Inflation of prices a danger involved in over-expansion

1 J. L. Laughlin, The Principles of Money, ch. 4.

Prices do not change uniformly or instantaneously

This protracted and uneven readjustment of prices, apart from final general inflation, may itself involve certain serious consequences. In the first place, an increase in the price of a given commodity may be interpreted by those engaged in its production as an indication of an increased demand for such commodity, and such producers are accordingly led to take advantage of the supposed increase in demand by increasing their output. In the final outcome, however, there may not as a matter of fact be such an increase in demand, indeed there may even be a falling off. To the extent that there is increased production to meet a falsely conceived increase in demand there is maladjustment of production that can have only unfortunate results not merely for those immediately concerned but finally also for all society.

Another source of possible difficulty is to be found in the fact that some incomes are fixed or are slow to respond to changes in price. A rise in prices is a real hardship to holders of bonds and similar securities bringing in a fixed money return, because, with rising prices, fewer and fewer things can be purchased for a fixed money sum. Then it is usually conceded that wages respond but slowly to changes in the price level, and, in so far as that is the case, it means that with rising prices of the goods purchased by laborers, the "real wages" of labor tend to diminish. Similarly, a rise in prices may involve a scaling down of debts, as far as real command of goods is concerned, and this is held to be an injustice to creditors.

The greatest danger of overexpansion, however, is that inflated prices stimulate unhealthy speculation, which causes capital to be diverted into unproductive channels and which usually ends with panic and depression. Rising prices have a stimulating effect on all business men. With prices moving upward confidence in the future is greatly strengthened. Output in established enterprises is increased and new ventures are seized upon with avidity. Difficulties are discounted while promise is magnified. In short, rising prices, irrespective of causes, are pretty generally considered to be synonymous with prosperity.

Price anges ay sug-st un-irranted inclusions nd also adjust-ents in al come inflated rices imulate peculation

But the confidence that characterizes boom times is not discriminating. It sheds its effulgence on the bad as well as on the good. Ventures that in saner moments would be regarded with circumspection are entered into by otherwise conservative men with uncritical assurance. Credulity seems at such times to displace sober and searching judgment. A fever of speculation sets in. Initiated in first instance, perhaps, by a rise of prices, speculation tends to carry prices still higher, and then feeding on what it creates it grows ever stronger and more violent. Capital is overinvested in many lines and completely mis-invested in a few. Obligations are assumed that can never be met. Finally, somewhere in the mutually sustaining threads of the complicated credit network, a break occurs. Some big firm fails. The credit structure crumbles. Prices tumble headlong. Economic production comes almost to a standstill. Thousands are ruined. Optimism is engulfed in gloom. Then little by little confidence is restored, the outlook becomes favorable and the situation again approaches normal. The price that is paid for such a wholesome chastening is, however, incalculable. The chastening should never be necessary.

But how to avoid it? There is the rub. Speculative fevers have come and have gone in more or less frequent if not regular cycles in the past.1 Numerous theories have been advanced to explain them, and equally numerous proposals for preventing them have been advocated. No attempt is going to be made in this place to expound another theory or to advocate another remedy. But what it does seem necessary to say is that, to the extent that it is possible to make provision against it, undue expansion of credit should not be added to the elements which, when appearing concurrently, provide the congenial environment for the development of speculative manias.

Speculation leads to mis-production

Expansion of credit ought to be controlled

1 For the most scholarly discussion of business cycles that is now available see Wesley C. Mitchell's Business Cycles.

There is, however, no divine intelligence to which appeal can be made to ascertain when undue expansion has set in. Purely human agencies have to be relied upon, and these are at best never certain or infallible. The accepted test, however, so far as the banks are concerned, is the relation between liabilities and reserves. Experience teaches what the normal relation ought to be. For individual banks or for particular communities there may be, as will be shown presently, an automatic checking up. But for the nation as a whole, there ought to be somewhere an agency strong enough to hold the situation to the normal, when, considering all the circumstances involved at a given moment, there seems to be a tendency toward departure from normal in the direction of credit inflation.

Inflation may, however, develop passively as well as actively. That is to say, if credit is not promptly withdrawn from use as the need for it declines a relative excess may remain in existence even though such excess was not in first instance intentionally created. Bank credit can originally be expanded only if there is a demand for it. The demand for it, as has been seen, is a complicated matter of confidence, business outlook, etc. The bank may stimulate demand by offering accommodation at low rates, but before general expansion can take place the other circumstances involved must also be favorable. In times of shattered confidence the lowest rates offer little inducement to borrowers. But when attendant circumstances are favorable it is possible for the bank to increase its obligations to a point which involves dangerous inflation. On the other hand, it has already been explained that demand for bank credit does not remain constant, that there are normal increases in demand and normal decreases. It is understood also that the expansion of bank credit to meet an increase in demand is, leaving possible legal restrictions out of account, within the.bank's control. Contraction of bank credit when demand falls off, however, is not necessarily within the bank's control. Contraction is possible only when those who hold the instruments by means of which bank credit is brought into use return them to the bank.