When Inflation Was Good… or was it?

Paul Krugman chastises inflation hawk Paul Volcker in “When Inflation Was Good”. Krugman accuses Volcker of a “selective reading of history”, and then asks why the U.S. didn’t relapse into the Great Depression after World War II ended in 1945.

Krugman points out that prices rose sharply during and after the war, and speculates that the Federal Reserve accelerated the recovery by inflating away private-sector debt.  As evidence, Krugman cites this chart:

The first sign Krugman’s conclusion is in trouble is this:

“The big rise in prices during and after WWII arguably did a lot to eliminate the debt overhang, making it possible for the economy to enter a sustained, non-inflationary boom.”

Yet, price growth doesn’t eliminate debt, income growth does. Price growth without wage or profit growth worsens the burden of debt, rather than reducing it.  The ideal case is wage or profit growth without price growth (i.e., normal wage growth and low or negative inflation).

Krugman doesn’t specify whether the 1946-1948 inflationary episode caused either wage growth or profit growth. As it turns out, it doesn’t matter; he’s wrong on either point:

The graph above is the same 1939-1951 CPI data as Krugman’s graph. Instead of being indexed to 1984, however, it’s indexed to January 1947 to improve the scale. The graph also plots Corporate Profits (CP) and Personal Income (PINCOME) from 1947-51, the only years data are available. The Adjusted Monetary Base (AMBNS) series from 1939-1951 is included, to allow the reader to estimate the effects of monetary policy.  Some of these data points have been superseded by newer measures, but those newer measures weren’t available for the period from Krugman’s post.

The U.S. government expanded the monetary base throughout the Great Depression, and accelerated that trend upon entering World War II in 1941. U.S. government debt exploded from $40B to $120B between 1941 and 1943. The Federal Reserve cranked on the printing presses, buying U.S. debt with fresh dollars; prices began to rise as the dollar was debased.

In 1941, the U.S. government imposed rationing and price controls, artificially limiting CPI growth. Prices were still allowed to rise significantly, however, to keep producers in business. In 1945, the war ends, and the U.S. experiences a slight recession from the hyper-employment of the war (1% unemployment to 5%). The Federal Reserve tightens monetary policy from very expansionary to neutral. Price controls are weakened (but not abolished) in 1946, and prices explode. Inflation peaks in 1947, with CPI rising about 20% year over year. Growth begins in 1950, after four years of neutral to contractionary monetary policy.

By Krugman’s hypothesis, we should see evidence of significant increases in either personal income (wages) or corporate profits during the inflationary period (“the big rise in prices” as Krugman calls it). The problem is, no such trend can be seen: corporate profits trail the rising prices in fifteen of sixteen quarters, often by a broad margin; personal income trails the price increases until the 1950 rebound.

The 1946-1948 inflation hurt households and corporations by diluting purchasing power. The consumer price inflation rates in 1941-1945 were carefully controlled not with monetary policy but with price controls and rationing. Price controls, monetary expansion and rationing combine to force savings. Businesses have low supply thanks to the government’s additional money, but cannot charge the rate the consumer would bear. Consumers have the cash to consume more at the controlled prices, but insufficient supply due to rationing. A rational, law-abiding consumer will practice thrift, paying down debt and saving cash.

This artificial reduction in standard of living is what eliminated the overhang of private sector debt, setting the economy up nicely for a solid recovery in the 1950s. Over a decade of active government intervention during the depression, including monetary debasing, social safety nets and fiscal stimulus, had failed to produce that result. The result suggests that the government’s response to the Depression should’ve been to get out of the consumer’s way and accept the short-term pain of deleveraging.

It would’ve made for a healthier economy in the long run, without a war, and an aggressive reduction in post-war productive output. Krugman’s protests to the contrary notwithstanding, inflation was good for nobody in the 40s. The economy recovered in spite of the government’s monetary policy, not because of it.


About Matt Murphy

I'm a software engineer with a certain company you've probably heard of. In my free time, I'm an advocate for individual liberty and free markets.
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