The National Bureau of Economic Research put out a book on the New Deal and World War II inflation, published in 1980. You can find a chapter of that book titled, World War II Inflation, September 1939-August 1949, here. It is a great discussion of how price controls affected the US economy during World War II. A comparison to the time period before and after price controls is also made.
First of all, the author points out that.
“…our [US] entry into active war [World War II] was rather surprisingly accompanied by a slowing down of the rate of rise in the available price indexes, while the termination of wartime deficits was accompanied by a sharp speeding up…wholesale price index rose at the rate of 4% a year during the period of wartime deficits, compared with 9 % in the prior period, and 16% in the succeeding period.”
Basically, the translation of the above is that while the US government was running large deficits to pay for the war, inflation remained relatively tame at 4% a year. This period of wartime deficits started in 1941 and ended in 1946. Normally, deficits lead to inflation, because government deficits are a sign that the government is buying and paying for things [the war] with money it doesn’t have. But inflation had actually gone down during the deficit years; inflation was 9% before the deficit years, and 16% in the period after [post-war].
Continued from NBER,
“General price control was instituted in early 1942 and suspended in mid-1946. During the period of price control, there was a strong tendency for price increases to take a concealed form, such as change in quality or in services rendered along with the sale of a commodity or the elimination of discounts on sales or the concentration of production on lines that happened to have relatively favorable price ceilings…where price controls were effective, “shortages: developed, in some cases-such as gasoline, meats, and a few other foods-accompanied by explicit government rationing. The resulting pressure on consumers to substitute less desirable but available qualities and items for more desirable but unavailable qualities and items was equivalent to a price increase not recorded in the indexes.”
Basically, the above can be summarized simply: price controls don’t work. Price controls are a communist and socialist concept, not a capitalist construct. Capitalism depends on the free flow of money and capital, allowing the market to determine the most efficient price of things, based on supply and demand. The market got around price controls, in ways that the government did not anticipate, such as trade in the black market. Furthermore, because price controls were not placed on everything (just items the government deemed essential to the war effort and the war economy were price controlled), shortages of goods from gasoline to good became commonplace. This led people to seek out less desirable, but available alternatives, which led to price inflation in things that normally should not have been expensive.
For example, price controls on new automobiles intended to force factories into not producing cars, and instead producing guns, led to price inflation in the used car market. The government did not measure the price of used cars when it calculated inflation. Therefore, inflation existed, even though it wasn’t being measured.
As the NBER put it,
“The result [of price controls] was that “prices”, in an economically meaningful sense, rose by decidedly more than the price index during the period of price control. The jump in the price index on the elimination of price control in 1946 did not involve any corresponding jump in “prices”; rather, it reelected largely the unveiling of price increases that had occurred earlier.”
So basically, actual prices of things people were able to buy, alternatives to things they couldn’t get their hands on, were skyrocketing in price, even though that inflation was not reflected in the wholesale price index (measuring the price of goods that were price controlled, and scarce).
Do you see the ridiculousness of price controls? The government was measuring the price of things that it controlled the price over, and then telling everyone, prices were under control.
When price controls were removed, and the free market returned, actual measured inflation soared, because it had been there all along. For example, since the price of a used car had soared under price controls, when new cars came back back on the market, they were priced above used car prices, which were above where new car prices used to be before the war.
For prices, the removal of government control meant it was time to play catch-up.
What we need to understand is that during World War II, price controls, whether it be the price of money [interest rate], or the price of gasoline, were intended to transform the economy from a consumer economy, to a war economy.
In this context, it becomes clear that capitalism can’t function in a war economy, because governments wage war, and when a government monopolizes production, the economy is no longer capitalist. It becomes a planned economy, where the government determines how resources are used. In instituting price controls, the main goal of the government was to prevent the scarcity of goods from driving up the price of those goods; in other words, the government did not want a shrinking supply of goods, to drive up the price of those goods.
Even if consumer demand went down during the war simply because of a reduction in the civilian population (as a result of a dramatic rise in the military population), the reduction of supply was far greater. As a result, the price of gasoline in the US did not go up during the war, but unfortunately, the supply of it (for civilian consumption) almost completely disappeared.
Going back to the example of automobiles, price controls on durable goods, such as automobiles, made it so that Ford and General Motors found it no longer profitable to manufacture cars that were price controlled. The price controls were set so that it would be less profitable to manufacture cars, as opposed to military equipment. As a result, GM and Ford turned to manufacturing tanks, exactly the effect the US government was going for. The intention of the US government was to indirectly prohibit investment by the private sector in anything other than that which was needed to fight the war. And it worked.
World War II saw the savings rate in the United States soar. Why was this?
After the imposition of price controls, Americans found that, for example, automobiles, an American infatuation at the time, were nowhere to be found. Dealerships had nothing on their lots except for used cars, and the price for a used cars soared. Rather than pay those prices, Americans simply didn’t buy cars. The same was the case with dishwashers, stoves, and all things known as “durable goods”. At the same time this was going on, Americans were flush with cash; wages were high, jobs were plentiful, and the war economy was leading to a historic post-Depression wealth accumulation. Price controls, and scarcity combined to make it so consumers had nowhere to put their money except into savings accounts, or War Bonds. And due to the patriotism and nationalism of the day, consumers made it their duty to invest in War Bonds.
The demand for War Bonds served to keep the interest rates on those bonds low. The US government didn’t have to entice the public to buy them; they were selling out at 2.89%, because of all the above reasons. Interestingly enough, prior to entering the war, the United States government became a massive owner of Gold.
As Nazi Germany militarized and began its conquest of Europe, it paid for American made goods, services, and loans, with Gold. The French and the British, upon declaration of war on Nazi Germany, sold off much of their Gold holdings to pay for their own military build-up. In addition, in 1933, President Franklin D. Roosevelt issued Executive Order 6102, which basically made it illegal to hoard gold, or own anymore than a small amount of Gold, either in personal or corporate possession.
The reason behind the Executive Order 6102 was to put more Gold in the hands of the Federal Reserve so that it could print more US Dollar currency. The Depression led US citizens and companies to shun US Dollars and hoard physical Gold, and that alone was causing the Depression to linger.
Under threat of imprisonment, people began to turn over their Gold to the Federal Reserve, at the price of $20.67 per ounce. In 1934, after seizing Gold from the public, Roosevelt declared that the new price of Gold was $35 per ounce, a price that was more reflective of the true value of Gold.
Do you see what happened there? FDR ordered the public to hand over their Gold for $20.67 per ounce. He then said, anyone who wants to buy Gold from here on out, needs to pay $35 an ounce. Incredible! The new gold, and its higher declared value, also allowed the Federal Reserve to print US Dollar paper currency, which was injected into American business via New Deal loans.
Roosevelt used the money to pay for the New Deal, and later to pay for World War II. The $35 price per ounce also created a new Gold Rush, worldwide. It suddenly became far more profitable to mine Gold. Newly mined Gold was overwhelmingly bought by the US Government, via Treasury, since it was illegal for US citizens to own more than $100 worth of Gold. The more Gold the Treasury owned, the more US Dollar currency it printed, and this loop financed the economic boom that lasted in the US throughout the late 1930s and 1940s.
By 1940, the US owned 19,543 metric tons of Gold, 51% of all the Government/Central Bank-owned Gold in the world. By the end of the war in 1945, the war had barely dented its holdings (then at 17,848 metric tons), which was 63% of Government/Central Bank owned Gold in the world. The following table from World Gold Council shows the details.
Notice how the 1934 devaluation of the US Dollar, taking the price of Gold from $20.67/ounce to $35/ounce, led to a near doubling of Gold owned by Central Banks. US ownership more than doubled. Again, this was caused by the Gold Rush triggered by the US Dollar devaluation.
The National Bureau of Economic Research published research on the topic of US inflation during World War II. From NBER,
“The outbreak of war in Europe in September 1939 ushered in a period of inflation comparable to the inflations which accompanied the Civil War and World War I, though more protracted than either. By the postwar price peak nine years later (August 1948), wholesale prices had more than doubled, the implicit price deflator had somewhat less than doubled, the stock of money had nearly tripled, and money income had multiplied more than 2.5x.”
NBER goes on further to talk about how at the same time as the above, the velocity of money plummeted. From NBER,
“As this comparison indicates, velocity on net fell over the period. After an initial rise to 1942, it fell sharply to 1946 and then rose mildly to 1948.”
The following table lists the important statistics that show just how far below market levels interest rates were being held during World War II.
|Indicator||Average Annual Change, 1939-1948|
|Implicit Price Deflator||+6.5%|
Wholesale prices are a measure of inflation. Wholesale prices are a measure of the change in commodity prices, year over year. In the US, the Wholesale Prices indicator is defunct; today, it is called the Producer Price Index. It is a measure of prices for goods that producers acquire in the manufacturing of products that will then be sold to consumers. Producer Prices eventually trickle down to consumer prices, and so the Producer Price Index sometimes can predict a move in the Consumer Price Index.
The Implicit Price Deflator is also known as the GDP Price Deflator. It is the difference between Real and Nominal GDP. The difference between Real and Nominal GDP is the inflation rate. For example, if Nominal GDP is +7%, and the Implicit Price Deflator is +2%, then Real GDP is 5%.
Money Stock, or more commonly known today, Money Supply, is the amount of currency in circulation in the economy. There are several measures of money supply; they are known as M0, M1, M2, and M3. For the purposes of this discussion, we will assume money stock is equivalent to the broad money supply. The Broad Money Supply is the amount of cash and cash equivalent and short-term easily convertible investment money, in the economy. This measure tries to quantify the amount of money that is circulating and usable today, as opposed to being tied up in long-term investments or in illiquid assets.
An example of an illiquid asset would be your house. If you have equity in your home, that money would not be included in the broad money supply. But, if you applied for a Home Equity Loan, or you refinanced, and received a credit line that is equivalent to the equity in your home, that credit line would be included in the Broad Money Supply since it is then accessible and liquid (easily convertible to cash).
Money Income is the equivalent of Gross National Income. It is the amount of money Americans make in total, before government taxes. From TheBalace,
“Gross National Income is a measurement of a country’s income. It includes all the income earned by a country’s residents and businesses, including any income earned abroad. Income is defined as all employee compensation plus investment profits. It includes earnings from foreign sources.”
Real income is Gross National Income adjusted for inflation. Change in real income can be thought of in the following way: if you get a 5% raise, from one year to the next, and during the same period, inflation was 3%, your change in real income was 2%. If you don’t get a raise, and inflation is 2%, then your change in real income was -2%.
Take that to your boss then next time your raise doesn’t come through!
Finally, Money Velocity is the pace at which money moves from one place to another, from one individual to another, or from one institution, private or public, to another. The velocity of money is a very cool concept because it measures how effectively, how productive, an economy is with its money supply.
Central Banks should only print as much money as is required for its economy to operate and grow in a stable and controlled manner. It’s a balancing act.
One of the reasons the US dropped the Gold Standard in the 1971 was because the supply of gold could not keep up with the money supply needed to grow the economy. Basically, US GDP was growing too fast for Gold supply to keep up. The only alternative was to devalue the US Dollar, so that more US Dollars could be printed without the need for more Gold. This is similar to what FDR did in 1933, what we talked about earlier.
The problem with that, of course, is inflation. Devaluing too much would trigger inflation, making it so US citizens would need far more money to buy basic goods. Devaluing too little would not have the intended effect of putting more Dollars into a growing economy. How much to devalue is very difficult to know, especially when by 1971, US Gold reserves had fallen dramatically from their peak in 1940. Between 1950 and 1971, US Gold reserves fell by over 50%.
In losing its Gold Reserves to the European countries it had rebuilt after World War II, the US had lost its ability to corner the Gold market, or de-facto determine the value of Gold in US Dollars.
On top of that, the US government budget, having been heavily mismanaged in the post World War II period, was running a larger and larger deficit. The below graph shows that the US government ran a deficit consistently throughout the 1960s and 1970s. In addition, the Corporate tax rate was nearly 50% throughout the 60s and 70s, which meant taxes were already high.
Not to mention the top tax bracket for Individual Income Tax was at its highest, 90%, and at its lowest, 70%!
The point being, the government was in a bind, between a rock and a hard place, running out of options to continue funding itself. As a result, President Nixon took the nuclear option: he abandoned the Gold Standard. He unpegged the US Dollar from Gold. It was now up to the Foreign Exchange markets to determine the value of the US Dollar. Not knowing how to respond, markets simply decided that the move was the first step toward unconstrained US dollar devaluation, which led to the inflation shocks that plagued the US during the 1970s.