Inflation is still a major problem
15 July 2013
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12 July 2013
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Economic Theory
If you look at UK inflation over the last few centuries, you are immediately struck by the change that occurred after 1945. Until then, inflation took place mainly during major wars and then periods of deflation followed where prices largely came back down. So, why did that not happen after 1945 and what implications does that have for us today?
Why inflation took off after the war
My new book shows that there are a number of factors. One of the main reasons for the change was the adoption of Keynesian thinking by governments around the world. Politicians simplistically took from the General Theory the idea that inflation was a necessary consequence of high employment.
At the same time, the UK emerged from World War II with debts of 237 per cent of GDP. Encouraging inflation helped to reduce the debt burden. The policies that encouraged inflation were largely justified on the grounds that inflation would help employment levels.
On the other side of the Atlantic, the US also encouraged inflation by following a policy of monetary expansion and specifically tasked the Fed in 1951 with targeting a persistent (low) level of inflation. What the US did mattered critically for the UK because of Bretton Woods. The UK then imported extra inflation from the US because of the pegging of the currencies. Indeed during that period, UK and US inflation had a correlation of over 70 per cent. In more recent times, the Bank of England has had an overt target for positive inflation too.
The other two factors that have encouraged inflation in the UK are the rapid expansion of the money supply (especially in the 1970s and 1980s) and the increase in commodity prices – though the effect of the latter is very much a ‘one-off’ rather than creating continuing inflation. Rises in commodity prices have been exacerbated by the long-term decline in the value of the pound and repeated devaluations, themselves a consequence of monetary laxity. The chart below summarises the main causes for all the inflation peaks since 1940.
Inflation today
All these factors persist and prices continue to rise almost unabated in the UK. For example, prices have gone up by about a half since the millennium.
Source: ONS
Why inflation took off after the war
My new book shows that there are a number of factors. One of the main reasons for the change was the adoption of Keynesian thinking by governments around the world. Politicians simplistically took from the General Theory the idea that inflation was a necessary consequence of high employment.
At the same time, the UK emerged from World War II with debts of 237 per cent of GDP. Encouraging inflation helped to reduce the debt burden. The policies that encouraged inflation were largely justified on the grounds that inflation would help employment levels.
On the other side of the Atlantic, the US also encouraged inflation by following a policy of monetary expansion and specifically tasked the Fed in 1951 with targeting a persistent (low) level of inflation. What the US did mattered critically for the UK because of Bretton Woods. The UK then imported extra inflation from the US because of the pegging of the currencies. Indeed during that period, UK and US inflation had a correlation of over 70 per cent. In more recent times, the Bank of England has had an overt target for positive inflation too.
The other two factors that have encouraged inflation in the UK are the rapid expansion of the money supply (especially in the 1970s and 1980s) and the increase in commodity prices – though the effect of the latter is very much a ‘one-off’ rather than creating continuing inflation. Rises in commodity prices have been exacerbated by the long-term decline in the value of the pound and repeated devaluations, themselves a consequence of monetary laxity. The chart below summarises the main causes for all the inflation peaks since 1940.
Data source: Inflationtaxbook.com
Inflation today
All these factors persist and prices continue to rise almost unabated in the UK. For example, prices have gone up by about a half since the millennium.