higher import prices; then the flow of money through banks will also increase in proportion. This is known as “Cost Push” inflation

This can be illustrated by thinking of one company faced with having to give their workers an increase in wages. When they start increasing the wage cheques a greater amount of money will flow out of their bank account, but if at a slightly earlier time they raise their prices an equal increase will flow into their bank account. The company has not needed any higher overdraft but the total flow of money through their bank has increased and short term deposits in their bank have increased. If you imagine this process happening continuously over thousands of enterprises you can see how prices and incomes can rise without the need for new bank loans to cover them. In the case of state enterprises increases in wages are covered by the increased tax receipts that come from increased direct and indirect taxes that flow from higher wages and sales values.

This inevitably causes higher deposits and an increase in the money supply; not as a deliberate action by the banks but as a natural result of the activities of their customers. Broadly speaking the increase of money in any one year will equal the increase in wages. In the days of the gold standard there was a limit set by the quantity of gold and in some countries there is a limit set by “base” money, but in the UK the banking system sets no effective limit to money creation.

The truth of the above statement is amply illustrated by the performance of the UK economy in the 1970’s. In 1975 wages increased by 27.5% in one year (see Chart No. 2 below entitled Bank Rate v. RPI (Retail Price Index) and Wages. The banks coped with the additional flow without any sign of strain. By any definition you care to use the quantity of money in circulation must have risen by at least 27.5% in 1975. Holders of savings lost over a quarter of their value while borrowers saw their debts diminished by the same amount. It was the time when pension funds first invested in art, farm land, forestry and property: anything to avoid holding money. The increase in money was permanent and has never shown any sign of being reversed.

The RPI is used in Chart No. 2 below rather than the CPI because the CPI was not in use before 1996. Bank Rate is used here interchangeably with Minimum Lending Rate (MLR)

Chart 2 demonstrates several interesting features:

  1. Wages have almost always been well ahead of the RPI.

  2. Bank Rate lagged both RPI and Wages by a large amount during the 1970’s so that effective interest rates were strongly negative throughout the decade. It therefore paid to borrow as much money as possible to buy assets such as property or land on the assumption that your income would rise much faster than the interest on your loans. Some people quickly realised what was happening and exploited it, others lost their savings.

  3. In the 1980’s Bank Rate moved well ahead of the RPI and wages in the early part of the decade, bringing both the RPI and the rate of wage inflation down steeply, but from 1987 Bank Rate was not far above the rate of Wage Inflation, allowing a second property boom based on rapidly increasing levels of debt. By the end of the 80’s very high debt levels were hit by a further round of high Bank Rates which caused a slump in property prices. Although the RPI has remained at a reasonably controlled level during the 90’s and onwards, Bank Rate has not been high enough to restrain borrowing and consequent asset price inflation. Bank Rate can be seen to be barely above wages since 1999.

The great inflation of the 1970’s can be put down to a variety of causes, some of them world wide such as rapidly increasing oil prices and the final demise of the gold standard and the Bretton Woods agreement, but in the case of the UK it was greatly exacerbated by the combination of very strong trade unions and nationalised industries. For most of the 1970’s British Rail and British Road Services had a monopoly on the delivery of goods while the Dockers’ Union was hereditary and had a complete stranglehold on all imports and exports. Physical controls on banks and wages were evaded and interest rates were effectively negative because of wage inflation.

Interest rates alone are not an effective check on inflation unless they are piled on top of existing high personal debt levels or are strongly positive in relation to wage inflation. In recent years the level of personal debt has been increasing rapidly in real terms and wage inflation has not been high enough to reduce it as it did in the 1970’s.

How prices have risen over the last 60 years based on the Retail Price Index, Average Wages, GDP, Houses, and a haircut.

Index or commodity

Value in late 1940’s

Value in 2006

Change factor in period


£100 £3091 X 31


£1891(1952) £184,000 X 97


£100 £9896 X 99


£12.1 billion £1343 billion X 111
Haircut 6 old pennies £6

X 240

Inflation clearly means what you want it to mean and the effect of using one measure rather than another as a target is explored in a later chapter.

Before the last world war a haircut cost six old pennies, in 2003 it cost at least six pounds. As there were 240 old pennies to the pound that makes a rate of inflation over the last 60 years of 240 times. If, however, you look at the official statistics of the purchasing power of the pound it has only dropped by a factor of 31. In round terms the cost of a haircut has risen eight times faster than the retail price index or RPI. This is an indication of the increasing disparity between the RPI and the cost of labour.

1971 was the turning point in the post war history of inflation, when the USA stopped backing the dollar with gold. The immediate trigger for this action was that General De Gaul started to demand payment in gold instead of dollars for purchases by the USA in France. The General felt, not unreasonably, that dollars were cheap to produce and had no absolute value. The price of gold in dollars shot up from 39 in 1970 to 594 in 1980. The price of gold in 1793 was 19 dollars, so it had taken 179 years to double in price and only ten years to multiply by a factor of ten. After 1980 the price fell to about ten times the price in 1970 but it remains a dramatic indicator of the unmarked monetary wilderness we now inhabit. We were left without any fixed point against which to value our currencies.

In Britain, at about the same time as America went off the gold standard, Edward Heath considerably loosened controls on the expansion of bank credit. We were soon far from familiar shores and the wind speed of monetary inflation began to pick up to near gale force.Arguments have raged as to whether this inflation was cost push or demand led but I think the twin reasons were uncontrolled credit expansion coupled with overwhelming trade union power in an economy dominated by state controlled monopolies.

At the beginning of the 70’s a business wishing to move its products had the choice of British Rail, British Road Services or the Post Office which depended mainly on British Rail. It was nearly impossible to get something delivered on the following day until British Rail started a service called Red Star, which, if you delivered the parcel personally to a main line station, would have it ready for collection at another main line station the following morning. It was even more difficult to export something; for this you had to run the gauntlet of the docker’s unions, who had been granted jobs for life after an enquiry by a noble Lord with very little if any practical experience. Business was at one time threatened with the extension of the docker’s monopoly to anywhere within 30 miles of tidal water. We were trying to run a manufacturing and export business near York, which is only one mile from the tidal limits of the river Ouse.

The 70’s saw two major attempts to control wages by government edict. The first, by Ted Heath, ended in complete defeat by the coal miner’s union, under the relatively benevolent leadership of Joe Gormley. The second, by Jim Callahan, ended in the winter of discontent with rubbish filling the streets and dead bodies unburied. The power of trade unions in the key services and industries was able to dictate wage increases that more than matched the rising cost of living. There was no restraint on the expansion of money required to accommodate higher wage costs. The clearing banks had the power to supply more money to fund higher wages because they were matched by higher prices all round.

Inflation is a highly effective stimulant for an economy provided that it is not anticipated, but like all drugs it requires an ever larger dose to produce the same effect. To begin with, inflation had a dramatic effect on reducing the level of unemployment. We even saw an attempt to define the trade off between the rate of inflation and the rate of unemployment in fixed terms and this seemed quite a stable relationship for some years but collapsed as yet another triumph of hope over experience.
Government economic policy in the 70’s demonstrated a complete lack of understanding of the economic storms that raged around them. At one point a new tax was introduced called the Selective Employment Tax, which was intended to favour manufacturing industries over service industries. Transport was grouped with the service industries although it was an integral component in all manufacturing and particularly extractive industries. It is almost unbelievable that Government could class transport as a service industry when historically, advances in transport have had more effect on increases in manufacturing than any other single factor. The industrial revolution would not have happened if the goods produced and the raw materials required could only be moved by pack mules!
It is not possible to exaggerate the adverse effects of government actions guided by theoretically qualified economists on the health of the economy. Dogmatic socialist faith in the effectiveness of state owned enterprises was alternated with feeble conservative attempts to bring back the discipline of the market. Conservatives continued to follow the solutions put forward by Keynes, completely ignoring the fact that Keynes had been dealing with completely different problems.

Purchase Tax was replaced by Value Added Tax that, at a stroke, added an extra two columns to every ledger in the Country. Only the increasing use of computers in company accounting kept the damage done to reasonable levels.

I have always been impressed by the ability of the ordinary British working man to produce good results in spite of incompetent management and awful government. “Lions led by donkeys” was the order of all our days.