It’s not stagflation, but inflationary impoverishment

May 17, 2018·Alasdair Macleod

It is a matter of personal interest that it was my uncle, Iain Macleod, who invented the term stagflation shortly before he was appointed shadow chancellor in 1965i. It is no longer used in its original context. From Hansard (the official record of parliamentary debates) 17 November that year:

We now have the worst of both worlds —not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of "stagflation" situation and history in modern terms is indeed being made.ii

The inflation that Iain was referring to was of wages, which were averaging an increase of 6.2%, and rising, and stagnation in production, which had declined from an index of 134 to 131. It was this divergence that gave him the opportunity to invent this portmanteau word. It has now passed into more common use to describe an economy that fails to respond to the stimulus of monetary inflation.

Its use in this context is therefore different from the original. The idea that stagflation exists as an economic phenomenon is only really true for neo-Keynesians, who view inflation as economically stimulative, and its failure to stimulate perplexing. In this sense it is frequently applied to conditions today, where massive monetary stimulus does not appear, so far at least, to have brought about the economic growth that might have been expected from it.

The explanation why monetary stimulus has not worked as intended is not difficult to understand, but for neo-Keynesians it is unpalatable. This article takes its cue from the misapplication of the stagflation term to explain why Keynesian stimulation of the economy is bound to fail, and symptoms commonly but incorrectly referred to today as stagflationary are simply a reflection of the costs of monetary policy imposed on ordinary people.

It involves the reinstatement of Say’s law to its rightful place, not as Keynes misleadingly described it, that supply creates its own demand. It requires an understanding of why inflation destroys wealth, the opposite of the creation of wealth that a stimulus implies. And it necessitates an appreciation that GDP is no more than a misleading accounting identity covering only a minor part of the economy. I shall explain the relevance of these topics in turn, and why stagflation is an inappropriate description of some sort of intermediate condition between inflation and deflation.

Say’s law

According to Say’s law, we work in order to consume, which is the purpose behind the division of labour. This is self-evidently true, and it is a mystery why anyone can think otherwise. Keynes resorted to sleight of pen by giving it a definition which was wrong, mysterious and therefore hard to comprehensively criticise. However, if we return to the point Jean-Baptiste Say made over two centuries ago, there can be no doubt he was right. Even the unemployed, the retired and children are included in Say’s law, because if they don’t work, someone else has to foot the bill out of their own production.

Say’s law was an insurmountable obstacle for state planners. Keynes needed to dispense with it to make room for the state to have a role intervening in our everyday affairs. Keynes denied the equation’s validity and played on our desire to believe that money rained upon us from the state is true money. Say’s law tells us this is impossible, but by establishing the independence of money from production, Keynes went even one step further, and divorced production from consumption entirely. So strong is the collective desire that this something-for-nothing formula is true, that we willingly subscribe to it.

But there is a cost, which is perhaps difficult for the ordinary citizen to grasp. If the state taxes the wealthy or debauches their money to redistribute wealth, the wealth is simply dissipated to the point where it is no longer wealth. It ends up paying the bureaucrat’s salaries and being spent on welfare. When it is invested in public services, it is done so wastefully. But above all, it is the state that impoverishes its citizenry through taxes and monetary debauchment, and it is the unwritten objective of monetary policy to enrich the state.

The justification for the state’s destruction of wealth relies heavily on the perception that saving plays no constructive role in creating demand, so it can and must be sacrificed. But Keynes went even further, claiming that increasing savings reduces aggregate demand which in turn lowers total saving. For Keynes, the danger is at its most acute when the economy falls into recession, when the increase in savings, driven out of consumption by fear of the future, accelerates the decline in aggregate demand, and therefore brings about a decline in savings themselves.

Keynes called this the paradox of thrift.

This nonsense comes from a lack of appreciation of the role of savings, which are more accurately described as deferred consumption. Money saved does not disappear, as Keynes implies. It is redirected through the financial system to investments in the means of production, made profitable by the reduction in interest rates that results from a downturn in immediate consumption. In fact, it is the accumulation of investments in production that forms the backbone of a country’s wealth and provides the higher standard of living we all aim to achieve. But no, Keynes stood this on its head and told us that money not spent on immediate consumption was a wasted resource.

Keynes’s solution was to discourage savings and replace them for the purpose of funding investment with an expansion of the quantity of money, including bank credit. What he kept silent on is that the extra money dilutes the purchasing power of the existing money in circulation. And he gets away with it because of the lead time between the increase in the quantity of money and the effect on its purchasing power, which can never be pinned down through the national statistics to establish cause and effect. The Keynesian stimulus is therefore no more than a false trick, which relies on the debasement of money. You cannot claim an economic improvement when everyone pays for it through currency debasement. Its stimulation (and even that effect is debateable) is only short-term being based on monetary prestigitation, and reverses when market prices reflect the dilution of purchasing power from monetary expansion.

Wealth destruction is the result

It is clearly the case that a Keynesian stimulus dilutes the purchasing power of money already in existence. From this, it follows there is a transfer of wealth from those who own money. The beneficiaries are the banks who create the new money and their favoured customers who first receive it as loans, including the government. These borrowers get to spend it before prices are driven higher by the new money entering circulation. It is important to understand that monetary inflation, instead of benefiting the wider population, leaves it worse off. The process whereby this wealth transfer occurs was recognised by Richard Cantillon, a banker at the heart of the Mississippi bubble three hundred years ago. He had noticed that the influx of gold and silver from the New World into Spain had devalued their purchasing power, making goods more expensive in the ports where the gold and silver were first landed, and in the cities to which they were transported. This new money was gradually distributed as it was spent, driving up prices in the wake of the new money’s absorption. This came to be known as the Cantillon effect. For those late in receiving this new money, prices had already risen to reflect its dilution. Their savings bought less goods than they did before, but so far as their earnings were concerned, the effect was uneven. In an agricultural economy, the value of produce demanded by the early receivers would rise ahead of the new money reaching the producers more generally, while the prices of the more basic foodstuffs eaten by the country folk might remain unaffected, at least for a period of time.

A modern industrial and services-based economy is very different. The wealth transfer effect on income disadvantages those on fixed salaries, whose wages buy less as a result of higher prices. It handicaps those who lack the power to demand higher wages, relative to those that do. In the UK of the 1960s, there were powerful unions, predominantly in the nationalised industries, which were able to hold the government to ransom, demanding higher wages. This was the inflation element in Iain Macleod’s stagflation. These wage rises were granted despite the decline in their collective output, the stagnation element in the production index.

By turning a blind eye to the link between monetary and credit expansion and their effect on prices, Keynes would have assumed governments could contain the fallout from monetary policy. Monetary expansion then became the economic cure-all. This was only possible because Keynes had dismissed Say’s law and the cast-iron links between production and consumption were therefore removed. For the UK fifty years ago, it was a huge mistake, leading to economic underperformance, a declining currency, industrial and civil disruption, and an eventual bail-out by the IMF in 1976.

Gross domestic product

The third leg of our sorry tale is the shortcomings of the principal indicator of the state of the economy. GDP is a money-total of only that part of the economy specifically included. The most common measure of GDP is consumption-based, the total of goods and services sold to consumers as final products. It is obvious that savings, which are not spent on final products, deplete the GDP total, and it is therefore in the political interests of any government which measures its success by growing GDP to discourage savings. As noted above, Keynes handily provided the justification for discouraging savings with his savings paradox argument.

GDP should be noted more for what it excludes rather than what it includes, and as a simple accounting identity is fine only to a point. GDP might be described on similar lines to a company’s sales figures. But if you were considering buying shares in a company, would you do so only on the basis of historical sales information? If you did you would be in the habit of losing money, because it is the profitable success of future production that matters. Yet, econometricians and Keynesians fail to make any distinction between an economy’s history and its future. They assume as a default that in aggregate we will purchase tomorrow what we bought in the past. There is no room in this approach for progress or change.

For this reason, GDP is a sterile backwards-looking statistic. Furthermore, the production of all goods and services takes time between the assembly of raw materials and the final product. None of this is logged in GDP, which only records final products. In a goods-based economy, these business-to-business activities (B2B) typically represent a total figure larger than GDP, while in a services-based economy, this B2B activity is not so large because of the shorter lead-times and lower complexity to product delivery. Nonetheless, in today’s US services-oriented economy, gross output, which is essentially B2B, still totals approximately 100% of additional activity to final product GDP.iii

The importance of B2B, which has only recently begun to be understood in the US (and unfortunately not yet elsewhere) is roughly half all non-financial economic activity in that economy and is driven by investment. In other words, B2B equates to and is additional to final consumption values represented by GDP. The only stable source of the investment that drives B2B is from savings, because bank credit fluctuates with the credit cycle. Yet Keynes dismissed savings entirely from his economic schemes, even wishing for “the euthanasia of the rentier”.iv

There is also the financial sector, where new money, intended to inflate GDP is initially tied up. The progression of monetary inflation through to prices and wages is delayed at the outset of the credit cycle by the route which it takes. Central banks suppress interest rates to encourage the expansion of bank credit for the stimulation of both consumers and industry. Monetary policy in effect sets in motion an expansion of credit by the banks for their benefit and for that of their favoured customers, who in the earliest stages of the credit cycle are not the producers of goods and services, but other financial institutions.

When confidence remains low on Main Street, on Wall Street there are clearly beneficiaries of lower interest rates. Governments, who issue bonds deemed to be riskless, take the opportunity to borrow at rates lower than free markets might otherwise demand, while owners of government bonds enjoy a significant increase in their wealth. Gradually, the wealth effect from asset inflation spreads, without at first any noticeable impact on GDP. It is only later, after bond prices have peaked, that money begins to flow in increasing quantities into the medium and smaller enterprises, which are responsible for the bulk of economic production in the private sector.

Therefore, as a measure of economic activity, GDP is frankly useless and misleading. It misses B2B and financial activity entirely and is a backwards-looking statistic. It conceals the transfers of wealth that result from economic distortions, as well as the general destruction of wealth from monetary inflation. It is not qualitative, being purely a quantitative measure of money that ends up being spent by consumers and ignores losses in money’s purchasing power.

Attempts to adjust GDP for inflation amount to double-counting, because if the adjustment was perfect, there would be no increase in GDP. We know this, because if we take a theoretical closed economy where everything was recorded, and the quantity of money was fixed, there cannot be any change in GDP. The fact there is a difference between nominal and inflation-adjusted GDP is down to the time taken for new money to fully enter into circulation, and because the statistical method has the watertight integrity of a sieve.

Any student of monetary inflations knows that they impoverish the ordinary people. The mechanism is summarised above. To ignore this suggests the Germans in 1920-23 must have been cock-a-hoop at the stimulus of monetary inflation, and the Venezuelans today are similarly blessed. The fact remains that inflation impoverishes. If it stimulates economic activity at all, it is only a temporary effect that rigs the numbers. The pre-Keynes classical and Austrian economists, who accepted and understood Say’s law and its implications broadly understood that inflation impoverished people. It seems modern economists are blind to the point.

This brings us back to the use of the stagflation term. When used to describe an economy that refuses to respond to the artificial stimulus from an increase in the quantity of money and credit, stagflation only makes descriptive sense for neo-Keynesians who fail to understand the true consequences of government interventions and deficit finances. It is not actually how the term was first used. They would be far better, if they have difficulty understanding the true effects of monetary inflation, in assessing the evidence of the effects before their eyes, instead of hijacking a term meaningless in this context.

i Iain Macleod was appointed Chancellor of the Exchequer after the Conservatives won the 1970 General Election. He died later that year.


iii It is only due to the efforts of Mark Skousen, Presidential Fellow at Chapman University, that the Bureau of Economic Affairs has begun to report gross output. Even so, most financial analysts appear unaware of its significance, or even its existence.

iv See the concluding chapters of Keynes’s General Theory.


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