Price inflation is not inevitable. One of the most common explanations for price growth is identifying it with capitalism. The argument is that inflation is unavoidable as the economy grows. It is thought that for businesses to have an incentive to invest and wages to grow, the prices of goods and services should rise in the first place. However, the history of the world’s most important economy, the United States of America, shows that growth is possible without inflation.
From the late 18th century until 1873, the US operated the so-called Bimetallic Standard System, whereby the dollar’s value was defined as a given quantity of two selected metals, gold and silver. As a result, a fixed currency exchange rate was established for these metals. During this period, the Americans enjoyed an overall price decline of 30%.
Nevertheless, significant fluctuations were observed. For example, in 1802 prices fell by as much as 14%, and during the Civil War, in 1864, the annual price increase was as high as 27%. For the ten years that followed, prices fell steadily and purchasing power recovered. Thus, even though the dollar was backed by gold and silver, significant spikes in inflation were not avoided but always replaced by the opposite process of deflation.
After the abandonment of the two-metal standard in 1873, the dollar was backed only by gold. During the so-called Classical Gold Standard period, which lasted until the outbreak of the First World War, prices in the US fell by around 10%. Although no significant price spikes were recorded during these forty years (with a peak annual inflation rate of 4%), the price falls were quite pronounced, with deflation reaching up to 9.4%.
Before World War I, in 1913, the Federal Reserve (Fed) was established in the USA. One of the main motives was to prevent price instability and the persistent cycles of inflation and deflation that were caused by recurrent episodes of financial panic. When the gold standard system was abandoned in 1914, many countries around the world renounced their commitment to back their currencies with this metal. However, the US and Britain continued to do so, and other countries opted to use these currencies as reserves. As can be seen later, the complete abandonment of this system led to even more rapid spikes in inflation.
In the first two decades of the Fed’s operation, notwithstanding the significant annual fall in prices during the Great Depression (-10.9%), inflation in the US as a whole amounted to 37%. The Americans had never seen such price rises before. During the peak period, prices increased by as much as 17.8% per year. Thus, the establishment of a central bank did not stop the upward-downward cycles of prices.
As is often the case, when a government plan does not work, it is not abandoned. On the contrary, the institutions are given even more power. To prevent a recurrence of the 1929 depression in the US, the Fed was given more power in 1935 to increase the money supply and to adjust interest rates. In addition, the Bretton Woods Agreement of 1944 specified that the dollar would remain the world’s reserve currency, with the US committing to continue converting it into gold. Until 1971, during the 36 years of this system, the strengthening of the central bank’s powers led to a significant increase in price growth, which reached an unprecedented cumulative rate of almost 200%.
Finally, as France increasingly demanded that the US dollars held in reserves be exchanged for gold, US President Richard Nixon completely terminated the Bretton Woods commitment to peg the dollar to gold in 1971. Such a move marked the beginning of the current fiat money system. The currencies of countries have since been based on a government decree and a declaration that a particular currency used in the country is the official medium of exchange. The value of money is no longer linked to any real physical asset.
The result is that prices in the United States have risen by almost 700% from the 1970s to the present. On several occasions, the annual increase in prices has exceeded 13%. The only brief period of annual deflation was recorded during the financial crisis when prices fell by 0.4% in 2009.
In retrospect, it can certainly be said that the country’s central bank “successfully” fulfilled its mission of avoiding price inflation-deflation cycles since we no longer have volatility and only stable and high inflation instead.
Thus, price inflation is not an inevitability. Perhaps we think otherwise only because we have become accustomed to universal, stable, and continuous price increases. It has become the new norm, without which one cannot imagine daily life. Yet this has nothing to do with capitalism or the principles of the free market. On the contrary, in a free market, falling prices are a natural phenomenon because, with the increase in the productivity of the economy, commodities become cheaper. The history of the United States only confirms that global and continuous inflation is primarily an attribute of the policies used by the central banks.
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