Free to Choose Chapter 9: The Cure for Inflation
Take a five-dollar bill out of your wallet. Now cut a rectangle of the same size from a glossy magazine. Both are pieces of paper. Both have pictures and numbers on them. One can buy you lunch. The other is garbage. Why? That question – why green paper has value – is where the Friedmans begin their chapter on inflation. And the answer is stranger than you might think.
This is post 14 in my Free to Choose retelling series.
Why a $5 Bill Is Not Just Paper
The printing on a five-dollar bill says “Federal Reserve Note” and “This note is legal tender for all debts, public and private.” That sounds official. But what does it actually mean? It used to say the government “will promise to pay” five dollars. If you walked into a Federal Reserve Bank and asked them to make good on that promise, they would have handed you five one-dollar bills. Ask them to redeem those, and you would get coins that, melted down, were worth less than a dollar as metal.
So the bill is not backed by gold, silver, or anything physical. It has value because everyone believes it has value. You accept it because you are confident the grocery store will accept it. The grocery store accepts it because they are confident their suppliers will accept it. The whole system rests on a shared agreement – a kind of fiction that works only because everyone participates.
This fiction is surprisingly durable. People will keep using money even when governments abuse it badly. But it is not indestructible. The phrase “not worth a Continental” comes from the American Revolution, when the Continental Congress printed so much currency to pay for the war that the money became worthless. When the fiction breaks, it breaks hard.
Inflation Is Always a Money Problem
The Friedmans state one of the most important ideas in economics in plain language: inflation is always and everywhere a monetary phenomenon. Prices rise when the quantity of money grows faster than the quantity of goods and services available for purchase. It does not matter what form the money takes.
They give a wonderful example from colonial Virginia, where tobacco was the legal currency for nearly two centuries. People paid taxes in tobacco. They bought food and clothing with tobacco. They even paid for brides with bundles of tobacco leaves. But growing tobacco was cheap and easy. Planters produced more and more of it. The money supply – literally – grew in the fields. Prices in terms of tobacco rose fortyfold over about fifty years.
The Virginia colonists tried everything to stop it. Laws prohibited certain people from growing tobacco. They ordered parts of the crop destroyed. They banned planting for an entire year. Nothing worked. People even formed mobs to destroy tobacco plants in the countryside, until the government declared that doing so in groups of eight or more was treason, punishable by death.
The pattern is always the same. Whether money is tobacco in 1650, gold coins in ancient Rome, or paper dollars today – when you create too much of it, prices go up. The German hyperinflation after World War I saw prices double from one day to the next. The Hungarian hyperinflation after World War II had money growing at 12,000 percent per month. These are extreme cases, but the principle behind them is the same one behind the moderate inflation Americans have experienced in recent decades.
Why Governments Print Too Much Money
If everyone knows too much money causes inflation, why do governments keep doing it? The Friedmans identify three reasons, at least for the United States.
First, government spending. When the government wants to spend more, it has three options: raise taxes, borrow from the public, or print new money. Raising taxes is unpopular. Borrowing drives up interest rates, which makes mortgages and business loans more expensive. But printing money? That is the magic option. Politicians get to spend more without voting for higher taxes and without visibly taking money from anyone. The cost is hidden in higher prices that show up months or years later.
The mechanics are simple. The Treasury sells bonds to the Federal Reserve. The Fed pays with freshly printed cash or new entries on its books. The Treasury spends the money. When that new money enters the banking system, it multiplies, and the total money supply grows far beyond the original amount.
Second, the promise of full employment. Governments want to reduce unemployment, which is a fine goal. But they set targets that are too ambitious and try to reach them by pumping money into the economy. This works for a while. More spending means more jobs – at first. Then prices start rising. Workers discover their higher wages buy less. The temporary boost fades and leaves behind permanent inflation.
As British Prime Minister James Callaghan told his own Labour Party in 1976: “We used to think that you could just spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you, in all candor, that that option no longer exists.”
Third, the Federal Reserve’s confusion. The Fed has the power to control the money supply. But instead of focusing on that, it has spent decades trying to control interest rates – something it cannot reliably do. The result has been wild swings in both. And because the Fed remembers the Great Depression, it has always been quicker to correct low monetary growth than high monetary growth. The bias runs in one direction: toward more inflation.
The Hidden Tax Nobody Votes For
Inflation is a tax. The Friedmans explain this with a simple example. Suppose the government builds a road and pays for it with newly printed money. The workers get paid. They buy food and clothing. It looks like something was created from nothing. But the extra money in the economy raises prices. Everyone who holds dollars finds that their money buys a little less than before. The difference – that lost purchasing power – is the tax. You paid for the road, but nobody sent you a bill.
This hidden tax operates in at least three ways. The most obvious is the direct loss of purchasing power. But inflation also pushes people into higher tax brackets even when their real income has not changed. A 10 percent raise that merely keeps pace with 10 percent inflation can push you into a bracket where you pay 15 percent more in taxes. Politicians then claim credit for “tax cuts” that only partially undo the increases that inflation created automatically.
The third way is the sneakiest. The government borrows in today’s dollars and repays in tomorrow’s cheaper dollars. Friedman gives the example of someone who bought a savings bond in 1968 for $37.50. Ten years later they got back $64.74. Sounds like a profit – until you realize it took $70 in 1978 to buy what $37.50 bought in 1968. The bondholder lost money in real terms. And then had to pay income tax on the “gain.” The government effectively charged its own citizens for the privilege of lending it money.
Why Wage and Price Controls Never Work
When inflation gets bad, governments reach for an appealing-sounding tool: wage and price controls. Just make it illegal to raise prices. Problem solved, right?
The Friedmans say this has been tried for forty centuries and it has never worked. Not once.
Controls seem to work for a brief period because quoted prices stay flat. But behind the scenes, businesses find ways around them. They lower the quality of products. They eliminate services. They promote workers to new job titles that pay more. The easy workarounds get used up first. Then distortions pile up. Shortages appear. Black markets grow. The pressure builds until the whole system collapses, and inflation comes back worse than before.
There is a deeper problem. In practice, price controls are almost always used instead of actual monetary restraint, not alongside it. The market learns this. When governments announce controls, people do not lower their expectations for future inflation – they raise them. Controls become a signal that inflation is heading up, not down.
The Friedmans are equally skeptical of “voluntary” controls. Whether you call them mandatory or voluntary, the economic effects are the same: distorted prices, wasted resources, and an economy that produces less than it should.
The Cure – Simple to Say, Hard to Do
The cure for inflation is easy to state: slow down the growth of the money supply. That is it. There is no mystery about what needs to happen. The difficulty is entirely political.
The Friedmans compare inflation to alcoholism. When the drinking starts, the good effects come first – the buzz, the confidence, the good times. The hangover comes later. And the temptation is always to have another drink to ease the hangover.
Inflation works the same way. When a government starts printing money faster, the first effects are wonderful. Jobs are plentiful. Business is booming. Everyone is happy. The bad effects – rising prices, falling real wages, stagnation – come months or years later. And the temptation is always to print even more money to get through the rough patch.
The cure reverses this sequence. When you slow monetary growth, the bad effects come first: a period of slower economic growth and higher unemployment that may last one to two years. The good effects – lower inflation, a healthier economy, the possibility of real growth – come later. It is like going through withdrawal. The pain is real but temporary.
Japan in the mid-1970s provides the textbook example. Money growth had climbed above 25 percent per year by 1973. Inflation soared. Japan responded by cutting monetary growth sharply and keeping it low for five years. The economy went through a painful adjustment in 1974. But by the late 1970s, inflation had fallen to near zero, and the economy was growing at a respectable five percent per year. No wage or price controls were imposed. Japan simply did the hard thing and stuck with it.
The Friedmans recommend two things to ease the transition. First, slow down gradually and announce the plan in advance, so people can adjust their contracts and expectations. Second, use escalator clauses – automatic inflation adjustments in wages, rents, and loan contracts – so that a slowdown in inflation flows through the economy faster. They also argue that the tax code and government bonds should be indexed to inflation, so the government itself has less incentive to inflate.
Key Takeaway
The Friedmans boil inflation down to five truths. Inflation comes from money growing faster than output. In the modern world, only governments control the money supply. The only cure is slower monetary growth. Both the disease and the cure take years, not months, to play out. And the side effects of the cure are real and unavoidable. The false choice that politicians offer – inflation or unemployment – is an illusion. The real choice is whether we accept temporary pain now for lasting stability, or whether we keep reaching for another drink.
Book: Free to Choose by Milton and Rose Friedman | ISBN: 978-0-15-633460-0
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