The Cure for Inflation – Inflation as a Monetary Disease
The ninth major argument in Free to Choose is a direct and uncompromising diagnosis of the causes and cure of inflation. The Friedmans argue that inflation is not a complex, multifaceted problem with a dozen different causes, as politicians and commentators often suggest. It is, in their famous formulation, “always and everywhere a monetary phenomenon.” Substantial, sustained inflation has one and only one cause: a rate of growth in the quantity of money that is more rapid than the rate of growth in the output of goods and services.
Understanding this simple but profound truth is the essential first step. From it follows a similarly direct conclusion about the cure. The only cure for inflation is to reduce the rate of growth of the money supply. While the cure is simple to state, it is politically difficult to implement because, like curing an addiction, the painful side effects (a temporary period of slower economic growth and higher unemployment) come first, while the benefits (stable prices and a healthy economy) come later.
The Nature of Money and the Cause of Inflation
To understand the argument, one must first grasp the nature of money. A five-dollar bill has value not because of the paper it’s printed on or the promise of the government, but for a single, circular reason: you accept it as payment because you are confident that others will accept it from you. Money is a social convention, a “fiction” that we all agree to accept because it is an incredibly useful “machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it.” It is the lubricant that allows a complex, specialized economy to function.
But this machine, as John Stuart Mill noted, “only exerts a distinct and independent influence of its own when it gets out of order.” And when it does get out of order, it can do immense damage. Inflation is the primary way modern money gets out of order.
The relationship between money and prices is one of the oldest and best-established principles in economics. If the amount of money in an economy grows faster than the amount of goods and services available for purchase, then the price of those goods and services, in terms of money, must rise. More money is chasing the same amount of goods. Each unit of money becomes less valuable, meaning it takes more of them to buy any particular item. This is the essence of inflation.
The Friedmans marshal overwhelming historical evidence to support this claim. They point to the inflation in the Roman Empire caused by the debasement of silver coins, the price revolution in 16th-century Europe caused by the influx of gold and silver from the New World, and the hyperinflations of Germany after World War I and Hungary after World War II, where the astronomical rates of price increases were matched step-for-step by astronomical rates of printing-press money creation.
This direct relationship is not just a historical curiosity; it is a contemporary reality. The Friedmans present charts for the United States, Germany, Japan, the United Kingdom, and Brazil, showing a near-perfect correspondence between the rate of growth in the money supply (per unit of output) and the rate of inflation. Countries with low monetary growth, like Germany, have had low inflation. Countries with high monetary growth, like Brazil, have had high inflation.
This evidence allows them to systematically demolish the popular alternative explanations for inflation:
- Greedy Businessmen and Grasping Unions: These are the most common scapegoats. But are businessmen in Brazil inherently greedier than those in Switzerland? Were American unions more powerful in the high-inflation 1970s than in the low-inflation 1950s? Of course not. Businesses and unions respond to inflation; they do not cause it. They may be the mechanism through which the price increases become visible, but they are not the ultimate cause. Crucially, neither a corporation nor a union has a printing press.
- The OPEC Oil Shock: The oil price hikes of the 1970s imposed a real cost on oil-importing nations and caused a one-time jump in the overall price level. But they did not and could not cause a sustained, ongoing rate of inflation. After the 1973 oil shock, inflation in Germany and Japan declined, while in the U.S. and U.K. it accelerated. This proves that the domestic policy response, not the external shock, was the determining factor.
- Government Deficits: Deficits themselves do not automatically cause inflation. If the government finances its deficit by borrowing from the public (selling bonds), it is simply transferring existing purchasing power from private individuals to the government. There is no creation of new money.
This leads to the crucial question: If inflation is a monetary phenomenon, who controls the money?
Why Governments Create Inflation
In the modern world of fiat money (paper money not backed by a commodity like gold), the government and its central bank (the Federal Reserve in the U.S.) have a monopoly on the creation of money. The government, and the government alone, is responsible for inflation. Why, then, do they do it? The Friedmans identify three main reasons for the excessive monetary growth in the United States:
- As a Source of Revenue (a Hidden Tax): The most ancient reason. When a government wants to spend more but is unwilling to raise taxes or borrow from the public, it has a third option: it can simply print the money it needs. When the government pays its bills with this newly created money, it acquires real goods and services. Who pays? All holders of money pay. The new money dilutes the value of all existing money, causing prices to rise. This is equivalent to a hidden tax on holding cash. Every dollar you hold now buys less. Inflation has also become a source of revenue by stealthily pushing people into higher tax brackets (“bracket creep”) and by allowing the government to repay its debt in cheaper dollars.
- The Commitment to “Full Employment”: Since the 1946 Employment Act, the U.S. government has been officially committed to promoting maximum employment. This has created a powerful political bias toward inflationary policies. Increased government spending and easier money are often seen as ways to “stimulate” the economy and create jobs. While there may be a temporary, short-term trade-off where higher inflation appears to “buy” lower unemployment, the Friedmans argue that this is an illusion. In the long run, there is no such trade-off. Persistently high inflation disrupts the economy and leads to both high inflation and high unemployment—a condition known as “stagflation.”
- Mistaken Federal Reserve Policy: The Fed, while paying lip service to controlling the money supply, has in practice been obsessed with controlling interest rates. But trying to control interest rates is like trying to grab a tiger by the tail. The Fed does not have the power to control rates for long. When it tries to keep interest rates artificially low, it must pump more and more money into the system, which eventually leads to higher inflation, which in turn leads to higher, not lower, interest rates (as lenders demand a premium to compensate for the erosion of their principal). This misguided focus has led to a volatile, roller-coaster pattern of monetary growth, with an overall inflationary bias.
The Cure and its Painful Side Effects
Just as the cause of inflation is simple, so is the cure: the government must slow the rate of monetary growth. There is no other way. Price and wage controls, as forty centuries of history have shown, do not work. At best, they temporarily suppress the symptoms while the underlying disease gets worse, leading to shortages, black markets, and an eventual explosion of prices when the controls are inevitably lifted.
The real problem is that the cure has painful, but unavoidable, temporary side effects. The Friedmans use the analogy of an alcoholic. For the alcoholic, the first drink brings pleasure, while the hangover comes the next morning. For the economy, the initial effect of printing money is a “high”—a temporary boom in business activity and employment. The bad effects—rising prices—come later.
Curing the addiction works in reverse. For the alcoholic, the first step of quitting brings the pain of withdrawal, while the benefits of sobriety come later. For the economy, the first effect of slowing monetary growth is a painful “withdrawal”—a period of economic slowdown and higher unemployment. This happens because wages and prices are “sticky.” Many are set by long-term contracts and expectations built on past inflation. When the government slows the flow of money, spending slows down, but prices and wages do not adjust immediately. Businesses find their sales falling, and they respond by cutting production and laying off workers.
This recessionary period is not the cure for inflation; it is the temporary side effect of the cure. It is a terrible mistake to think of unemployment as a “tool” to fight inflation. The cure is, and only is, slower monetary growth. The recession is the price that must be paid to break the inflationary fever and readjust the economy’s expectations to a non-inflationary world.
How to Mitigate the Side Effects
While the side effects are unavoidable, their severity and duration can be reduced. The best way to do this is to make the cure gradual, steady, and credible.
- Gradual: A “cold turkey” approach of slamming on the monetary brakes will cause a deep and painful recession. A gradual reduction in the rate of monetary growth over a period of several years allows more time for contracts, wages, and prices to adjust.
- Steady: The policy must be consistent. A stop-go policy—where the central bank slows down, panics at the first sign of a recession, and then opens the monetary spigots again—is the worst of all worlds. It produces a roller-coaster economy and convinces the public that the government is not serious, which keeps inflationary expectations high.
- Credible: The government must announce its long-term plan to reduce monetary growth and then stick to it, convincing the public that it is truly committed to ending inflation. If the policy is credible, people will adjust their expectations and their contract terms more quickly, shortening the painful transition period.
The Friedmans also advocate the wider use of escalator clauses (or cost-of-living adjustments) in contracts during the transition period. Clauses that automatically adjust wages, rents, and loan principals for inflation can help the economy adapt more quickly to a lower rate of inflation. They also strongly advocate for indexing the tax system to prevent the government from profiting from inflation through “bracket creep.”
Conclusion: The Political Will
The problem of inflation, then, is not technical; it is political. We know how to cure it. The question is whether we have the political will to endure the temporary pain of the cure. For decades, politicians have found it easier to yield to the temptation of the printing press—to finance spending, to pursue an illusory full employment—than to exercise the monetary discipline necessary for stable prices.
The Friedmans conclude with a case study of Japan in the 1970s, which successfully cured a raging inflation by implementing a policy of gradual, steady, and credible monetary restraint. It endured a temporary recession but emerged with a stable and healthy economy. Their message is clear: the cure is known, and it works. The choice of whether to apply it is a test of a nation’s political maturity and its commitment to a stable economic future.