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Inflation, hyperinflation and Monetarist perceptions about the functioning of the economy

I dealt before with the persistence of Monetarist views, in particular regarding economic history (here and here). Interesting thing is that recently the Bank of England admitted that money is endogenous, and, hence, at least the simplistic notions that money causes prices are clearly in the defensive. Mind you, as I noted in my post, admitting money endogeneity does not mean they are heterodox by any means, since for them the system still has very much a tendency to full employment.

At any rate, a full discussion of the several views on inflation with a taxonomy is presented here.  The second session that provides a historical overview of inflation is posted below.

Inflationary Processes in Historical Perspective

Price Revolutions are often neglected by economists, but have been central for economic historians. The conventional wisdom among economists is that monetarist views are the dominant interpretation of those long term processes. This is particularly the case about the 16th Century Price Revolution, which is the one associated with the first clear expositions of the Quantity Theory of Money (Arestis and Howells, 2001-2). This is not the case, and in general historians stress the real causes of inflation based on neo-Malthusian models that emphasize demographical forces, in which money is endogenous.

Price Revolutions begin in periods of prosperity, and end in periods of crises. The classic demographic or real model is essentially based on a Malthusian insight, was developed by Michael M. Postan (1973) and used to explain the behavior of the later-medieval western European economy, and in particular the behavior of price movements. Postan had argued that population growth and a relatively static agrarian technology led unavoidably to diminishing returns. Diminishing returns, in turn, drove grain prices up during the long thirteenth century (1180-1350), at a rate estimated by Postan to be around 0.5 percent per year. Symmetrically, population decline during the fourteenth and fifteenth centuries, caused by terrible famines, epidemics and wars, led to a fall in grain prices. In Postan’s framework monetary changes played no role in late-medieval price movements or in any of the changes that the economy underwent during the late middle-ages for that matter.

Not surprisingly, some historians disagree with Postan neo-Malthusian model. Day (1978) argues that the economies of the late middle-ages remained hard money economies – despite the incredible development of credit instruments – and that monetary contraction should be seen as the essential cause of the fourteenth and fifteenth centuries’ deflation. The decrease in money supply resulted both from Europe’s limited monetary stocks, and the permanent outflow of bullion resulting from permanent balance of payments deficits with the East (Day, 1978, p. 79). Hackett Fisher (1996, p. 19) suggests, however, that even though money and population changes both play a role, “population appears to have been the primer mover.” In this sense, the turning point in the 1380 would have more to do with harvest failures and the plague than with money shortages.

Hackett Fisher (1996, p. 72) argues subsequently that the prime mover in the following Price Revolution was the “revival of population growth, which placed heavy pressure on material resources.” Monetarist inclined authors emphasize the silver and copper mining boom in Central Europe in the 1460s – before the discovery and inflow of American bullion – as a major factor ending the European bullion famine (e.g. Munro, 2003). Hence, monetary factors would be central to explain the sixteen century inflation.

The Price Revolution of the sixteen century is well known among economists, and Earl Hamilton’s (1934) is the classic interpretation, putting emphasis on the effects on prices of American gold and silver inflows. When the price revolution became evident several explanations were developed. Jean Bodin and the authors of the Salamanca School – Martin de Azpilcueta and Tomás de Mercado more prominently - are usually credited with formulating the first clear version of the Quantity Theory of Money (QTM).[1]

Wrigley and Schofield (1981) develop a neo-Malthusian model along Postan lines. The main problem with the conventional monetarist view is that prices started to go up considerably before the American bullion arrived in Europe. Historical causality indicates that prices increased first and then the money supply followed suit. In fact, Hackett Fisher (1996, p. 84) suggests that the great inflation created such demand for monetary medium that even “old mines were reopened at heavy expense.” Arestis and Howells (2001-2) emphasize the role of endogenous money in the realist neo-Malthusian tradition. In the neo-Malthusian view bad harvests, famine, disease and war – in particular the Thirty Years War (1618-48) – led to a reversion of demographical trends and led to the end of the second price revolution.

The price revolution of the eighteen century started in the 1730s. The flow of the recently discovered Brazilian gold in Minas Gerais to London via Lisbon is seen by bullionists as the initial cause of rising price trends (Vilar, 1960).[2] It is in this period that David Hume (1752) produces his famous defense of the quantity theory of money, and the specie flow mechanism, according to which inflation resulted from increases in gold inflows related to trade surpluses.[3] On the other hand, population trends – a decline in age at marriage and a subsequent increase in the fertility ratios – suggests that demographical forces were also at play. However, the eighteen century price revolution is ultimately famous for the debates that it provoked in England in the late eighteen century and early nineteen century, known as the Bullionist debates.

David Ricardo is usually described as the main bullionist (defenders of the 1810 Bullion report) author and a champion of the view that inflation was caused by the overissue of bank notes by the Bank of England during the suspension period (1797-1821) – in which bank notes were not convertible to gold. Green (1992) notes that the classical authors – Ricardo included – believed in some variation of the labor theory of value and, hence, concluded that the price of commodities depended on technical conditions of production (labor embodied or commanded) for a given wage level (subsistence).[4] Hence, the price of gold – the numeraire – would also be determined by the technical conditions of production in that sector.

However, if the relative price of gold is determined in that way, the prices of all other commodities in terms of gold cannot be determined by the quantity of gold. Prices in terms of the standard (gold) must be determined by the costs of production of gold, so that causality is reversed and the quantity of money is endogenously determined. Green (1992, p. 56) refers to this classical view of endogenous money as the Law of Monetary Circulation. According to the Law of Monetary Circulation, even though in the long run money supply is endogenously determined, in the short run – when market prices deviate from normal prices – exogenous changes in the money supply may affect prices.

The idea that Ricardo does not defend the Quantity Theory in the long run contradicts the popular vision that assumes that there is a stream of monetary thought that begins with Hume, Ricardo, and the Currency School (e.g. Torrens) and culminates with modern monetarism (Hicks, 1967, pp. 155-173).[5] The anti-Quantity Theory current, in this view, starts with Thornton and the Banking School (e.g. Tooke) and culminates in Keynesian economics.

The main opponent of the bullionist view of the eighteen century inflation was the economist and price historian Thomas Tooke – the leader of the Banking School.[6] According to Tooke (1844, p. 123) “the prices of commodities do not depend upon the quantity of money indicated by the amount of bank notes, nor upon the amount of the whole of the circulating medium; but … on the contrary, the amount of the circulating medium is the consequence of prices.” Prices increased, still according to Tooke, as a result of bad harvests, the depreciation of the external value of the currency that increased the price of imported goods, and higher interest rates, which led to higher financial costs. Reversal of these trends in the post-Napoleonic War period, hence, explains the deflationary forces in action, and the end of the price revolution.

The last price revolution starts with the end of the Great Depression (1873-1896), the year of William Jennings Bryan Populist bid for the presidency in the US, based on his attack on the Gold Standard, and his defense of a bimetallic monetary system. While conventional views would emphasize the role of the discovery of new sources of bullion in South Africa, alternative views would emphasize the importance of distributive conflicts in the inflationary process. Adherence to the Gold Standard, and the so-called crime of 1873 – the demonetization of silver (Goodwin, 1978, pp. 16-7) – meant that money was scarce, and led to deflationary forces, which in turn hurt debtors (mid-western and southern farmers) and benefited eastern industrialists and bankers (the Robber Barons). The agrarian revolt and the rise of populist and progressive movements – that led to the regulation of monopolies, the passing of an income tax, the creation of a central bank, and a series of other reforms – turned the tide and generated inflationary pressures. The importance of these events is that for the first occasion in modern times it became clear that inflation could result from disputes over the proverbial pie. Distributive conflict would become central for several explanations of inflation in the twentieth century.

Distributive conflict may very well have had a role on the inflationary surge in the US, but it was ultimately an American phenomena. Hackett Fisher (1996, p. 186) argues that the twentieth century price revolution has structural causes related to rising living standards, a public health revolution that led to rising population, and institutional changes that led to what Heilbronner referred to as “floors without ceilings.” The rise of corporations, and the development of a more regulated economy, with increasing participation of governments, led to an upward bias in prices. Thus, Joan Robinson (1971) famously argued that “the general price level has become a political problem.”

Distributive conflict and political disruption were particularly important in the discussion of inflation in the 1960s. Conventional wisdom presumes that the inflationary pressures were brought about by the expansionary fiscal policies in the U.S., and the propagation of these inflationary pressures through the international system (Laidler and Parkin, 1975). The increasingly expansionary fiscal policies of the 1960s – resulting both from the Vietnam War and the Great Society experiment of the Kennedy-Johnson administrations – led to growing balance of payments deficits. The U.S. deficits were initially considered instrumental for the working of the international monetary system that was desperately in need of dollars to obtain the essential imports of capital goods needed for reconstruction. However, by the late 1960s the accumulation of idle dollar balances started to put pressure on the money supply of the rest of world, leading to inflation. That is, according to the monetarist logic, inflation was caused by the U.S. fiscal and monetary policies, and transmitted to the world as a result of the system of fixed parities.

An alternative explanation for the inflationary pressures of the 1960s is possible though. This alternative explanation, compatible with the post-Keynesian view, would minimize the effects of the U.S. expansionary fiscal policy and the fixed exchange rate regime. The Golden Age accumulation regime implied a commitment to full employment and the creation of a safety net for unemployed workers. Additionally, the imposition of capital controls and the cheap money policies – which led to low real rates of interest – implied a favorable environment for workers. Parties with strong ties with the labor movement were in power in several Western countries, and this was tolerated, to a great extent, since it was considered a form of reducing the dangers of the Soviet menace. Further, full employment tended to increase the bargaining power of the working class.

In this environment, workers pressures for higher nominal wages were usually accommodated. For a given real rate of interest, and a fixed nominal exchange rate, the only effect of rising wages would be higher prices. In sum, inflation was the result of wage pressures – cost-push – rather than the expansionary fiscal and monetary policies – demand-pull – (Coutts, Tarling and Wilkinson, 1976). Note, however, that for a good part of the Golden Age, wages increased at the same pace that productivity, and hence, had a negligible inflationary impact. Hence, the inflationary process of the 1960s and 1970s seems to be related to the increases in taxes (passed to prices), competitive depreciations (more prominently after 1973), and supply side shocks, notably the two oil shocks of the 1970s. Stabilization and the end of this last price revolution would not be related then to fiscal consolidation, but to the fall in the prices of commodities, and the weakening of the labor movement (Kaldor, 1976; Eisner, 1989).

It is worth noticing in this birdseye view of inflation in historical perspective that the quantitativist tradition faces an important conundrum. If exogenous increases in money supply are the ultimate cause of inflation, then a diabolous ex machina is the culprit for increasing the money supply (Hackett Fisher, 1996 p. 83). Corrupt and incompetent politicians are the main suspects. This explanation of the ulterior causes of inflation is one that emphasizes the role of individuals at the expense of the structural constraints faced by them. Alternative theories are less dependent on methodological individualist premises, and on the moral and intellectual qualities of politicians to explain inflationary processes.

Last but not least, our brief description of the historical record of money and inflation cannot leave hyperinflationary processes out. The most famous episode of hyperinflation is the post-World War I German case. Historians, says Ferguson (1995a, p 19), have essentially followed two interpretations of the German hyperinflation. The first was offered in the 1930s by the Italian economist Constantino Bresciani-Turroni (1931),[7] who blamed poor monetary and fiscal policy and argued that the inflation had predominantly negative consequences (Camara and Vernengo, 2001). Recent scholarship among historians, however, Ferguson admits has emphasized alternative views of inflation (e.g. Kindleberger, 1985).

The view according to which deficit spending was the main cause of German inflation was named the English or allied view by Bresciani-Turroni (1931, p. 46) in his classic The Economics of Inflation.[8] The allied view, which was forcefully defended by Bresciani-Turroni, corresponds to what today would be called monetarist, and was later formalized by Cagan. In this view, the burden imposed by the internal war debt, the payment of pensions to war veterans, widows and orphans, the reconstruction of the few devastated regions, and the process of war demobilization were too heavy for the young Weimar Republic and the leftist Social Democrat government to carry. In addition, the incapacity to raise fiscal revenues implied that the increasing fiscal spending had to be financed by the Reichsbank.

According to Bresciani, the empirical evidence for his views is provided by the monetary reform of November 1923, which for him represents the moment when the German government found the necessary energy to stop the monetary issues (ibid., p. 399). One of the crucial characteristics of the monetarist interpretation of inflation is that the rise in money supply precedes the rise in the price level. Also, given the dominance of purchasing power parity as the explanation of exchange rate determination in that period, the rise in the domestic price level precedes and causes the depreciation of the deutsche mark. There is a chain of causality that runs from the exogenous money supply to the price level and then to the exchange rate.

For Bresciani-Turroni, the solution to the inflationary problem was simply to cut the fiscal deficit. Once the principles of sound finance were re-established, the price level would be stabilized. The German government was to blame then. Still, as noted by Merkin (1982, p. 25) among the defenders of the quantity theory of money there was a certain degree of acceptance that in reality the rise in the price level preceded the increase in the quantity of money, and, hence, expectations of future money supply increases played a role.

For some authors the rise in wage costs bring about inflation quite independently from the rise in money supply, at least in the short run. Schumpeter was among the authors that argued that “the conviction of the practical man that wage increases drive up the price level is not so wrong as one might believe” (Merkin, 1982, pp. 25–6). Wicksell (1925, p. 202) also criticizes the quantity theory, in particular the proposition that “the velocity of circulation of money at any given time is approximately constant.” Further, Wicksell is one of the first authors to introduce the idea of endogenous money in marginalist analysis. For him (ibid., p. 201) “it … stands to reason that a general rise in the market prices of both goods and services itself creates the purchasing power required for meeting the higher prices.”

Wicksell’s contributions and also those of Schumpeter and Bortkiewicz stand in a category of their own (Merkin, 1982; Laidler and Stadler, 1998). They all see velocity of circulation as an important element of hyperinflation, and they all introduce endogenous money. However, they also still believe that hyperinflation is the result of excess demand. In particular, Schumpeter and Wicksell credited excess demand to a low market rate of interest, while Bortkiewicz emphasized the acceleration of consumption caused by expectations of further monetary expansion.

The German officials that had to deal with the day-to-day problems of running an economy under hyperinflationary conditions saw the problem, not surprisingly, from a different perspective. The most notorious defender of the so-called balance of payments theory was Karl Helfferich. This view was named the German view by Bresciani-Turroni (1931, p. 47).

The disruption of the war led the German government to regulate the foreign exchange “by way of a direct control of all foreign payments and credits”, (Helfferich, 1927, p. 259). However, “as the collapse of the German nation shows, the force of circumstances proved more powerful than any policy of exchange control” (ibid., p. 262). That is, trade deficits led to depreciation despite the control of the German authorities. As correctly noted by Howard Ellis (1934, p. 224), “the balance theory takes as its point of departure the decline of German exports.” Helfferich argued that the permanent unfavorable trade balance, caused by the war and the impositions of Versailles, led to depreciation. This was the root of German problems. For him contrary to the widely held conception, not inflation but the depreciation of the mark was the beginning of this chain of cause and effect. Inflation is not the cause of the increase of prices and of the depreciation of the mark, but the depreciation of the mark is the cause of the increase of prices and of the paper mark issues (Bresciani-Turroni, 1931, p. 45).

In other words, causality runs from the exchange rate to the price level. That means that the rise in the price level cannot be related to the increase in the money supply. Graham (1930) defended Helfferich’s position in what was to become, up to the publication of Bresciani’s book in English, the most influential view of the German hyperinflation. Graham (1930, p. 172) argues that “the proximate … chain of causation, up to August 1920 at least, and perhaps at other times, ran from exchange rates to prices to volume of circulating medium rather than in the reverse direction”. According to the balance of payments view it is not possible to stabilize the economy without stabilizing the exchange rate. This was only possible if foreign reserves were available. The renegotiation of reparations in 1922 and the loans obtained through the Dawes Plan in 1924 allowed the stable foreign value of the rentemark to be maintained.[9]

It is clear that some notion of passive or endogenous money is present in the work of the defenders of the balance of payments theory. Yet, Joan Robinson (1938, p. 74) noted that there was no explanation of the role of wages in the inflationary process. In her words, “neither exchange depreciation nor a budget deficit can account for inflation by itself. But if the rise in money wages is brought into the story, the part which each plays can be clearly seen.” As correctly pointed out by Joan Robinson, there is an inverse relation between the real wage and the exchange rate, so that depreciation leads to a decline in the real wage. If workers resist the fall in the real wage, because tradables are an important component of the wage basket for example, then domestic costs will increase, and so will prices. That is, distributive conflict is an essential part of the hyperinflation story. Joan Robinson’s reformulation of the German view provided a sound basis for alternative explanations of hyperinflation.

Quantitativists and the Balance of Payments school are the two main groups with opposing views on the German hyperinflation. Cagan developed the typical monetarist view on the basis of the quantitativist or monetarist analysis. On the other hand, the Balance of Payments school argues that reparations and depreciation are the cause of hyperinflation. Joan Robinson introduces the notion of wage/foreign-exchange spirals and distributive conflict. Her contribution can be named post-Keynesian. Variations of these two views remain the canonical interpretation of hyperinflationary processes.

[1] On the Salamanca School see Grice-Hutchinson (1952), and Popescu (1997).

[2] The Methuen Treaty established that Portugal would export wine and import manufactured goods – textile products fundamentally – from England at very low tariffs. The treaty – later used by Ricardo in his attack on the Corn Laws – implied that Portugal became dependent of British goods, which were ultimately imported with the inflows of Brazilian gold. The discovery of gold meant complete submission to British hegemony for Portugal.

[3] Hume, one should note, considered John Locke the source of his defense of what we now term the Quantity Theory and the ultimate authority of the issue (Green, 1992, p. 31). Sir James Steuart represented, on the other hand, the main opponent of the quantity theory in the eighteen century. Steuart believed that changes in the supply of money would ultimately affect the velocity of circulation rather than the price level.

[4] Marx (1859, p. 173) criticizes Ricardo for his contradiction of his theory of value and his monetary theory. That would be the case, since, according to Marx, Ricardo adopts the view that the value of gold is determined by the quantity in circulation in conformity with the quantity theory, rather than being determined by embodied labor. In contrast to Marx’s claim, Ricardo (1817, pp. 85-6) argues that “the same general rule which regulates the value of raw produce and manufactured commodities, is applicable to metals; their vale depending … on the total value of labor necessary to obtain the metal, and bring it to the market.” For a discussion of Marx’s views on money see Foley (1986).

[5] On Ricardo’s often misrepresented views on inflation and foreign exchanges see Marcuzzo and Rosselli (1986). For a conventional view see Fetter (1965).

[6] The Banking School is sometimes seen as a precursor of post-Keynesian analysis of endogenous money (Wray, 1990). The endogeneity of money is implicit in the Law of Reflux – the Banking School version of the Law of Monetary Circulation. Reflux implies that commercial banks cannot create credit above the level demanded by economic agents, since excess credit would be used by those economic agents to repay pending debts, thus canceling the rise of the means of payment.

[7] Bresciani’s book carried a foreword from Lionel Robbins describing Hitler as "the foster-child of the inflation." Hitler’s rise to power occurred only ten years after the hyperinflationary crisis, and if an economic problem should be mentioned as part of the complex causes of his rise to power the depression and the ensuing unemployment should take the prize. In other words, although the monetarist view of hyperinflation developed by Bresciani is still dominant, other aspects of his analysis are now considered inaccurate. In particular his view according to which the fall of the Weimar Republic and the rise of the Nazi regime can be attributed to hyperinflation. On the latter see Holtfrerich (1986) and Feldman (1993).

[8] Keynes shared the Allied view of inflation (Keynes, 1923). However, Ferguson (1995b, p. 445) claims that his views on German reparations – which emphasized the ability to pay as a principle to be followed by the Allies – bestowed credibility to German officials that “were deliberately exacerbating inflation to undermine reparations.” Ferguson (1995b) and Macmillan (2001, p. 192) seem to indicate that Keynes’ calculations of the burden of the transfer problem were too high, and that hyperinflation can be ultimate explained by the malice of German officials. The diabolous ex machina of all quantitativist stories shows his face. It seems, however, more reasonable to believe that the constraints imposed by reparations were a serious cause of hyperinflation, and that a more benign Treaty would have lessened the profundity of the crisis.

[9] The rentemark was introduced in November 15 1923, and had its parity fixed at 4.2 million marks per dollar. Until the monetary reform of October 1924 the rentemark circulated together with the old paper mark. The idea of maintaining two currencies circulating simultaneously was exposed by Helfferich, but the actual plan suffered some modifications. See Holtfrerich (1986), and Burdeking and Burkett (1996).


  1. "In other words, causality runs from the exchange rate to the price level. That means that the rise in the price level cannot be related to the increase in the money supply. "

    This is not correct. The increase in the money supply can cause the exchange rate change, and that in turn the inflation.

    I have explanations for the mechanics of hyperinflation feedback loops in a number of different theories:


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