View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

On delivery:
September 25, 1965 - Philadelphia
October 2, 1965
- Los Angeles


Karl R. Bopp, President
Federal Reserve Bank of Philadelphia

Before the

Eastern and Western C.L.U. Educational Forums and Conferment Exercises
Sponsored by the American College of Life Underwriters and the
American Society of Chartered Life Underwriters
10:00 a.m. to 12:30 p.m., on
Saturday, September 25, 1965, in Philadelphia, Pennsylvania, and
Saturday, October 2, 1965, in Los Angeles, California


Karl R. Bopp

Among the reasons that Dave Gregg asked me to discuss Forces of
Inflation and Deflation with you are, first, that the balance of these forces
is of enormous importance to all of us and particularly to life underwriters
who deal in long-term money contracts; and, second, because there is a wide­
spread view that the economy of the United States suffers from chronic long­
term inflation.

It is for this latter reason, incidentally, that I shall

concentrate on inflation although the consequences of severe deflation are even
more devastating.

More specifically, I want to talk about what inflation is

and what damage it can cause in an economy such as ours.
some of the causes of inflation.

Then I want to outline

Finally, I should like to look at the problem

of price stability in the context of our other economic goals and comment briefly
on the recent behavior and outlook for prices.
What, then, is inflation and what sort of damage can it cause?


discussing what inflation is, I should like to say what it is not. Inflation is
not just a price rise in one or a few goods.

On the contrary, price fluctuations

play a vital role in a free enterprise economy.

Price changes in individual


commodities may be no more than signals from the free market.

Increases are

green lights, as it were, indicating that consumer demand is rising more
rapidly than supply.

The green lights signal producers to expand plant and

hire more workers, to increase output.
into the market.

And they signal new producers to come

Correspondingly, decreases in prices are red lights which

signal producers to reduce output.

In other words, changes in individual prices

serve to allocate scarce resources of land, labor and capital to the production
of the goods consumers demand and which are most profitable to produce and away
from the production of goods already in relative oversupply.
There are imperfections and frictions, of course.

Things do not work

so smoothly or so quickly as Adam Smith and some others believed.


as I see it, this is basically the way in which our economy operates:


consumer dictates, the quest for profit motivates, and the price system
Inflation, then, is something different from individual price
fluctuations, such as the housewife sees in the supermarket from time to time:
pork and butter a few cents more this week, coffee and potatoes a cent or two

Inflation is a more insidious thing.

upward movement in the whole range of prices.

Inflation is a general and persistent
During a severe inflation, the

price of virtually everything rises and the purchasing power of money corres­
pondingly declines.
What are the dangers and difficulties of inflation?

The most obvious

difficulty is simply that it costs more to live; more dollars must come out of
your pocket and mine for the daily necessities of life.

But inflation creates

more far-reaching problems that may be classified under three broad headings:
(l) it brings random and inequitable changes in the distribution of income and
wealth; (2) it may contribute to severe economic instability —

the booms and


busts of the business cycle; and (3) it may undermine and inhibit economic

Let us look briefly at each of these problems.
Inflation redistributes wealth and income inequitably because it

rewards not in terms of an individual's contribution to production but rather
gives to those with strong bargaining positions and those who own physical
assets (directly or indirectly) what it takes from those with relatively fixed
incomes and those whose wealth is held in fixed money form.
I need not remind you, who have dedicated yourselves to life under­
writing, that your customers are among the great losers from inflation.


rare exceptions, your policies and your annuities are written both for long
terms and for fixed dollar amounts.

Compound interest is so powerful that even

a so-called moderate rate of inflation has devastating effects on financial
planning over less than a single lifetime.

Consider a school teacher, age ¿-,

who enters a contract for an annuity for $X for a year, beginning age 65, on
the assumption that it will enable him to live comfortably in retirement.
A 3 per cent annual increase in the cost of living would reduce the purchasing
power of his annuity by more than half!

And the earlier he starts, the greater

the havoc to his retirement!
Inflation picks the pockets of the 120 million holders of life insurance
policies, the 39 million shareholders in savings and loan associations, the 2k mil­
lion employees with pension rights under private plans, the 66 million covered by
social security, the holders of bonds, including savings and other Government bonds
as well as private bonds.

It harms those with relatively fixed incomes.

Those who gain from inflation include workers in highly unionized
industries who are able to gain acceleration clauses, speculators who guessed
right, and those generally who own physical property, including inventories,
that appreciates in value.

Another broad category of problems I mentioned earlier is the adverse
effects inflation can have on economic growth.

These effects stem directly from

the income and wealth distortions just discussed.
Let me explain in more detail what I mean.
and a growing population must have —
or improved —

A growing industrial economy

if the standard of living is to be maintained

a proportionate growth in capital.

Only with such a growth in

capital can new plants be built to provide goods for a growing population.


if new plants are built can the growing population find employment and hence
income to maintain and increase its standard of living.
To illustrate how real and pressing this problem is, the President’s Commit­
tee on Manpower included the estimate that 1.5 million new jobseekers will enter the
labor force each year between now and 1975* To provide these people with goods
and with jobs, industry must expand.

Industry can expand only if savers and

investors are willing to provide funds for this expansion.
Now suppose we should have a severe inflation in this country.
quite possible that our citizens —
gnawed away —

It is

seeing their incomes and their past savings

would be reluctant to commit new funds to savings accounts, bonds,

insurance policies and other forms of fixed, dollar assets.

The tendency would be

to consume instead of save, or to put money into commodities, real estate, equity
securities, and other forms of investment that would provide a hedge against rising

We could become a nation of speculators instead of savers and our growth

rate and standard of living would suffer.
But inflation endangers not only the long-run process of saving and investment
(and hence our long-run growth).

It also can cause serious short-run trouble.


can aggravate the boom and bust phases of the business cycle, with all of the
human misery and suffering which this entails.
some of the ways this can happen.

Let me describe in greater detail

Inflation at the outset tends to push business profits up.
at least two reasons for this.

There are

First of all, the process of production is a

lengthly one in which the businessman buys before he sells.

He buys countless

raw goods to be funneled into his factories and machines and he usually keeps
some inventory of his finished products.

If, month after month, prices are

rising, then this stock appreciates on his hands.

He is continually selling at

a price better than he expected and. hence securing a windfall profit.
These profits are inflated for another reason.

It is clear that a manu­

facturer wears out his plant and. equipment as he produces his output.
and tear, or depreciation, is a cost of production.

Such wear

By the time the asset is

completely worn out, enough depreciation should have been charged to replace it.
If, however, depreciation is computed on the basis of original cost and prices
have risen during the life of the asset, the depreciation allowance will be
inadequate to replace it.

The cost of depreciation will have been understated and

profits correspondingly overstated.

George Terborgh has estimated that the

inflation in the decade 19^7 to 1956 resulted in overstating corporate profits by

$lkk billion.

Reported profits were $187 billion, whereas true profits were
It does not take much imagination to appreciate that business

decisions may be irrational if they are based on the assumption that profits are
30 per cent higher than they really are.
Here, then, sits the businessman, his profits inflated by windfall
inventory gains and by understated costs.

The future looks rosy indeed.

Expectations of future sales and profits lead him to expand his plant and equipment.
Rosy expectations also lead him to accumulate greater inventories, both because
his sales are rising and because he desires to lay in more stock before the prices
of that stock rise.

In short, we have a typical inventory and capital spending

Things go on rising for a while but then the bubble bursts.

The business­

man realizes that additions to productive capacity have outrun consumer demand.
He realizes that his inventories are high relative to any reasonable forecast of

He cuts back on inventory purchasing and capital spending.

The firms

which supply him with inventory and which build his plant and equipment are forced,
to cut back their production and lay off workers.
a pond, the effects spread.

Other firms selling to the second group of suppliers

and builders find sales declining.
income falls.

Then, like a pebble dropped into

More workers are laid off and hence consumer

With income declining, business sales fall even further.

In short,

we have the familiar downward spiral of business into the depths of recession, a
recession which will continue until top-heavy inventories and excess plant capacity
are corrected.

Once more inflation has helped breed the excesses which result in

These, then, are some of the dangers of inflation:

an inequitable and

haphazard redistribution of income and wealth, a tendency to undermine the savingsinvestment process and to retard economic growth, and finally, an aggravation of
the expansions and contractions of the business cycle.
If inflation has these undesirable effects, we might well select as a
next point of discussion the reasons for inflation.

Only if we understand why

and how inflation develops can we hope to hold it in check.
Basically, inflation develops when the effective demand of consumers,
business, and government is excessive relative to our ability to produce.

At the

risk of some oversimplification, the problem is one of "too much money pursuing
too few goods."

But why does a situation develop in which "too much money

is seeking too few goods"?
this question.

A glance back into history will throw some light on

A chart of wholesale prices* since the beginning of the 19th century
reveals four peaks of inflation sitting like majestic stalagmites in the stratosphere
of the kingdom of prices.

Each of these was associated with war:

the Civil War, the First World War, and the Second World War.

the War of 1812,

Somehow, then,

inflation seems to he associated with war.
A somewhat closer inspection of the chart of wholesale prices reveals four
footmen to the royal stalagmites, four lesser but still significant periods of

The first of these, from 1832 to 1837 > was associated with the rapid

expansion of state banks as a result of President Jackson's war on the Second Bank
of the United States (and hence with a rapid increase in the ability to create

The next three periods also had to do with changes in the monetary base:

gold discoveries in California and Australia (l848 to 1857); more gold discoveries
in the Klondike and Cripple Creek (l897 to 1909); and finally, a revaluation of
gold in the Great Depression (1932 to 1937).

Thus, inflation would also seem to

be related to money creation.
To tie the two phenomena of war and money creation more closely together
(and to show in more detail how they relate to inflation), let us move in history
a bit closer to the present.

Let us look at the experience of World War II.

It is estimated that total military expenditures of the combatant nations
in World War II surpassed $1 trillion, over six times those of World War I.
Producing goods in such magnitude for war was inflationary.

Civilian output, of

course, was reduced to a minimum as productive facilities were turned to weapons.
Yet, still the wartime production workers received wages for their work.
must be paid whether they produce munitions or automobiles.


Since workers don't

buy munitions, however, the wages which they might have spent on cars, appliances,
and the like were socked away for a day when the enemy was vanquished.
words, a huge volume of liquid purchasing power was built up —

In other

the money supply

of the equation implied in the phrase "too much money pursuing too few goods."

*It is, of course, hazardous to compare prices, especially over very long periods,
because of such factors as changes in the commodities and weights which comprise the
index. The index, however, is accurate enough to support the very general statements

that I shall make.

Yet the war was inflationary in still another way, the way it was
paid for.

The funds not raised by taxes during the war were obtained by

borrowing, by selling bonds.

Bonds sold to individuals and savings institu­

tions came out of savings and thus were not so inflationary.

But the billions

of dollars worth of bonds sold to commercial banks during the war were paid
for with newly created money — money right off the keyboard of the bookkeep­
ing machine, as it were.
So long as price controls and rationing were enforced the inflationary
potential of all this liquid purchasing power could be at least partially con­

But then when the controls were removed the wartime dollars came

home to roost.

They descended on a market place hardly prepared to accommodate

such massive demands, and prices rocketed.

This was the environment in which

savers watched as their savings dwindled away in purchasing power.

This was

the environment in which businessmen experienced windfall profits, in which
inventories appreciated in price and profits were inflated because of inadequate
depreciation charges.

This environment and its aftermath also set the stage

for what later was called "cost-push" inflation — a euphoric environment in
which workers could push up wages faster than productivity and business could
pass these costs along to the consumer in the form of higher prices.


in short, was the postwar inflation and the motive force which propelled it.
Let us now turn to the future.

How are prices likely to behave as

we advance further into the decade of the sixties?
There have been enough major surprises in the history of prices to
suggest caution in looking forward.

Who predicted that the gold discoveries

would bring an end to the inadequacy of gold which had so much to do with the
persistent downward trends of prices until the late 18^0's and l890's?


universal generalization that every major war is followed by falling prices
was broken after the Second World War, despite the convictions of Sewell Avery.


I think we can learn something from history.

important lesson is that the future of prices is not inevitable;

The most

it lies in

our own hands, a result of human policies and decisions.
How are the great historic forces o f inflation and deflation likely
to operate in the future and how m a y they be brought under control?
What about war, the great historic force of inflation?

I have no

better foresight than anyone else concerning the probability of an all-out

Should it occur,

it seems to m e that the magnitude of destruction:

of people, mate r i a l things, and records (including records of primary and
derived ownership) would be so great that anticipatory attempts of individuals
to protect themselves financially w o u l d be nullified.

Survivors of the nominally

victorious powers wou l d have to begin life anew in terms of the material r e ­
sources still available.
O n the other hand, continuation or even significant intensification
of the cold war could and in m y judgment wo u l d be handled without serious
inflationary consequences.

M y primary reason for reaching this conclusion is

that w e have reached a somewhat better understanding of the m o n e y illusion,
o f the difference between real costs and finance.
We still have a lot to learn and w e shall probably,

I do not want to exaggerate.
as in the past, not do so

w e l l as we could if we followed the most intelligent advice.
have m a d e progress and we have enormous and growing resources.

Nevertheless, we
O f course, we

would face the prospect of rising tax rates and slower expansion in social
services; but these hardships could b e borne.

For the immediate future, we

also have the prospect of a rapidly expanding labor force as the postwar ba b y
crop comes o f w o r k i n g age.

We could,

if need be, devote m u c h m o r e to defense

without creating inflation.
The other great cause of historic inflation has b e e n the surprise
d iscovery o f large n e w gold deposits.
prises in the future?

What is the likelihood of similar s u r ­

In considering this question we m u s t distinguish between


form and substance:
to the form,

the form is gold; the substance is monetary policy.


it seems to m e not bey o n d the realm of possibility that a nuclear

physicist might one day discover a m ethod of producing gold at a very cheap

As to the substance,

I have not the slightest doubt that such a d i s ­

covery would not be permitted to produce a major inflation.

The history of

monetary policy has been one of gradually reducing the tyranny of gold.
link to gold has been made more and more tenuous.
nuclear gold,


In the event of cheap

it probably w o uld be broken altogether.

So m u c h then for gold and war as possible causes of inflation in
coming years.

Are there other reasons to expect that the second half of the

sixties might be characterized b y u pward pressure on prices?

Some would say

there are reasons to believe this, that an economy geared to the goals of
m a ximum employment and rapid growth must b y its very nature veer in the d i r e c ­
tion of chronic inflation, that inflation is inevitable, even desirable, as
a stimulus to these other goals.
The vi e w that m a x i m u m growth and inflation w ent together like a set
o f Siamese twins had its roots in the early postwar period.

As m u c h of the

w a r effort was shifted to civilian purposes, we ha d rapid and w idespread
increases in the standard of living.
and some

As already noted, we also ha d inflation

c o n c l u d e d that inflation and r apid rises in the standard of living

go hand in hand.

"If this is what inflation means,

was the conclusion.

M a n y people,

let us have more of it"

including some leading economists, were will'

ing to accept rather cavalierly significant increases in the price level as a
p o ssibly necessary cost of maintaining full employment, and they were ready
to predict a rising tre n d of prices in th e future.
These were the ideas of the mid-fifties.
ideas against the "facts" of the case.

Let us now examine these

The inflation theorists based their argument on an appeal to history,
citing as evidence of the linkage between growth and prices historical periods
in which both rose together.

Now I happen to have spent a considerable num­

ber of man-years trying to squeeze uniformities or principles from historical
evidence in the specialized field of central banking.

I have found such study

rewarding, but I must confess that I also have found it slithery and full of
In the matter at hand, I find that at different times rapid economic
growth has been associated not only with rising prices, but also with falling
prices, as during the latter part of the 19th century, and with relatively
stable prices, as during the 1920's.

It seems to me difficult to demonstrate

historically that rising prices are a necessary condition for rapid growth.
What has been the experience in more recent years?

In the past few

years we have maintained a rapid rate of growth, perhaps not so rapid as we
would like (in view of the unemployment which has persisted) but still a
rate high by historical standards and one which has helped gradually to push
down the rate of unemployment.

What has been the behavior of prices during

these years? Have growth and inflation gone hand-in-hand?
The fact is we are now living in the most sustained period of sta­
bility in the official wholesale price index in the history of our own or any
other highly industrialized society.
At first glance the notion of chronic inflation seems to be supported
by the behavior of the official consumer price index published by the Bureau
of Labor Statistics, which has risen at a rate of about 1 - per cent a year
for the last eight years.
But how accurate is this index?

No one knows for sure.

We do know

that the Price Statistics Review Committee of the National Bureau of Economic

Research has this to say about both this and the Wholesale Price Index:
If a poll were taken of professional economists and
statisticians, in all probability they would designate
(and by a wide majority) the failure of the price
indexes to take full account of quality changes as the
most important defect in these indexes. And by almost
as large a majority, they would believe that this fail­
ure introduces a systematic upward bias in the price
indexes — that quality changes have on average been
quality improvements.

The evidence is less than convincing that on average consumer prices
have risen since 1957*

And it is not unlikely that wholesale prices have in

fact declined.
In my view, then, inflation is not an unavoidable characteristic
of a society aiming at rapid growth and maximum employment.

Indeed, in my

view relatively stable prices, not rising prices are a prerequisite to the
realization of our other goals.
This view, of course, is not mine alone.

There is now widespread

agreement that stability of the price level is and should be a major objective
of economic policy.

This certainly is the major purpose of the so-called

guidelines developed by the President's Council of Economic Advisers.


guidelines are based on the assumption that if wage rates increase more rapidly
than efficiency or output per hour, the result will be either rising unemploy­
ment or rising prices.

If, however, wage rates rise in proportion to increas­

ing efficiency, prices can be held stable.
Rising wage rates over time are consistent with a stable price level
over time because "real" costs undoubtedly will continue to decline as invention
and improved management techniques increase efficiency or output per man-hour.
Although there are always Cas sandras who judge that material improvement must
end some day, the burden of proof remains on them.

Hitherto, they have been

proved wrong, decade by decade, ever since the dawn of the industrial revolution.
The human mind is too fertile to believe that it will not continue to have new


I had reached this optimistic note in my preparation when Herb Graebner
reminded me, late in August, that I had agreed to submit a manuscript before
September 1.

That, you may recall, was before the settlement of bargaining in

the steel industry.
I had no inside information on the steel negotiations.

It must be

obvious that I was more optimistic than many that a non-inflationary contract
would be reached.

Some of my friends accuse me of being an eternal optimist;

but it seems to me that the actual contract justified the optimism

— and

is encouraging in the longer run.
Everyone, of course, has his own precise interpretation of the contract.
It seems to me that Gardner Ackley, Chairman of the President’s Council of
Economic Advisers, gave a reasonable interpretation before the American Statistical
Association in Philadelphia on September 9*
Let me quote briefly from Mr. Ackley's statement:

The steel settlement last week was a victory for the course
of moderation and responsibility that has marked our labor
history over the past five years. There has been so much
said that could confuse the casual observer that I want to be
very clear about how we regard that settlement. Its elements
have been priced out by the parties as adding up to between
51 or 52 cents an hour. Our pricing of it is closer
to the lower end of that range— let's say about ^8 cents.
One Government expert prices it even below k j cents. I
would remind you that the interests of the parties to the
settlement may, quite innocently, influence their pricing
of the settlement. Judging only by the newspapers, for
example, the union apparently held during the negotiations
that some elements included in the final package cost
appreciably less than they now agree they are worth.
But even U8 cents is interpreted by some observers as
well in excess of 3*2$. They reach this conclusion by a
process of reasoning for which I can find no shred of
logical support. They argue that this is a 35"*nonth settle­
ment beginning September 1. On that basis, they conclude
that this was a 3*5 to 3•7$ settlement.
But the l- cents, or whatever figure you take, includes
the ll|- cents granted as of last May 1. If you want to
treat the settlement as running from September 1 you have
no choice but to deduct this 11- cents. You then must
calculate the remaining 3&i cents increase against a base
which includes the Hj> cents. Total hourly compensation
last April was a shade above $^Al. Adding the 11§- cents
brings the base as of September 1 to about $^.53* Based on
this calculation, the percentage comes out well below jf>.



But this is not sensible either. The only
reasonable approach is to treat the total cost as
including the ll|- cents downpayment, in a settlement
running for 39 months beginning May 1 , 1 9 6 5* and
calculated on the April base of $4.^1. On this
basis, l- cents per hour comes out to a nice,
guidepost figure of 3*2$.
This digression so far has been concerned primarily with identifying,
quantifying, and vilifying the process of inflation.

The task given me, however,

included also that of commenting a bit on deflation.

Indeed, the word deflation

appears in the title of this paper.

So as to maintain the balance and integrity

of my charge and my title (and also to give this most trying and humanly depriving
economic problem its full due),

I should like now to say just a few words about

The steepest of the great historic slides into deflation have been those
that followed wars.

As we look to the future, it is significant that we had no

economic collapse after the last war.

This was no mere accident.

Fears of a

postwar collapse produced public and private plans and programs that prevented its

It is true that the return to civilian life was so rapid that some

called it military disintegration rather than demobilization.

But we also had

developments such as the C.E.D. and passage of the Employment Act of 19^6.


the international front we had the creation of the International Monetary Fund and
the International Bank for Reconstruction and Development.
The other great deflations of history have been associated with inadequate
supplies of money.

It is these depressions that have had the most devastating

effects upon the whole social fabric.
In my own view, we have learned the lesson of clearly inadequate supplies
of money.

You will aggravate but cannot liquidate a depression by calling loans

and destroying money.


In this connection, it is significant that responsible leaders of
the western world are already developing plans to assure that prosperity will
not be imperiled because of inadequate international liquidity.
Again, some might criticize me as overly optimistic in my assessment
of the probability of future deflations.

In my own defense, however, I must

say again that I have faith in human ingenuity and in human intelligence.
lessons of the past are there.
read it backward.


Though we must live history forward, we can

Herein lies my hope for the future.