Initiating inflation

The ordinary functioning of an economy should result in distributing and using income in such a manner that aggregate demand for output is equivalent to the cost of producing total output, including profits and taxes. At times, however, the government, businessmen, or labor may attempt to secure a larger part of the output than would thus accrue to them. If other sectors are not prepared to acquiesce in this increase in the share of output used by any one sector, all of the sectors together will be trying to get more of the national output than production has provided. This is the basic framework for the inflation process, when aggregate demand for all purposes—consumption, investment, and government—exceeds the supply of goods at current prices.

Assume, for example, that the government wants to use more of the national output than the ordinary functioning of the economy provides through taxes and loans from the public. If the government is insistent on securing additional resources, it will get them in one way or another, e.g., by issuing currency or by borrowing from the central bank and commercial banks. If other economic sectors—particularly the active sectors, business and labor—are unwilling to contract their investment or their consumption by the amount of these additional resources used by the government, an inflationary process will be initiated.

Similarly, if businessmen wish to use more of the national output than the ordinary functioning of the economy provides through savings out of profits and savings lent or invested by the public, ³ the additional funds for financing a higher level of investment may then come from bank loans; in this way businessmen will secure the means to acquire more resources for investment. If other sectors of the economy—and in effect this means labor—are unwilling to contract consumption by the amount of these additional resources, an inflationary process will be initiated.

Consider, on the other hand, what would happen if labor were to acquiesce in a reduction of consumption and allow a shift in the share of total output going into investment. The initial impact toward inflation (that is, the expansion of investment) would then result in a rise of prices. With wages and other nonprofit incomes unchanged, the consumption of wage earners and other nonprofits receivers would decline. Prices would rise and total consumption would decline to the extent necessary to provide the additional resources that businessmen are using for investment. With a higher level of prices and an unchanged level of wages, the national income would be distributed in a manner that would enable businessmen to maintain, thereafter, the expanded scale of investment without any further rise in prices.

If this should happen, the economy would have established a tenuous stability that might or might not be easily upset—depending very much on the rigidity of wages. The expansion of investment will have made profits high relative to what businessmen ordinarily expect. They may then compete with each other to expand their scale of operations by bidding up the rate of wages. If this happens, wages may rise, investment may subside, and the distribution of real income revert approximately to its previous pattern. The inflation will have resulted in a once-for-all expansion of investment. On the other hand, wages may be quite rigid, remaining relatively fixed despite the high profits. In the Philippines, for example, profits were exceptionally high in the period 1947-50 without apparently affecting customary wage rates. The index of money wages for skilled labor in Manila was 101 in 1947, 100 in 1948, and 102 in 1949 and 1950. Prices fell gradually, however, as the initial cause of the expansion in investment (reconstruction) began to lose its force and ultimately subsided.

Several diverse results may follow an initial expansion in investment. One may be an initial rise in prices, relatively stable wages, an increase in profits and savings, and a larger scale of investment with stability in prices at a higher level. A second result may be an initial rise in prices, a later rise in wages, a decline in investment to the pre-expansion level, and stability in prices at a higher level. A third may be an initial rise in prices, a subsequent decline in investment to the pre-expansion level, and a fall in prices to the previous level. A fourth result may be an initial rise in prices, a subsequent rise in wages, a new expansion of credit to sustain investment, and a spiral of rising prices and wages.

Price-wage spiral

Only the continuous inflation of a price-wage spiral is so striking as to be regarded unequivocally as a manifest inflation. A price-wage spiral is actually far less common in underdeveloped countries than is commonly supposed. One reason, of course, is that relatively few underdeveloped countries have tried to increase investment to a significant extent by a large expansion of bank credit. And in some of the countries where investment has been financed by expanding bank credit, the inflation manifests itself in a distorted distribution of income (i.e., high profits and rents relative to wages), some spill-over of the low-grade inflation into a balance of payments deficit, and moderate stability in prices relative to the prices of the United States and the United Kingdom. Even when prices have risen considerably in some underdeveloped countries, a considerable part of the rise has been a consequence of higher export and import prices, the rise in domestic prices and wages being an essential means of distributing throughout the economy the real benefits of an improvement in the terms of trade.

As pointed out above, the process of continuous inflation depends on the resistance of one sector in the economy to a reduction in its share of the national output and the insistence of another sector on an increase in its share of the national output. Thus, when prices rise, real wages fall. If labor recognizes and resists this change in real wages, it will insist on an equivalent rise in wage rates. Businessmen will be in a position to meet the wage demands because profits are higher. But the rise in wages will necessitate a reduction in investment, unless businessmen find a way to meet the higher wage demands and still maintain investment. If they have easy access to bank credit, they may persist in maintaining the larger scale of investment. There will then be an unresolved struggle for the distribution of the national output, each rise in prices being followed by a rise in wages, and each rise in wages being followed by a new rise in prices.

Although this paper is concerned particularly with the relation of inflation to development, it is necessary to recognize that inflation may be initiated by the effort of any sector of the economy to secure a share of the national output which is larger than would be provided by the ordinary functioning of the economy. This is obvious where the government acquires additional resources by the issue of currency or by credit from the central bank or commercial banks. It is equally true where labor is insistent on real wages higher than the economy can provide. While labor is not in the same position as business or government to take the initiative in securing the additional resources through bank credit, it may be able to exert pressure on businessmen and the government to yield to its wage demands.

Suppose, for example, that labor organizes to demand a wage higher than businessmen can pay without reducing profits below the level that would induce them to maintain the current level of employment. Businessmen may be compelled to meet the wage demands, particularly if the government indicates that difficulties might arise from strikes or lockouts. Even then, the expected behavior of businessmen would be to reduce the level of employment and investment, not only because production would be less profitable at higher wage costs, but also because the businessmen would be unable to finance the previous level of employment and investment. If, however, businessmen can secure credit from banks, they may pay the higher wages, mark up their prices, and maintain the prevailing level of employment and investment. The expectations of labor for higher real wages will thus be defeated.

The attempt to secure excessive social security benefits will have the same inflationary effects as expectations of excessive real wages. To the businessman, what matters is the cost of employing labor—wage costs and social security contributions. If businessmen must make larger contributions to a social security system, they must either pay lower wages or raise prices. A rise in prices will, however, reduce real wages and the real value of the social security benefits. If businessmen can secure credit from banks to meet the higher costs, they will be able to mark up their prices and maintain the level of employment and investment. And as long as businessmen do not reduce investment, leaving out of account the effects of productivity and imports on the supply of consumer goods, real wages cannot be increased.

The frustration of labor’s attempts to secure higher real wages inevitably leads to demands for massive wage increases, 15 or 20 per cent at a time. The hope seems to be that a large wage increase must succeed in bringing about the shift in real income to labor that a small increase has failed to achieve. In fact, even a massive wage increase must fail to satisfy the expectations of labor. Any wage increase can result in proportionately higher real wages only if there is an increase in the supply of consumer goods. With a small rise in wages, this is made possible by reducing inventories and by allocating more exchange for consumer goods. In the longer run, higher real wages (apart from the effects of productivity on supply) require some shift in productive resources from investment to consumer goods industries.

Labor occupies a key role in the inflation process, for it is labor’s insistence on a certain level of real wages that is an essential part of the continuous rise in prices. This does not in any sense imply that labor’s excessive expectations of real wages and social security benefits are always or even often the cause of the price-wage spiral. It may very well be that the steady demand for higher wages which businessmen have steadily met—and also steadily offset—by higher prices is no more than an attempt by labor to defend its interest in an equitable distribution of the national output. In considering the possibility of directing more real resources into development, one point to be kept in mind is that the acquiescence of labor is required. Otherwise, the stimulation of development will initiate a continuous inflation through a price-wage spiral.

Role of the monetary system

A continuous rise in prices could not occur unless some means were found to finance the prevailing scale of production at the higher level of prices and costs. At any given time, the public holds an amount of money (currency plus deposits) that is in general adequate to finance production, consumption, and investment. A rise in prices and wages reduces the liquidity of the public and for this reason tends to bring the inflation process to a halt. That is not to say, of course, that prices and wages cannot rise at all unless the amount of money is expanded. Clearly, there is some flexibility in the capacity of the public to adjust itself to variations in liquidity; but this flexibility is limited and the limit can ordinarily be quickly approached if prices and wages rise while the money supply is unchanged.

Labor could, of course, press for higher wages even if the money supply did not expand, and might actually secure higher wages under such conditions. But businessmen might have difficulty in financing the same level of employment and production at higher costs. And even if it were possible to finance the same level of employment, production, and investment with a moderate rise in prices and wages, it would be quite impossible to do so with a substantial and continuous rise in prices and wages. Under such conditions, the rise in wages would soon compel some curtailment of employment, production, and investment. Prices would rise less than costs. The inflation process would come to an end. It is only the steady expansion of the money supply that permits the price-wage spiral to continue.

The money supply is seldom expanded through the simple procedure of issuing currency, even when the government is itself the initiating factor in inflation. With modern budgetary procedures, the process is likely to be different in form if not in substance. The budget authorizes spending in excess of tax revenues. The deficit must be covered by borrowing. As the public is unwilling or unable to provide loans equivalent to the deficit, the government must have recourse to the banks. The banks themselves are limited in their capacity to lend to the government, even if they are willing, for the loans to the government will increase deposits which will be partly withdrawn in the form of currency. In any case, the larger volume of deposits will compel the banks to hold larger reserves, either to meet legal requirements or to meet their legitimate needs for vault cash and clearing funds. The banks, therefore, can lend only limited amounts to the government (and then only by holding down their loans to business) unless they can obtain additional resources.

The central bank is in a position either to facilitate or to halt this expansion. Unless it provides reserves for the banking system, the loans to the government must stop. It can facilitate the expansion, however, by lending directly to the government, which will have some effect in strengthening the free reserves of the banks, or by lending to the banks through rediscounts or advances (or by purchase of their holdings of government obligations), which will strengthen the free reserves of the banks to the full extent of these operations. As the banks secure free reserves, they are able to acquire currency and to meet their needs for cash withdrawals, clearings, and legal reserve requirements, if any. In the last analysis, the central bank must be a party to the inflation process.

The central bank may be, although generally it is not, hampered in facilitating expansion by more or less formal restraints on the issue of currency and the extension of credit. Limitations on the note issue by means of reserve requirements of gold or foreign exchange are, however, easily changed or suspended. The more practical limitation imposed by inability to meet a balance of payments deficit can be overcome by exchange and import restrictions. Limitations on direct or indirect lending to the government can be overcome by open market operations in which the central bank buys securities previously issued, or by advances to the banks or the public on the basis of securities. Mechanical devices for restraining credit are completely ineffective where the monetary authorities are not determined to check expansion as a matter of policy.

The ease with which the monetary system can be used to provide additional resources for the government is clear enough. In fact, it is equally easy for business to use the monetary system in this way, if the monetary authorities acquiesce in such a policy. For businessmen may borrow from the banks, the banks borrow from the central bank by rediscounting commercial, industrial, or agricultural paper, and the central bank in turn issue currency to the extent demanded by such a policy. The proof that this may happen is that it does happen. It may happen because the monetary authorities have inadequate power to refuse rediscounts, because the monetary authorities are of the opinion that “credit for productive purposes” is not inflationary, or because the monetary authorities believe that credit expansion will serve a useful social-economic end, by encouraging investment or by financing production in the face of rising costs.

The role of the banks in such an inflation process may be active or passive. It is active if the banks press the expansion of credit with a view to increasing banking profits; they may offer businessmen easy credit and attractive terms, replenishing their lending power by resort to the central bank for rediscounts and advances. On the other hand, the banks’ role is passive if they resist the expansion of credit but succumb to the insistence of the government or the monetary authorities that credit should be expanded to help the government or to avoid the social consequences of strikes or unemployment.

As a practical matter, it is difficult to distinguish between the banks’ active and their passive participation in any credit expansion. Some banks are always prepared to extend credit and to press their access to the facilities of the central bank to the limit permitted. If some banks do this, others, even if they are fearful of the effect of such action on inflation, may feel impelled to keep in step in order to retain their customers and maintain their relative position in the banking system.

In the end, the monetary authorities are the ones that bear the responsibility for a continuous inflation. They alone have the power to limit credit expansion. In a very real sense, they make credit policy, even if the policy is one of indifference to the manner in which the inflation is fed by a steady expansion of credit. This expansion of credit is the key to the price-wage spiral. Without a steady addition to the money supply the spiral would come to a halt. The parallel movements of an expanding money supply and rising prices, wherever there has been a large and continuous inflation, are evidence of the important role of credit in this process.

Shift of income and wealth

In order to increase investment under conditions of full employment, businessmen must bid up the prices of materials and labor needed for investment, using for this purpose the credit made available to them by banks. By offering higher prices and higher wages, they attract productive resources away from the consumption field into the investment field. Prices must rise, in turn, in the consumption sector, partly because incomes will be higher and partly because the supply of consumer goods will be diminished. The effects on the supply of such goods will depend on the productivity of the labor drawn away from producing them and on the scale of the expanded investment.

The rise in prices and the lag in wages, particularly in the consumer goods industries, will increase profits and shift real income to the recipients of profits. It is out of these increased profits that the additional saving will take place, which is equivalent to the increase in investment that businessmen have undertaken on the basis of bank credit. It must not be assumed, of course, that businessmen will save all of the increase in their profits (in real terms), and that the shift in real income to profits will be precisely equal to the increase in investment. On the contrary, some of the increase in profits will be paid in taxes, some will be used to increase consumption, some will be used to transfer funds abroad, and some will be used to acquire other assets at home; only the remainder will provide the net addition to savings that is the necessary concomitant of the increase in investment. The proportion of the increase in profits that remains as savings for the increase in investment will determine how large a shift in real income is necessary to induce a given increase in investment.

Some shift in income to profits receivers is essential to secure the additional investment. The smaller the shift in income relative to investment, the less will be the social cost that the inflation entails. There is no way of measuring this relationship with any certainty. The shift in real income would be much smaller in the United States than in underdeveloped countries. The high rate of corporate income and excess profits taxes would take a very considerable part of the increase in profits (in money terms) for the government. The corporate structure of business induces the management to retain some of the earnings as corporate savings. Finally, the highly progressive income tax absorbs much of the distributed profits before they are spent. Since taxes are equivalent to savings, if government expenditure is not increased because of the larger tax collections, the ratio of savings to the rise in profits is exceptionally high. This is a major factor in limiting the impact of credit expansion (whether for government or business) on the level of prices in the United States.

In underdeveloped countries, taxes on profits are generally much lower than in the United States. A far larger part of the shift in real income to profits emerges as disposable income for profits receivers and is used for purposes other than the financing of new domestic investment. That is why the shift in income to profits receivers is much larger than the amount of additional investment undertaken by businessmen. If two thirds of the increase in real income in the form of profits is used for purposes other than financing the increase in the volume of domestic investment, then the shift in real income will have to be three times the volume of additional investment financed through the inflation process.

An inflation that is successful in increasing the volume of investment not only reduces aggregate consumption by the amount of the additional investment, but also reduces the consumption of the public other than the profits receivers by a much larger amount. The additional reduction of the consumption of the nonprofits receivers makes possible the increased consumption of the profits receivers. Nor is the reduction in consumption among nonprofits receivers likely to be distributed evenly. Apart from the fact that those living on savings and pensions are less able to protect their consumption standard, the incidence of the reduction in consumption is quite unequal even among workers. Labor in the inflation-favored industries may be able to secure a rise in wages that maintains or raises its standard of consumption. Labor in the inflation-penalized industries may have no means of protecting its standard of consumption. For example, in Brazil, the rise in wages in the construction industry enabled the workers there to secure a substantial improvement in their economic position relative to that of other workers.

As pointed out above, the savings that businessmen are induced to undertake out of their inflated profits do not represent in their entirety a net increase in real savings. In the absence of inflation, there would have been some voluntary savings, however small. With inflation, some voluntary savings will cease because it no longer pays to hold savings in the form of money assets and because the real income of some savers will be reduced. To the extent that businessmen provide savings out of profits equivalent to the reduction in savings by other sectors of the economy, there is no net increase in investment. There is simply a shift in the ownership of such investment from the general public to the profits receivers. The ownership of wealth becomes more concentrated.

This concentration is not confined to the newly created wealth. While new saving in the form of money assets is discouraged by the depreciation of purchasing power, other savers may even attempt to protect their standard of consumption by liquidating past savings. The public as a whole cannot succeed in getting more consumption in this way. Those who liquidate past savings will succeed in protecting their standard of consumption only at the expense of other consumers who are not profits receivers. As far as profits receivers are concerned, this process of dis-saving merely assures them that the ownership of both new and old wealth will come to them in larger part.

The public thus pays an extremely high price for investment financed by inflation. The net increase in investment is bound to be less than the investment financed by inflationary devices. The general public gives up consumption to the extent of some multiple—say, for example, three times—of the amount of the investment financed in this way. Of the shift of income to businessmen, two thirds has no other economic function than to be large enough to induce them to save one third of the increase in their profits. Beyond this increase in the consumption of the profits receivers at the cost of the general public, businessmen become the proprietors of the investment goods that emerge and of some of the old wealth as well.

Form of investment

The form of the investment induced by inflation is as significant as its aggregate amount. The only justification for submitting an economy to the strains and distortions of inflation in order to raise the scale of investment is that a higher level of production and a rise in the standard of living will be made possible. If all investment undertaken by inflationary devices had this effect, the economic cost of the inflation might be regarded as worth bearing, even though it might be excessive. The rest of the public would be compelled to consume less, and the reduction of their consumption would to some extent become embodied in investment goods owned by businessmen. While the private benefits of the ownership of investment would go to the businessmen, the social benefits of the use of investment, in the form of greater productivity, would ultimately go to labor and the public generally. And these latter benefits of investment are invariably larger, at least after the inflation has been brought to a halt. Under stable conditions, a diminishing part of the increased output consequent upon production with more capital equipment will be distributed as interest or dividends, and a larger part as higher wages.

Not all investment contributes in equal degree to the attainment of increased production and higher standards of living. Continuous inflation, in fact, usually induces the wrong kind of investment. When the investment is of a type that increases the demand for labor, and increases the supply of goods for consumption by the lower income groups, its use (social) benefits are high. Such investment tends to raise wages relative to other incomes and to hold down the cost of living relative to other prices. Investment in industry and in agriculture is notably of this type. On the other hand, when the investment is of a type that offers large profits, including capital gains, its ownership (private) benefits are high. Investment in holding foreign assets is of this type. In fact, any investment in holding wealth rather than using it is likely to involve a high degree of ownership benefits and a low degree of use benefits.

The businessman is concerned primarily with the ownership benefits—profits and capital gains—rather than the use benefits. Under stable conditions, this distinction is of small consequence, because the field of profitable investment where the use benefits are relatively low and the ownership benefits are relatively high is quite circumscribed. However, the windfall profits and capital gains of inflation broaden very considerably the scope of profitable investment where the use benefits are low and the ownership benefits are high. Three such fields of investment are inventories, some types of construction, and foreign assets.

One characteristic of inflation is that cash accumulations and fixed money assets depreciate in real value, and therefore the holding of such forms of wealth is avoided. It takes foresight and enterprise to undertake and manage well-conceived investment in agriculture and industry. A businessman who is accumulating cash from inflation profits may find that the opportunity for expansion in his own business is limited, and he may have neither the facilities nor the inclination for investment in other business. For such businessmen, and particularly for merchants, the accumulation of inventories is an attractive investment. Prices are bound to rise, supplies are likely to be more difficult to get, especially import goods, and inventories, within limits, can always be liquidated if necessary or used as collateral for bank credit. They are, for this reason, a favored type of investment.

Another form of investment likely to be abnormally expanded under the impact of inflation is real estate investment, particularly in the form of high-priced apartments and elaborate commercial buildings. In some underdeveloped countries, great prestige is attached to the ownership of real estate. There is, further, the mistaken view that no special capacity is needed to manage real estate investment. Professional people and beneficiaries of inflation profits, with limited opportunity for investment in an operating enterprise, are likely to be attracted by real estate investment with its sure appreciation of the money value of investment. The fact that lending institutions regard real estate as very secure collateral adds materially to the attractiveness of this form of investment. In the Philippines, a secured bank loan almost invariably means a loan with real estate collateral.

Finally, the ownership of foreign assets (including gold) is a form of holding wealth which may become extremely profitable. Where continuous inflation leads to an expectation of exchange depreciation, there is a strong temptation to hold some assets in the form of foreign funds. The inducement to hold some investment in this form is much greater when inflation involves rapid adjustment in wages, so that the real level of profits may be little higher than it would be under conditions of monetary stability. Funds transferred abroad prior to devaluation may yield enormous ownership benefits. The use benefits of such investment are zero.

It is not, however, merely through the incentive given to forms of investment which approach the pure holding of wealth that the pattern of investment encouraged by continuous inflation is unsatisfactory. The fields in which investment is most likely to be best suited to the economies of underdeveloped countries are the consumer goods industries and the export industries. Yet the low-income consumer goods industries are the ones that are penalized by the inflation which shifts income to profits receivers. Furthermore, the illusion that inflation can be held down by price control often leads to the maintenance of unprofitably low prices on home-produced foodstuffs and the import of foodstuffs at exchange rates which are in effect subsidies. Similarly, the export industries in which the country has special advantages may be held down by an overvalued currency—the inevitable concomitant of continuous inflation. Thus, investment is discouraged in the fields which have the highest use benefits. And even where investment in production is encouraged by inflation, it is likely to be excessively concentrated in the field of luxury consumer goods, the imports of which are sharply curtailed by import and exchange controls, and which the economy is not well suited to produce.

Correction of price distortion

The price distortion incident to inflation involves relatively high prices in the inflation-favored sectors and relatively low prices in the inflation-penalized sectors. The inflation-favored sectors may be broadly defined as the construction industry, the industries that produce luxury consumption goods, and, under certain conditions, the import group. The inflation-penalized sectors may be broadly defined as the industries that produce consumer goods for wage earners. Under certain conditions, as for example with price control, the agricultural sector, which produces the most distinctive consumption goods, may be very adversely affected by inflation. And if the exchange rate is fixed, and has not been depreciated, the export sector may be seriously penalized by the rise in domestic costs relative to foreign prices.

Prices in the sectors most favored by inflation will have to be brought down sufficiently to eliminate inflation profits. Since resources must be drawn away from these sectors, their prices will have to be lowered relative to the prices of the inflation-penalized sectors. Because the termination of inflation will in any case place severe pressure on these sectors, the adjustment in relative prices should not be brought about by measures that induce too much deflation. The level of costs in the inflation-favored industries presents a more or less firm limit to the reduction of prices in these sectors. The remainder of the adjustment in relative prices is probably better achieved by a rise in prices in the inflation-penalized sectors. The precise methods by which this should be accomplished will depend on the individual position of each inflation-penalized sector.

First, there may be an inflation-penalized sector which produces essential consumer goods, whose prices have been kept down by direct controls. The removal of price controls will result in some initial rise in the prices of these goods. If the demand is inelastic (in terms of price and wage incomes), there may for a time be a tendency toward an excessive rise in prices, and this tendency will be reinforced as wage adjustments are made. The reason for the excessive upward pressure on prices in this sector is that output will have been reduced below the amount suitable to a stable economy.

Second, there may be an inflation-penalized sector which produces consumer goods for low-income groups for which demand is relatively elastic in terms of wage incomes. Prices and output in this sector will have been depressed by the shift in real income away from wage earners. The expansion of production and the emergence of more remunerative prices in this sector will be a slower process. In general, the rise in prices will follow the income readjustments that are discussed below.

Third, in a country with a fixed exchange rate there may be an inflation-penalized sector producing goods for export, for which exchange proceeds are converted into local currency at a rate of exchange that overvalues the local currency. There may also be an inflation-penalized sector producing goods which compete with imports paid for at a too favorable rate of exchange, provided that demand for imports of this kind is reasonably met despite exchange and import restrictions. For these sectors, it may not be possible to secure the necessary adjustment of prices to costs without a change in the exchange rate.

The changes in relative prices which are part of the process of stabilization are necessary for two reasons: First, they permit the shifting of income from the inflation-favored to the inflation-penalized sectors and from profits receivers to other income recipients; second, they are indispensable for the proper apportionment of resources to each sector of production on a basis suited to stable economic conditions. When the changes in relative prices have been completed, the distribution of resources among the various types of production will permit the supply of goods from each sector to meet the demand for such goods at stable prices.

Shifts of real income

The starting point in the shift of real income is the adjustment of prices, for prices constitute the incomes derived from production. A fall in prices in the inflation-favored sectors reduces aggregate income from such production; a rise in prices in the inflation-penalized sectors raises aggregate income from such production. There remains the more difficult problem of shifting income among factors of production—wage earners, civil servants, profits receivers, etc.

There is no practical method for restoring the real income of those who accumulated savings in the form of fixed money assets which have depreciated in value as a consequence of the continued inflation. Something can be done, perhaps, to improve the position of pensioners, particularly if their incomes are derived from public funds or trust funds under the control of the government. For the most part, the shifting of real income that is part of the stabilization process will have to be among the active groups in the economy.

The principal shifts would be between profits and wages, and between wage earners in the inflation-favored industries and those in the inflation-penalized industries. The decline in demand for goods in the inflation-favored industries will eliminate inflation profits and hold down wages in these industries. The increase in demand for goods in the inflation-penalized industries will make it possible to raise wages and, if necessary, profits in such industries. In fact, some deliberate policy for adjusting relative wages will have to be worked out, as the ordinary processes of wage determination are almost certain to have broken down under the impact of the massive wage increases that are a feature of a long-continued inflation. As salaries of civil servants are likely to have become quite unsuitable, a rise in such salaries will also be part of the required shift in incomes.

Where the inflation has brought about a serious discrepancy between foreign and domestic prices, it may be impossible to avoid a depreciation of the exchange rate. The adjustment of the exchange rate is the means by which inflation profits are taken away from importers who buy foreign goods at a world price converted at an overvalued rate for local currency and sell these goods on the basis of scarce supply and inflated domestic demand. With the adjustment of the exchange rate, this income, in turn, is transferred to exporters, who produce goods at inflated costs in local currency and sell these goods abroad at a world price converted at an undervalued rate. The rise in income in the export sector is almost entirely the consequence of a shift in income from the import sector. The export sector is, however, a supplier of some goods for sale in the domestic market. The rise in export prices in local currency, therefore, involves a minor shift in income from other domestic sectors to the export sector, to the extent that export goods are consumed at home.

The adjustment of the exchange rate in the process of stabilizing an inflated economy cannot be regarded as a totally independent force inducing a price rise. To the extent that it represents a shift in the windfall profits of importers to exporters, it involves no real cost to the rest of the public. To the extent that it induces a rise in prices of home goods, it may do no more than reflect the higher demand that will in any case manifest itself with the rise in wages and in other incomes penalized by inflation. There will, of course, be some goods in the import-export sector the prices of which will to some extent rise autonomously because of the adjustment of the exchange rate. But this is no more than the means by which the better balanced distribution of income and the more appropriate use of resources are achieved through stabilization.

Role of policy

It would, of course, be possible to take the view that the inflation will be halted—say, by stopping the expansion of bank credit—and the economy will then be allowed to adjust itself to a stable position. As a practical matter, however, this would present serious difficulties. The stabilization crisis, with its painful readjustment of values, and the cash crisis, with its strong inducement to liquidation, may set in motion a deflation that could defeat the objective of restoring stability. During the process of stabilization, the monetary authorities will find it desirable to take measures intended to ease the adjustment from steadily rising prices to stable prices.

For this reason, it is preferable to think of the stabilization process as involving a gradual halt in the rise in prices. In general, the principle should be that adjustments should be made by letting the relatively low prices and incomes rise gradually to the level of costs in the more inflated sectors. This need not involve any considerable or long-continued rise in prices. A period of six months to a year should be adequate for slowing down the inflation and bringing it to a halt. It is most important that, in this period of gradual stabilization, the expectation of a steady rise in prices should be terminated. This can be done by slowing down the rise without bringing it to an abrupt stop. Above all, it is necessary to avoid restarting the wage-price spiral. For this reason, an upward adjustment in food prices may have to be made by a series of small steps.

The policy in such a situation is not exclusively the better control of credit. The continuous inflation will have brought about an undesirable use of resources and an unfair distribution of incomes which must be corrected. The price and wage adjustments are two facets of the same process of shifting real income and productive resources until they approximate a pattern suited to a stable economy. The authorities are more likely to be successful in restoring stability if their policies comprise the whole field of credit, budget, wages, investment, and international payments than if they are confined entirely to the limitation of credit.

Institutional reforms

The first and most obvious means of securing additional resources for development is from voluntary savings. The desire to accumulate moderate savings is much stronger in low-income countries than is generally assumed. The restoration of monetary stability is certain to have a beneficial effect on the savings habits of those for whom the holding of money assets is the only convenient form of saving. Small savings may be stimulated by providing easier access to savings banks and postal savings institutions as convenient places of deposit, and by offering savings certificates and savings bonds as convenient forms for holding savings. And this effect may be further encouraged by allowing a generous return on small savings. Nevertheless, it is very unlikely that any considerable increase in small savings can be secured merely through better institutional arrangements. The most important factor limiting the amount of small savings is the low level of real income.

Institutional arrangements are likely to be of greater significance in determining the direction of investment. The primary objective of development, an increase in the productivity of labor, can often be achieved, not only by means of great irrigation and power projects and large industrial undertakings, but also by providing the small farmer, the cottage worker, and the small manufacturer with very modest financial assistance and technical advice.

One solution to the problem of low agricultural productivity is to provide credit for small farmers through rural banks on terms they can afford to pay. The rural banks should have associated with them a farm management service which would provide advice on farm management and the proper use of credit for production. If the provision of credit and the dissemination of technical knowledge thus go hand in hand, the traditional fear of the farmer in dealing with financial institutions and hesitation in introducing new methods of cultivation could be overcome.

The provision of financial resources for small-scale industrial enterprises presents more complex problems. The great danger is that an industrial bank intended for development will be used to salvage inefficient and bankrupt firms rather than to encourage the establishment of new enterprises and the expansion of old. The prerequisite for financial assistance should be the willingness of the owners of an enterprise to provide a large portion of the capital. Wherever possible, the financial arrangements should be made through an existing banking institution and with the greatest possible participation by the institution. An engineering advisory service and an industrial research service attached to the industrial development bank would provide safeguards against misdirected investment and should be of great help to the enterprises that use the resources of the bank.

In most underdeveloped countries there is great difficulty in securing capital for corporate enterprises through the sale of securities to the public. One reason for this is the marked preference of savers to retain direct control over their savings, as is possible, for example, through the ownership of real property. If the public is unwilling to participate in the ownership of corporate enterprises on a wider scale, development is certain to be retarded. If capital for corporate enterprises is to come from a broad group of savers, who can participate in the firm only by sharing the risks and profits of the enterprise, the rights and interests of the stockholders must be carefully protected. A revision of the company and securities laws may be a helpful means of encouraging the provision of savings for development.

Even if tax revenues are substantially increased, the governments of underdeveloped countries will still have to secure additional funds for development from the savings of the public. They will have to finance many of the larger development projects and, if credit is to be available for smaller agricultural and industrial enterprises, they will have to provide some of the funds. In some underdeveloped countries, the large expansion of bank credit which has accompanied the continuous inflation has seemed necessary because the government has been unable to acquire savings directly from the public. The establishment of a government bond market of a simple kind would encourage saving and increase the resources available for development.

The first step in establishing a government bond market is to put the public finances on a sound basis. Interest coupons and matured bonds should be treated as sight drafts on the treasury, and should be collectible by deposit in a bank and presentation to the fiscal agent of the government. Where bonds are registered, a check for interest and, on maturity, for the principal should be sent to the holder not later than the due date. The availability of suitable types of government securities is also important. While savings banks, insurance companies, and some individuals will prefer long-term bonds, commercial banks and other financial institutions will prefer short- and medium-term bonds. It will be necessary, too, to provide some additional degree of liquidity for government bonds, either by assuring an orderly market or by making bonds acceptable collateral for loans at a slightly preferred rate of interest.

Savings by and through the government

The wartime interest in forced saving has inspired suggestions that such measures be used to provide real resources for development. There is a vast difference between the use of forced saving as an emergency measure during war, with the expectation that much of the saving will be liquidated after the war, and its use as a means to finance development. In a free economy, the amount of private wealth accumulated by the public is determined with reference to the present and prospective level of income. There is no way, except by rigorous control of spending, to force the community to accumulate savings at a higher rate than it prefers. Unless a country is prepared to maintain rationing and price control indefinitely, it should not resort to forced saving schemes.

The social security system, on the other hand, opens up a large new source of savings that could be made available for development. A social security system based on the principle of actuarial reserves will accumulate large savings, at least for a time, because future benefits (retirement and death benefits) must be preceded by a period in which reserves are built up. In a mature system, payments would on an average equal receipts, except to the extent that the working population grows or the risks are overestimated. In an underdeveloped country where the coverage of the social security system is steadily extended as the area of the “business economy” grows relative to the “nonbusiness economy,” the period of accumulation may be very long. The sums thus collected may represent a very marked addition to savings.

Most of the underdeveloped countries in the Middle East and Far East have no well-developed social security system. The experience of a few Latin American republics is, however, noteworthy; the annual average increase in the social security reserves in Brazil, Chile, and Paraguay appears to have been between 1 and 2 per cent of national income. In the United States, the increase in all social security reserves (excluding government life insurance funds and including investment income of other funds) was $1.9 billion in 1949 and $3.4 billion in 1950, i.e., an average of 1 per cent of national income. Over the past 16 years, the aggregate social security reserves accumulated in the United States have amounted to $27 billion, a notable addition to savings.

It should not be assumed, of course, that any social security system will necessarily provide net savings. Where present benefits (dependency allowances, unemployment payments, medical care) are large relative to future benefits, accumulations are likely to be small. If extensive social services are provided through the social security system, it may be difficult to cover their cost through levies on workers and employers. Far from providing a surplus of current receipts over payments, the social security system may then become a drain on the budget. This may also occur if, after a prolonged period of continuous inflation, benefits must be paid out on the basis of recent earnings, while reserves have been accumulated on the basis of the much lower earnings of the past.

The significance of the accumulation of social security reserves for development depends in large part on how the reserves are used. In the United States, accumulations are automatically invested in a special series of government bonds. In certain Latin American countries, the social security funds (which are generally organized by industries) are more or less autonomous and retain great freedom in investing their reserves. In practice, they make large investments in real estate, and make loans to their own beneficiaries in much the same way as life insurance companies lend on policies. On the whole, it is difficult to say that the social security reserves have been used very effectively for development.

Satisfactory means can be found for investing at least part of the social security reserves in enterprises of social and economic significance. Such trust funds, however, should not be invested haphazardly without adequate supervision. The proper safeguard would be to establish a list of enterprises whose preference securities would be eligible for investment because of their record of continuity and stability in earnings. The public utility enterprises—electric power, telephone communications, etc.—are likely to meet these tests to a high degree. With rates reasonably adjusted to the cost and value of the services they provide, public utility enterprises should have no difficulty in providing a good return on the social security reserves invested in them.

Another important means of securing additional savings for development is through higher taxation. In many underdeveloped countries, the proportion of the national income collected as taxes is very small. The available data show that in 1948-49 the central and the state Governments in India collected in taxes an amount equal to approximately 7 per cent of the national income. In the Philippines in 1950, the tax revenues of the Commonwealth Government were not much more than 6 per cent of the national income. Even if generous allowance is made for taxes levied by local authorities, aggregate tax revenues are certainly a relatively small part of the national income in these countries. In the larger Latin American countries, the aggregate tax revenues are generally around one eighth of the national income.

Low-income countries cannot be expected to collect taxes on the same scale as high-income countries, where aggregate national and local taxes exceed 25 to 30 per cent of the national income. It is difficult, however, to see any good reason why even low-income countries should not be able to collect 15 to 20 per cent of the national income in taxes. An increase in tax revenues to such a level could be accomplished without any disturbance to the economy, particularly where there are inflationary pressures. In the Philippines, the tax revenues of the Commonwealth Government were increased by 80 per cent in 1951 compared with 1950. There is no indication that production and investment were in any way hampered by the increase.

In many countries, social custom does not sanction, and administrative techniques are not adequate for, a system which relies heavily on highly progressive taxes on personal incomes. An excessive concern with the incidence of consumption taxes has led many experts to underestimate the importance of taxation as a source of real resources for development. When a country is experiencing severe inflationary pressure and tax revenues are inadequate by any reasonable standard, the incidence of a tax on expenditure is unlikely to fall wholly or even in large part on the consumer. A general sales or excise tax on domestic or imported goods is presumed to be borne by the consumer because, at the previous price, costs would exceed price and the supply would be curtailed. This analysis is not applicable in a period of inflation, when price exceeds costs and businessmen secure inflation profits. Under such conditions, a general tax on sales will not restrict supply, and the effect will be to narrow somewhat the excessive margin of profit.

There is, indeed, a need for a better balance in tax revenues from the principal sources—income, property, and consumption. Even when allowance is made for the social and administrative conditions in underdeveloped countries, the conclusion is justified that in most of them land and real property do not bear a reasonable share of the tax burden. In India, for example, land tax revenues have remained virtually unchanged since before the war, yielding 260 million rupees in 1938-39 and only 300 million rupees in 1946-47. The tax structure in underdeveloped countries should be reformed to place more of the tax burden on large incomes and property holders. There is no reason, in the meantime, for delaying an increase in tax revenues until the whole tax structure is reformed. In a country faced with inflationary pressures, all taxes have the effect of restraining inflation.

No general conclusion can be drawn about the volume of additional resources that could be secured for development through an increase in tax revenues. The practical limit for tax revenues in the near future may be less than 15 per cent in some countries and as much as 20 per cent in others. On the whole, it is not too much to say that most underdeveloped countries could increase taxation by an amount equal to about 3 or 4 per cent of the national income. Part of this would be offset by a reduction in voluntary savings; but a substantial amount would become available for essential investment by the government or by the private sector with finance coming from the government.

Foreign investment

In most low-income countries, even the most forceful measures for increasing savings and for applying them to the most urgent needs would still leave the economy with inadequate resources for the investment necessary to assure tolerable progress in raising productive efficiency and expanding production. The only way of securing adequate resources for development in such countries is by supplementing domestic savings with capital from abroad. There was a time when international investment responded readily to profits opportunities abroad. While capital was not always available for investment in the directions of greatest importance for the development of low-income countries, the failure of the foreign investment of the late nineteenth and early twentieth centuries to utilize all the socially most desirable avenues for development was much less striking than the vast scale on which it actually provided resources for purposes whose beneficial effects are incontrovertible.

The magnitude of foreign investment before World War I is indicated by the fact that during 1904-13 new foreign investment by Britain alone averaged more than £150 million a year, and reached nearly £200 million in 1913 ($1 billion at the exchange rate then prevailing) . It is estimated that, if other capital exporting countries are taken into account, the net export of long-term capital averaged more than $2 billion a year in the years immediately preceding World War I. ⁴

The machinery for private foreign investment has not been functioning in recent years as it did before World War I. One cause has been the general state of uncertainty in world affairs for which the underdeveloped countries are in no sense responsible. Another cause has been the fear of expropriation, limitations and restrictions on the remittance of profits, and similar risks which are the consequence of the policies of some underdeveloped countries. The taxation of profits in those countries is not generally regarded as burdensome, but overvalued exchange rates and taxes on exchange transactions sometimes bear unduly on foreign-owned enterprises.

Apart from the unfavorable political and economic environment, foreign investment has been seriously hampered by the inability of the United Kingdom, France, and the Netherlands—the great foreign investing countries of the pre-1914 era—to restore their international payments to a position that would leave a surplus for foreign investment. In those countries, the level of domestic investment is much higher than it was in the past, and it is certain to absorb nearly all of the savings that the countries are likely to be able to provide. Their inability to resume large-scale foreign investment is of particular importance to the countries in Asia and Africa for which Britain and other European countries used to be the principal sources of foreign capital. ⁵

The United States has now become, and is likely for some years to remain, the principal source of foreign capital. From 1947 to 1950, the net outflow of private long-term capital from the United States averaged $1.3 billion a year (Table 5). Nearly all of this was direct investment, a very considerable part of which represented the undistributed earnings of subsidiaries and branches abroad. More than 25 per cent was in Canada and another 11 per cent in Europe. Latin America, Asia, and Africa received nearly 64 per cent of the total, but more than 60 per cent of the investment in these three continents was in petroleum. Direct U.S. investment in all underdeveloped countries in manufacturing, agriculture, mining, public utilities, and all other enterprises except petroleum averaged less than $300 million a year from 1947 to 1950 (Table 6).

Table 5.

Net¹ Outflow of Private Long-Term Capital from the United States, 1946–51

(In millions of U.S. dollars)

Source: Compiled from U.S. Department of Commerce, Survey of Current Business, December 1951 and March 1952; and International Monetary Fund, Balance of Payments Yearbook, Vol. 3 (1949-50).

¹All figures are net, i.e., net of redemption and amortization of U.S. investment abroad, but not net of changes in investment by foreigners in the United States.

²Branch profits during 1946-50 aggregated $2.9 billion, of which 55 per cent was retained abroad.

³Includes long-term loans by banks.

⁴Includes a net outflow of $325 million to Canada and a credit of approximately $190 million by U.S. financial institutions to the French Government for the purchase of U.S. Government securities.

Table 5.

Net¹ Outflow of Private Long-Term Capital from the United States, 1946–51

(In millions of U.S. dollars)

				1946	1947	1948	1949	1950	1951
Direct Investment
	Undistributed earnings of direct in-
		vestment subsidiaries		303	387	581	436	443	—
	New capital and branch profits re-
		tained abroad 2		183	724	684	786	702	513
			Total	486	1,111	1,265	1,222	1,145	—
Portfolio Investment
	Purchase of IBRD obligations			0	243	7	20	1	147
	Other 3			−124	−157	57	−10	465	121
			Total	−124	86	64	10	466 4	268
Total Net Outflow of Private Long-
	Term Capital			362	1,197	1,329	1,232	1,611	—

Source: Compiled from U.S. Department of Commerce, Survey of Current Business, December 1951 and March 1952; and International Monetary Fund, Balance of Payments Yearbook, Vol. 3 (1949-50).

¹All figures are net, i.e., net of redemption and amortization of U.S. investment abroad, but not net of changes in investment by foreigners in the United States.

²Branch profits during 1946-50 aggregated $2.9 billion, of which 55 per cent was retained abroad.

³Includes long-term loans by banks.

⁴Includes a net outflow of $325 million to Canada and a credit of approximately $190 million by U.S. financial institutions to the French Government for the purchase of U.S. Government securities.

View Table

Table 5.

Net¹ Outflow of Private Long-Term Capital from the United States, 1946–51

(In millions of U.S. dollars)

				1946	1947	1948	1949	1950	1951
Direct Investment
	Undistributed earnings of direct in-
		vestment subsidiaries		303	387	581	436	443	—
	New capital and branch profits re-
		tained abroad 2		183	724	684	786	702	513
			Total	486	1,111	1,265	1,222	1,145	—
Portfolio Investment
	Purchase of IBRD obligations			0	243	7	20	1	147
	Other 3			−124	−157	57	−10	465	121
			Total	−124	86	64	10	466 4	268
Total Net Outflow of Private Long-
	Term Capital			362	1,197	1,329	1,232	1,611	—

Source: Compiled from U.S. Department of Commerce, Survey of Current Business, December 1951 and March 1952; and International Monetary Fund, Balance of Payments Yearbook, Vol. 3 (1949-50).

¹All figures are net, i.e., net of redemption and amortization of U.S. investment abroad, but not net of changes in investment by foreigners in the United States.

²Branch profits during 1946-50 aggregated $2.9 billion, of which 55 per cent was retained abroad.

³Includes long-term loans by banks.

⁴Includes a net outflow of $325 million to Canada and a credit of approximately $190 million by U.S. financial institutions to the French Government for the purchase of U.S. Government securities.

Table 6.

Private U.S. Direct Investment Abroad, by Area and Industry¹

¹Compiled from U.S. Department of Commerce, Survey of Current Business, December 1951. Figures refer to the increase in the value of private U.S. direct investment abroad from the end of 1946 to the end of 1950.

Table 6.

Private U.S. Direct Investment Abroad, by Area and Industry¹

				Amount (million U.S. dollars)
					Latin
		Per Cent			American		All Other
		of Total	All Areas	Canada	Republics	Europe	Countries
Manufacturing		29.6	1,388	651	356	276	105
Distribution		6.9	325	63	164	42	56
Agriculture		2.3	109	1	91	0	17
Mining and smelting		5.6	262	117	118	−4	31
Petroleum		49.0	2,303	340	1,004	157	802
Public utilities		1.3	61	−35	86	−2	12
Miscellaneous		5.3	248	50	100	51	47
	Total	100.0	4,696	1,187	1,919	520	1,070
(Per cent of total)			(100)	(25.3)	(40.9)	(11.0)	(22.8)

¹Compiled from U.S. Department of Commerce, Survey of Current Business, December 1951. Figures refer to the increase in the value of private U.S. direct investment abroad from the end of 1946 to the end of 1950.

View Table

Table 6.

Private U.S. Direct Investment Abroad, by Area and Industry¹

				Amount (million U.S. dollars)
			View Expanded
					Latin
		Per Cent			American		All Other
		of Total	All Areas	Canada	Republics	Europe	Countries
Manufacturing		29.6	1,388	651	356	276	105
Distribution		6.9	325	63	164	42	56
Agriculture		2.3	109	1	91	0	17
Mining and smelting		5.6	262	117	118	−4	31
Petroleum		49.0	2,303	340	1,004	157	802
Public utilities		1.3	61	−35	86	−2	12
Miscellaneous		5.3	248	50	100	51	47
	Total	100.0	4,696	1,187	1,919	520	1,070
(Per cent of total)			(100)	(25.3)	(40.9)	(11.0)	(22.8)

¹Compiled from U.S. Department of Commerce, Survey of Current Business, December 1951. Figures refer to the increase in the value of private U.S. direct investment abroad from the end of 1946 to the end of 1950.

Nearly all of the enormous postwar flow of funds abroad from the United States has been in the form of grants and credits by the Government. During the six years ended June 1951, the United States provided nearly $31 billion of foreign aid. Of this total, only $1 billion went to Latin America, Africa, and Asia (excluding China, Japan, the Philippines, and South Korea). Without loans from the International Bank for Reconstruction and Development and the Export-Import Bank, aid to underdeveloped countries would not have reached even this very limited sum of $200 million a year. For some countries in Asia, the principal source of foreign resources has been the use of sterling balances.

Whatever other measures the underdeveloped countries could and should undertake, they will be unable to provide themselves with adequate resources for development out of their own savings. Their real level of income is too low and their need for investment is too great to enable them to meet in full their own capital requirements. Any rational program for economic development must involve much more dependence on foreign capital than has been possible in recent years. With such foreign assistance, it is reasonable to hope that the underdeveloped countries could follow a policy of monetary stability. Without such foreign assistance, they will inevitably be driven to the expedient of inflation in the futile hope that somehow bank credit will prove to be a substitute for real savings.