Latent Inflation: Problems and Policies

International Monetary Fund. Research Dept.
Published Date:
January 1950
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IN TIME OF WAR, unless measures are taken to limit civilian demand, the aggregate demand for real resources for civilian uses and for war purposes invariably exceeds the available supply. This is an inevitable consequence of a war program, since it may be taken for granted that countries will not limit the resources they dedicate to carrying on a war. If a country engaged in war does not have an inflation problem, it is in fact not pushing its war effort to the maximum. Inflationary pressure is a natural by-product of war.

This was the common experience of every belligerent country in World War II. In some, as in the United States and Canada, an enormous expansion of output enabled a large part of the increased demand to be satisfied from greater production. In others, as in the United Kingdom, an import surplus financed by the liquidation of overseas investment, supplemented by lend-lease and foreign borrowing, provided resources that added to the supply available from gross national output. But neither greatly increased output nor a large import surplus was sufficient to prevent the development of inflationary pressures; this was as true in a fully controlled economy like Russia as in a comparatively free wartime economy like the United States.

In the occupied countries, the policies imposed by the enemy had the same inflationary effect as direct war expenditure. Enemy occupation, far from decreasing the pressure on resources, tended to increase it. Heavy occupation costs had to be met, and a considerable part of current output was exported to Germany without corresponding imports being received. Occupation costs produced heavy budgetary deficits met by borrowing from the public and from the banks. The export surplus resulted in large payments by the central bank to local producers, and these were represented by central bank claims on Germany.

If the increased wartime demand had been allowed to become effective, there would inevitably have been a sharp rise in prices, that is to say, an active inflation. Such inflation might have impaired the capacity of the economy to maintain production, and in particular to shift productive resources to war needs. Active inflation raises profits, and by making civilian production more profitable lessens the inducement to shift production from civilian to war uses. This is the primary reason why controls were imposed in the belligerent countries and even by Germany in the occupied countries.

There were also important social reasons for preventing active inflation. Essentially, the inflationary pressure resulting from war needs meant that the volume of real resources devoted to civilian consumption had to be curtailed. It would have been socially intolerable, particularly in view of the increasing inequality of income distribution associated with inflation, to permit the burden of this reduction of consumption to be allocated among consumers in accordance with their ability to pay inflated prices. To assure a reasonable distribution of real income, governments used price controls to make inflation less active, and rationing to limit consumption inequalities.

One danger arising from active inflation requires special emphasis. The reduction of consumption imposed by rising prices means also a reduction in real wages. Under such circumstances, labor is likely, in an attempt to maintain real wages and consumption, to press for an adjustment of wage rates. Since in wartime consumption cannot be increased, any rise in wages will cause a further increase in prices without in fact increasing the real income of wage earners. An upward wage-price spiral may be unavoidable if wage payments are allowed to determine the volume of expenditure on consumption and if consumer prices are allowed to determine its distribution.

During the war, price ceilings and rationing were imposed, inter alia, to assure consumers that, although their desired level of consumption could not be maintained, the purchasing power of their wages would not be reduced. Deficiencies in consumption would be compensated by additional savings which presumably would be available for consumption in the future. Thus the pressure for higher wages, which would inevitably have accompanied an active inflation, was held in check as workers were induced to regard the accumulation of savings as an adequate but temporary wartime substitute for the maintenance of consumption.

Repression of Spending

An attempt may be made to limit spending by the simple method of fixing the maximum prices that may be paid for goods. Supply being inadequate to meet demand at these prices, unspent income then remains in the hands of the public. This unspent income becomes unintended savings. Where supply shortages are not too great, the mere fixing of price ceilings may limit total expenditure sufficiently without imposing too serious hardships on any section of the community. The fortuitous limitation of consumption by price ceilings might, however, be unjust when applied to commodities of which even modest shortages would affect the well-being of the people. In such cases, if the opportunity to consume is to be distributed in proportion to needs, price ceilings must be reinforced by rationing. Where the supply of consumer goods of all kinds is very short, rationing may have to be applied to a large segment of consumer spending.

Restraints not unlike rationing must also be applied to limit the use of resources for civilian investment. Indeed, just because the productive resources used for investment are most suitable for the production of war equipment, limitations on civilian investment are needed in wartime even more urgently than limitations on consumption. For this purpose, governments may use such devices as limiting the financial resources available to industry for civilian investment, requiring prior approval for investment, or allocating investment materials. The resources released in these ways, through consumer rationing and investment allocations, can then be used by the government for war purposes.

The funds to pay for the resources devoted to war and other government purposes may be in part raised by taxation. To that extent the incomes available to individuals and to business firms are diminished. The wartime needs of governments, however, are usually so large that the full financing of war by taxation has never been possible; governments have therefore relied on borrowing. When securities are sold to individuals or business firms (other than banks), the gross savings that correspond to the wartime deficit of the government take the form of holdings of government securities. When securities are sold to the central bank or to commercial banks, the savings of the public and of business firms to this extent take the form of currency and bank deposits.

The wartime repression of spending in World War II left consumers with greatly increased savings, much of them unwanted in the sense that additional consumption would have been preferred. At the same time the repression of outlays for investment left business firms with large liquid resources in the form of cash balances and government securities corresponding to their wartime gross savings. These resources were equal to the undistributed profits of business firms plus the liquid reserves resulting from the net reduction of their investments in inventories and equipment. Consumers were left with excess wealth which affected the desire to consume, and business firms and the public with excess liquidity which affected the desire to invest.

The repression of spending which is brought about by controls on consumption and investment does not eliminate the inflationary forces that have necessitated them. The inflation, however, is prevented from manifesting itself fully in higher prices. It remains in part a latent inflation to be dealt with in the future. The latent inflation which exists at any given time is represented by the excess savings held by the public and the excess cash balances and securities held by business firms which they wish to apply to consumption and to investment in the near future. If this residue of wartime inflationary forces is not to become active in the future, means must be found to deal with latent inflation.

Excess Private Wealth

The desire of the public to consume depends upon a number of factors, among which, for the purposes of this analysis, special emphasis should be placed on the level of income and of private wealth. Changes in the level of national income, which in some years may be as much as 10 per cent to 20 per cent in either direction, have a large and immediate effect on consumption. Changes in the aggregate level of private wealth (in real terms) are not, however, likely in ordinary times to vary by more than from −1 per cent to +4 per cent in a year, and consumption is unlikely to be much affected by such minor changes. After a great war, however, it would be a serious mistake to overlook the possibility that changes in private wealth may have been on such a scale as to become a major factor in determining the propensity to consume.

When the public find that their private wealth has increased rapidly by a very considerable amount, they will feel that, given the present and prospective levels of income, they have more private wealth than they wish to keep. The utility of present consumption relative to future consumption therefore rises very sharply. If the public could find some way to use part of their private wealth for consumption, they would do so. This may be attempted in two ways: either by massive spending of the excess private wealth held, concentrated in a short period, or more probably by a moderate increase in consumption relative to income maintained over a period of years until private wealth has been restored to a level more appropriate to present and prospective income levels.

In the United States, for example, the growth of private wealth during World War II may be roughly measured in terms of net new private investment plus the increase in the government debt. Between 1939 and 1945 net new private investment may have amounted to about $10 billion and the increase in federal debt to $215 billion. With no account taken of price changes, private wealth would thus have risen by some $225 billion. Such a large change in so short a period must inevitably affect the propensity to consume when money can again be freely used to buy consumption goods.

The problem thus created for the monetary authorities is obvious. The wartime repression of spending will have kept the upward movement of prices within bounds; but this has not solved the inflation problem. Whenever the community recovers its freedom to choose between holding and spending the savings which have been accumulated, it will want to spend at least a part of them. In countries which escaped a steep rise in prices by repressing spending during the war, the postwar inflation problem has been to find some means of dealing with the latent inflation that remained, either by eliminating the excess private wealth of the community or by working it off. Otherwise, this wealth remains a threat to the price level.

Under any circumstances, and apart from the accumulation of excess private wealth, the propensity to consume is certain to be abnormally high after a great war. During the war, durable consumer goods are not available in customary amounts, and the setting up of many house-holds must be postponed until demobilization. As will be shown later, this is not, in the long run, a very serious aspect of the postwar inflation problem, since deferred consumer demand (with the important exception of housing) can be satisfied without great difficulty as soon as the generation of new inflationary forces ceases. In the short run, however, it adds materially to the difficulty of dealing with latent inflation.

Excess Liquidity

The wartime repression of spending creates not only a problem of excess private wealth; through the form which this wealth takes, it also creates a problem of excess liquidity. Just as the excess private wealth of the community tends to increase consumption demand, so excess liquidity tends to increase investment demand.

The attitude of individuals toward the accumulation of private wealth is extremely complex. As far as the amount to be accumulated is concerned, they wish by saving to add as much as will equalize their preferences for holding additional wealth and for current consumption. As far as the form of private wealth is concerned, their wish is to equalize their preferences for each type of wealth held. From this point of view, wealth may be classified in three broad categories:

  • (a) Real wealth—including land and houses, business enterprises, and common stocks;

  • (b) Money-at-interest—including government bonds, industrial bonds, mortgages, preferred stocks, and interest-bearing time and saving deposits;

  • (c) Cash balances—including currency and demand deposits.

Individuals in distributing their accumulated wealth will give weight to their desire to maximize the income received from private wealth, their desire for assurance of stability in its real value, and their desire to hold some wealth in relatively liquid form. In ordinary times, the allocation of holdings of wealth among its various forms is part of the normal economic process, and can be achieved without great disturbance. Direct investment, the issue of new securities, changes in the prices of real estate and of securities, and changes in interest rates, all act to equalize at the margin the advantages of holding wealth in each of its forms.

After a great war the problem is far more difficult. During the war limitations on construction and investment made it impossible to increase real wealth to any significant extent. Nearly all the increase in private wealth in that period was due to the government deficit, so that of necessity it had to take the form, for the most part, of an increase in cash balances and in money at interest, primarily government bonds. This sharp change in the composition of private wealth is not likely to correspond to the long-run preferences of the public, and in time steps will be taken to correct it.

As already noted, some (although not all) of the additions to private wealth held by individuals will be regarded as excessive and will be held with a view to future spending. To that extent the public may have no objection to holding for a time a proportion of their wealth in the form of cash and money-at-interest greater than their normal requirements. But the public will undoubtedly regard some of the increase as permanent; and they will wish to change the form of that part gradually, by transforming cash balances and money-at-interest into real wealth. This can be done by bidding up the prices of real wealth—land and houses, shares, etc.—and the rise in prices of real wealth may eventually equilibrate the public’s preferences for holding wealth in the various forms that are available, and incidentally facilitate the financing of investment. On the other hand, a rise in interest rates affecting the price of government bonds would increase the public’s desire to hold this form of wealth instead of cash balances and real wealth.

The problem of liquidity arises in an even more acute form in the change in the pattern of business firms’ assets. During a war, many firms find it impossible to undertake net new investment or even to replace equipment and inventories. They have to accumulate cash balances and government securities equivalent to their disinvestment and their undistributed profits. As business firms they are interested after the war in placing their assets in a form that will maximize their profits. For nearly all of them, this must mean a shift away from cash and government securities into buildings, equipment, and inventories. The liquidity of business firms, therefore, directly affects their willingness to invest.

There is in any event a deferred demand for capital goods, carried over from the war, comparable to the deferred demand for consumer goods, and this is likely further to strengthen the inducement to invest. Wartime destruction and structural changes in the economy are also likely to add to the need for new investment. The resulting very great demand for investment is still a major factor in the inflationary pressure in a number of countries; and even though the tendency toward excessive consumption expenditure may have been halted, there may be continued difficulty in limiting investment.

Excess private wealth and excess liquidity together constitute the problem of latent inflation. So long as this latent inflation exists, the removal of price and wage controls, rationing, and allocations is impossible without a consequent rise in prices. On the other hand, as time goes on, it becomes increasingly difficult to maintain these controls. After a decade of denial, public support of controls becomes increasingly unwilling, even among the best disciplined peoples. Administration of controls is more onerous and more arbitrary, as changes in the economic structure make the application of simple devices (e. g., price freezes, base periods) less suitable to the new conditions. It may be accepted that in most countries any reasonable measures for dealing with latent inflation would be welcomed by both people and governments. There are, however, likely to be great differences between the attitudes which in different countries determine the measures regarded as reasonable for this purpose.

Conditions for Dealing with Latent Inflation

What can be done to solve the problem of latent inflation? As a prelude to any effective policy, a country with considerable latent inflation must first take steps to ensure that no additional inflation is currently generated. Even if a moderate rise in prices is not regarded as a great evil, an inflation spiral would have serious economic and social effects. The government must be sure that its budget, including the budget of state enterprises, does not show a deficit which, added to new investment, would exceed the savings of the public at constant prices. At the same time, increases in income which are not associated with corresponding increases in output must be prevented. The aggregate demand for goods and services for consumption, for investment, and for use by the government must not exceed available supplies. An import surplus may be temporarily useful, but it cannot be regarded as a normal substitute for other methods of limiting inflationary forces.

The fact is, of course, that only a few countries in Western Europe have as yet reached the state where additional inflation is no longer being generated. The activation of latent inflation in such countries would, therefore, still be dangerous. For them, the immediate and urgent problem is to bring government outlay and investment to a level appropriate to the available output, so that they will not add to the latent inflation. While the deferred demand for consumption and investment made this difficult immediately after the war, it should be possible four years after the end of the war to bring the generation of additional inflation to a halt.

The deferred demand for consumer goods is for the most part concentrated upon durable goods. It may be assumed that even a prolonged deficiency of nondurable goods will not significantly increase the future demand for these goods, although it may temporarily affect the desire for certain forms of consumption. The effect of a deficiency in durable consumer goods will be more far-reaching, but this, too, will tend to correct itself as the flow of normal supplies is restored. For example, if the average life of a shirt is four years, and the supply of shirts available to consumers is maintained at the normal replacement level for four years, consumer stocks will be fully replenished at the end of that period. If the life of such durable consumer goods as household equipment is eight years, a normal flow maintained for the same period will replenish consumer stocks. For most textiles and household equipment, deferred consumer demand should therefore disappear in a few years.

The deferred demand for investment is a more complex problem, partly because of its magnitude and partly because of its urgency, if the economy of Europe is to be made self-sustaining. The replacement period for equipment is usually quite long, and even the restoration and maintenance of normal supplies for a considerable time will not of itself make good the deficiency in investment arising from inadequate replacement and expansion during the war. If, for example, the average life of industrial equipment were assumed to be from 15 to 20 years, a constant flow of such supplies at normal levels would be necessary throughout this extended period before the deferred demand would have been satisfied. In the meantime, presumably, the economy would have to get along with over-age equipment, although the effect of this deficiency in quality would steadily diminish as normal replacement continued.

The process of making good the deficiency in investment by means of a continued supply of normal quantities of new investment goods would under ordinary circumstances be so lengthy that the inducement to invest would tend to remain high for quite a long period. In fact, the volume of investment for reconstruction and modernization in Europe since the war has been abnormally large, and much of the deficiency in investment arising from the war has already been made good. The European Recovery Program is providing a large import surplus that will in part meet the needs for investment which still remain, by supplying imported equipment and by releasing domestic resources for investment. If ERP continues for the full period for which it has been planned, the deficiency in industrial and agricultural investment will have been largely met. There will still remain, no doubt, a considerable deficiency in public construction and in housing; but these forms of investment can be controlled with much less difficulty than other forms.

Activation of Latent Inflation

Once the generation of new inflationary forces has been halted, the government has several alternative courses: it may either permit the latent inflation to become active, it may wipe it out, or it may work it off.

The first alternative means simply removing the controls which have kept spending in check and allowing prices to rise until the real value of cash and government securities has fallen sufficiently to eliminate the pressure on consumption arising from excess private wealth. An active inflation does not, however, reduce the value of real wealth. The value of land and buildings and business property, including common stocks, will presumably rise at approximately the same rate as the price level (except as they are affected by rent, dividend, and similar income controls), so that real wealth in these forms is not reduced. Insofar as private wealth consists of mortgages, preferred stocks, and corporate bonds, the reduction in real wealth consequent on the activation of inflation is offset by the increase in the wealth of the debtors, that is, the owners of mortgaged property and common stockholders. The net reduction in the total real value of private wealth which accompanies active inflation is brought about only by lowering the real value of cash balances and government bonds. The activation of past inflation also changes the composition of the private wealth of the public and business firms by reducing the proportion held in cash balances and government securities—that is to say, it reduces excess liquidity.

Since the real value of private wealth and its liquidity are reduced by activation of past inflation, both the propensity to consume and the inducement to invest will also be lowered. It must not be-assumed, however, that the propensity to consume will be reduced to the levels usually associated with a given level of income and wealth. The inadequacy of the community’s stocks of durable consumer goods may be expected for a time to keep the propensity to consume a little above these levels. Similarly, although reduced to some extent by the decrease in liquidity, the inducement to invest will remain above normal levels as long as stocks of equipment and business inventories are inadequate, because of new needs and of insufficient maintenance and investment in earlier periods.

The full activation of latent inflation would diminish the need for controls on consumption, except as an adjunct to balance of payments policy. There might still, however, remain an urgent need to limit some or all forms of investment, including housing. And the need to retain exchange or import restrictions would continue until the current balance of payments had been fully restored on a proper price/exchange rate basis.

If latent inflation were activated after the generation of new inflation had ceased, an increase in money wages commensurate with the rise in prices would be possible, because there would then no longer be any need to check the real demand arising from current income. If workers would be content to accept an adjustment in their money wage rates sufficient to restore and maintain their level of real wages, without attempting to offset the decline in the value of their private wealth, there would be no danger of an inflationary spiral. Prices and wages would rise to the same extent, but they could be maintained at the new level without generating a current demand for goods and services which exceeded available supplies.

Depreciation of a currency, even when it is not the consequence of activation of latent inflation, will have some effects on private wealth and on liquidity not unlike the activation of latent inflation. To the extent that the cost of living rises, the real value of private wealth is reduced; and to the extent that larger cash balances are needed to finance business at the higher level of prices, liquidity is reduced. Nevertheless, it should be noted that when home prices are kept from rising significantly—and this is one indication of a successful policy for making depreciation effective—latent inflation is reduced to only a minor extent by depreciation.

Wiping Out Latent Inflation

The second alternative which governments might adopt after the generation of new inflation had ceased is to reduce the volume of private wealth and the degree of liquidity until they are no longer excessive. This could presumably be done by heavy taxation or by a capital levy, the effect of which would be to raise more revenue than the government spends, and to permit repayment of government debt to the banking system and the public. Such measures would reduce the volume of private wealth, particularly in liquid form. Other measures could be taken to reduce excess liquidity without significantly affecting the amount of private wealth, for example, by the forced conversion of cash balances, including deposits. Such counter-liquidity measures (since they lessen the present value of the blocked funds) might indeed affect not only investment but also consumption.

The wiping out of latent inflation by reducing the volume of private wealth is a difficult process. An over-all cash budget surplus enables the government to repay debt. If repayment is made to the banking system, the liquidity of the public is also reduced. A consideration of the magnitudes likely to be involved shows more clearly the limited capacity of a budgetary surplus to wipe out latent inflation. The amount of latent inflation in some countries may run as high as one half or more of one year’s national income. A budget surplus, unless it is the result of a capital levy, is not likely to be of the order of more than 3 to 5 per cent of national income. Obviously, a budget surplus of this magnitude, while of the greatest importance in preventing the generation of new inflation, cannot do much toward reducing the amount of excess private wealth. Indeed, if net investment is in excess of the budgetary surplus, the absolute amount of private wealth will not be reduced. It may, however, be reduced relative to present and prospective income, and in becoming less liquid the composition of private wealth will be changed.

A capital levy would, of course, reduce the absolute amount of private wealth. But it would have to be unusually large to eliminate all or most of the latent inflation. Under the assumptions that the amount of private wealth is about four times national income, and that the amount of latent inflation is between four months’ and one year’s national income, it would take a levy of between 10 and 25 per cent to wipe out the whole latent inflation. To permit smooth adjustment, the collection of the levy would have to be extended over several years. The public might regard the full liability as a reduction in private wealth; but, in practice, a capital levy whose payment is extended for several years is unlikely to achieve any significant reduction in the absolute amount of private wealth.

Considerably more can be done, however, by other means to reduce excess liquidity. A forced loan, represented by nontransferable government securities or the blocking of currency and deposits, would not reduce the nominal amount of private wealth. It would, however, have immediate effects upon liquidity. Furthermore, by making non-transferable such a considerable portion of the community’s wealth, it might affect the psychological attitude toward private wealth and lower the propensity to consume in the same way, if not to the same extent, as if private wealth had been reduced. Even if the effects of such measures on consumption were unimportant, they should tend to limit investment.

One other major factor remains which could help to wipe out latent inflation: an import surplus obtained, for example, through ERP. By adding to the supply of available goods, an import surplus makes it possible to maintain consumption and home investment at higher levels. To the extent that the import surplus increases the supply of consumption goods, both excess private wealth and liquidity are reduced. If it increases only the supply of investment goods, private wealth is unaffected but liquidity is reduced.

It would, however, be a mistake to place too much reliance on an import surplus as an instrument for reducing excess private wealth and liquidity. The ratio of import surplus to national income has in most ERP countries been quite low, in some countries no more than 2 or 3 per cent. If it can be assumed that current intentional savings (including the budget surplus) would otherwise equal net new investment, latent inflation would be reduced by the whole of the import surplus. Given an amount of latent inflation equal to one-half year’s national income, the proportionate reduction would obviously not be large. Furthermore, as the import surplus financed by ERP is intended primarily to increase the amount of investment, the consumption side of latent inflation, represented by excess private wealth, would not be much affected.

An import surplus, indeed, is more likely to be helpful in strengthening the economy through additional investment, and thus, by increasing the capacity to produce, to enable latent inflation to be worked off at a later date.

Working Off Latent Inflation

The working off of latent inflation, the other alternative which remains for consideration, would be the result not of a reduction in the amount of private wealth, but rather of a gradual rise in the income of the public until the amount of private wealth at a given level of prices is not excessive in relation to prevailing and expected income levels. This does not depend on a reduction in the absolute amount of private wealth. As already indicated, the only effective means for reducing the absolute amount of private wealth are a budgetary surplus and an import surplus. This concept of working off latent inflation will be recognized as identical with that which regards excess private wealth, awaiting expenditure on consumption, and excess liquidity, awaiting outlay on investment, as an insurance against depression.

It is possible to work off latent inflation by maintaining consumption and investment at a higher ratio relative to income than would have been possible without the existence of excess private wealth and excess liquidity. For example, if the maintenance of full employment were to become more difficult as the level of production rises, the existence of latent inflation would increase the aggregate of consumption and investment, and this in turn would bring into use resources which would otherwise be idle. The real income of the country would be higher than would otherwise be compatible with the normal behavior of consumption and investment relative to income and the growth of production. As long as this situation continues, latent inflation can be worked off gradually.

As the amount of private wealth begins to recede to an appropriate level relative to prevailing and expected income levels, the propensity to consume will gradually decline and will finally be restored to normal. In the meantime, of course, the additional investment will reduce the relative liquidity of the community and change the proportion of private wealth held in the form of real goods, compared with cash balances and money at interest.

One other means of working off latent inflation should be mentioned. It is sometimes suggested that, if wage rates could be kept down as productivity increases, latent inflation might be worked off by maintaining a stable price level. Thus, for example, if productivity increases by 5 per cent, prices remain stable, and wage rates do not rise, any increase of consumption made possible by increased output will then be paid for either by the workers keeping down their current savings or using up their excess past savings. The maintenance of prices with expanded production involves a rise in national income, even though wages are kept at their former level. Such a policy, therefore, involves a shift of income from wages to profits and dividends.

Even though workers save less, and may even draw on past savings, private wealth is in such circumstances not reduced. The expenditures of workers (including drawing down past savings) become the receipts of businessmen, and in turn part of business savings or of the savings of recipients of profits and dividends. Less private wealth will be held by workers and more by recipients of profits and dividends, which may mean that some of it passes out of the hands of those who want to spend and into the hands of those who want to save. In this sense, latent inflation is worked off. Furthermore, to the extent that keeping down wages enables more current output to go to investment, the relative liquidity of the public is further reduced.

The difficulty about such a program is that it requires a great deal of restraint in wage policy. It is a universal experience that full employment brings insistent wage demands. Too much is expected of governments if they are to be asked to keep wage rates stable in the face of increased productivity.

The Practical Problem of Policy

With these three alternatives before them—the activation of latent inflation, wiping it out, or working it off—governments must choose that combination of policies which will enable the economy to function with a minimum of disturbance to production, distribution, and use of the national income.

Political and social considerations will undoubtedly have to be taken into account. Obviously, every country would like to avoid the activation of inflation, even at the cost of continuing controls for a few years longer. With prices far above the prewar level, the social strain that might result from activating the remaining latent inflation may lead some countries to strengthen controls until the latent inflation can be wiped out or worked off. It should be noted, however, that if current inflation is avoided, the activation of latent inflation need not involve a wage-price spiral and should not result in a diminution of real wage rates.

If countries prefer to wipe out or work off latent inflation rather than to activate it, what likelihood is there that they can succeed? An answer to this question requires an examination of the magnitudes likely to be involved and the feasibility of adopting very strong policies. Where latent inflation amounts to one-year’s national income, the prospects for wiping out or working off the excess private wealth would be very dim. On the other hand, where it amounts to one fourth of a year’s national income, the problem would be manageable, particularly with the aid of the import surplus. Under such conditions, heavy taxes or a capital levy, and strong measures to reduce liquidity, might wipe out or work off latent inflation in about five years.

The first critical question is the magnitude of the latent inflation as indicated by excess private wealth and excess liquidity. This, however, cannot be determined quantitatively. Too much depends on the extent to which the public will want to maintain the abnormal savings of the war period. American experience indicates that many people do not. But this cannot be made the basis for a confident judgment on behavior in European countries.

During 1939-47, personal savings in the United Kingdom amounted to £8.2 billion, slightly less than one year’s national income at present prices. In the same period, the real value of prewar holdings of cash balances and government securities declined. Under any circumstances, it might have been expected that some intentional savings on a modest scale would occur during those years, and that those savings would subsequently be retained. Furthermore, as a consequence of war destruction, disinvestment, and to some extent liquidation of overseas assets, about £3 billion was shifted from real assets into government bonds and claims, and paid for at a lower level of prices. The increase in private wealth in the United Kingdom since 1938 is probably about £5 billion at 1947 prices, which was equal to nearly 60 per cent of the national income of that year. On the other hand, relatively more savings are now held by people at the lower income levels. Such incalculable elements make it difficult to estimate accurately the amount of latent inflation in the United Kingdom piled up during the war. It was very likely somewhat more than one fourth of a year’s national income.

The second critical question is one of political feasibility. Is it possible to impose heavier taxes or a capital levy? Is it possible to continue much longer the controls on consumption, relaxing them gradually as supplies of consumer goods increase? The future distribution of income is likely to involve a greater average propensity to consume, and the extension of state enterprises a greater tendency to invest. Can the public be led to think of its additional savings and greater liquidity as a normal and desirable aspect of the economic system? If not, the pressure on consumption and investment will continue for several years.

The investment problem, associated with excess liquidity, is less difficult to deal with than the consumption problem. It may well be that the immediate danger of too much investment demand as a consequence of excess liquidity is greater than that of too much consumption demand as a consequence of excess private wealth. But difficult as the control of investment undoubtedly is, it is far less so than the control of consumption. The urgent necessity of bringing about a significant improvement in their payments position will compel some countries to take stringent measures to limit investment.

All things considered, there are no grounds for optimism in regard to latent inflation. It is difficult to believe that all or even most of the problem can or will be solved by wiping out or working off excess private wealth and liquidity. Expediency will probably dictate a compromise by gradually activating the latent inflation with slowly rising prices and wages.


Disappointment will undoubtedly be widespread if, after ten years of inflation control, latent inflation is permitted to become active and there is a considerable rise in prices. It is not unlikely that some governments will feel they simply cannot accept such a policy. But the prospect of wiping out or working off latent inflation in any moderate period of time is very slight. The continuance of controls on consumption for a minimum of five to ten years and perhaps even longer, which may be necessary to work off latent inflation, is an unpleasant prospect for people to whom the free use of income has already been denied for a decade. It is not unlikely that at some stage public opinion will prefer at least a partial activation of latent inflation to continued sub-mission to extended consumer controls. In the meantime, there is every reason to deal with the latent inflation as far as possible by absorbing it through taxation and by measures to reduce liquidity. At the same time, with increased output it should be possible to work off part of the latent inflation.

Even if it becomes generally recognized that all or most of such inflation cannot be wiped out or worked off, its immediate activation may be unwise. It would be reckless to remove controls that repress spending until there is assurance that the generation of new inflation is definitely ended. The first step, therefore, should be to reduce the gross inflationary forces until it is clear that no new inflation is being generated. At the beginning, some dependence may perhaps be placed for that purpose on the import surplus. But in time, and necessarily in brief time, payments deficits must be eliminated and investment brought down to the normal capacity of the country to save. Until then, inflation controls cannot safely be removed. Furthermore, caution would suggest the continuation of certain controls as an aid to restoring the balance of payments.

At some stage in the near future, governments must face the difficulties presented by latent inflation and recognize that a comprehensive program for dealing with it must be put into effect. Unless such programs are adopted, there can be no great confidence that international payments problems can be solved simply by imposing more rigorous and more extensive controls.

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