The Inflation Myth and the Wonderful World of Deflation. Mark Mobius

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“I do not think it an exaggeration,” the economist Friedrich Hayek once wrote, “to say that history is largely a history of inflation…”² Price rises can be witnessed around the world, as indicated by Germany's Weimar Republic hyperinflation in the early 1920s, the inflation of Eastern Europe following the collapse of the Berlin Wall in 1989, the stagflation of many Western countries in the 1970s, and the inflation that Japan witnessed following the end of the economic miracle in the 1960s.

      It's important for us to look at the consequences of such information flows regarding “inflation,” “deflation,” “hyperinflation,” etc. and what are the effects on decision‐making not only in governments but also in business and investment. We want to look at the impact of inflation/deflation statistical information flows and how they can be so misleading.

Importance of Inflation Numbers

Ever since the earliest price indices were first introduced at the start of the eighteenth century, the measurement of inflation and attempts to control its growth have become increasingly salient. After the Second World War, full employment was seen as one of the major goals of economic policy. Then, over the next forty years, price stability took its place as the primary economic aim of governments and central banks. As mentioned previously, it was Ronald Reagan in the 1980s who described the threat of inflation as being “…as violent as a mugger, as frightening as an armed robber and as deadly as a hitman.”³ Showing the priorities of modern governments, in 1991 the then British Chancellor, Norman Lamont, told the House of Commons that: “… rising unemployment and the recession have been the price that we have had to pay to get inflation down. That price is well worth paying. That focus on keeping inflation down remains at the heart of monetary policy.”⁴

      Central banks around the world are charged with keeping inflation at an agreed rate. For example, in the UK each year, the Chancellor of the Exchequer writes to the Governor of the Bank, confirming what the inflation target is. Should the inflation rate deviate from this target by more than 1%, the Governor must write to the Chancellor, explaining why the inflation target has been missed and what steps the Bank is going to take to rectify the situation.

      Price instability is, of course, not just an issue for governments. For investors, information regarding the rate of inflation plays an important part in deciding where they put their money. Rising levels of inflation supposedly reduce the value of savings and investment unless interest rates and returns on investment keep pace. This has an impact on everyone – from those with savings in a bank account, to where pension funds are being invested.

The Long Coffin

      At the center of the Bank of England is a small courtyard garden, which is the preserve of the incumbent governor. Originally, the garden was a graveyard. When the Bank moved to Threadneedle Street in 1734, it soon expanded to take over the church next door which was subsequently deconsecrated and demolished. However, the decision was taken to leave the graveyard there. In the 1920s and 1930s, when the Bank needed rebuilding again, the Garden Court was dug up to reveal several coffins, one of which was the curiosity of William Jenkins. Jenkins worked at the Bank in the late 1700s, was 6 feet 7 inches tall, and was buried in the Garden Court as his friends were worried that his body might be stolen and sold. Such was the size of Jenkins’ coffin that when it was moved to Nunhead Cemetery, it had to be placed in the catacombs as it was too long for the vaults.

Back at the restored Garden Court meanwhile, as part of the renovations the Court was planted with mulberry trees. The reason for the choice of trees was twofold. First, there was the practical consideration that the roots of the mulberry tree grow horizontally, rather than straight down into the ground: handy when the Bank of England’s gold vaults (which contain some 400,000 bars of gold) are directly underneath. Second, and more symbolically, the mulberry tree has played a critical role in the history of money. In seventh‐century China, the bark of the mulberry tree was used to make the earliest form of paper currency. The old saying has it that money doesn’t grow on trees. But in early China, it did; and when it arrived, inflation was swift to follow.

Marco Polo and Money

      In 1271, the traveler and explorer Marco Polo set off for the court of Khubilai (otherwise known as Kublai Khan) the same year the latter established the Yuan Dynasty and became Emperor of China. Polo's journey to reach Khubilai's court at Shangdu took him four years and was not without incident: the fall of the city of Xiangyang in 1273 to Khubilai's troops was just one episode in which Polo was involved. All of this, and his impressions of Khubilai's court, Polo wrote up in a book that in France was traditionally called Le Livre des Merveilles (The Book of Marvels) and which is known in English more prosaically as, simply, The Travels.

      Out of the many marvels that Marco Polo was struck by was the Yuan Dynasty's use of banknotes. “The emperor's mint is in this city of Khanbaliq,” he wrote, “and it is set up in such a way that might well say he has mastered the art of alchemy.” Polo described in detail how the Great Khan, as he called him, went about making the notes: “He has the bark stripped from trees – to be precise, from the mulberry trees whose leaves are eaten by silkworms. Then the thin layer of bast fiber between the bark and the wood of the tree is removed. After being ground and pounded it is pressed with the aid of glue into sheets like those of cotton paper, which are completely black. And when these sheets are ready, they are cut up into pieces of different sizes, rectangular in shape and of greater length than breadth. And they are made with such authority and solemnity as if they were cast from pure gold or silver … when everything has been done correctly the chief of the officials deputed by the emperor dips the seal entrusted to him in cinnabar and stamps it on the piece of money, so that the imprint of the seal dipped in the cinnabar remains impressed upon it; and then the money is legal tender.”⁵

      Polo's enthusiasm for paper money is proof of how far ahead China was in its understanding of monetary policy in comparison to their Western counterparts: it wasn't until the seventeenth century that paper bills began to be used in Europe. But what Marco Polo had been so impressed by, wasn't something new to China. In fact, the concept had its origins several hundred years earlier during the Tang Dynasty of 618–907. Here, bills of exchange, printed on pieces of textile, were used by businessmen and government officials to take money from one city to another. The notes were known as Feiqian or “flying money,” on account of the money being able to “fly” back without the need for coins or gold.

But it was not long after the invention of the idea that the appearance of inflation followed suit. An official version of Jiaozi, or certificate of exchange, was launched in 1023, with the stipulation that the notes were convertible to coins. However, the pressure on government finances due to fighting wars resulted in the printing of more Jiaozi. By devaluing the notes against the coins they were meant to represent, the result was a sharp rise in inflation – by 1107, there was 20 times the total amount of Jiaozi compared to the initial launch. The result was that the notes were ultimately withdrawn and replaced with a new set of notes: to avoid another round of rising prices, a set percentage of the printing of any new notes had to be matched by an increase in coin reserves.

      By the 1160s, the now dominant Southern Song Dynasty added a further stipulation – all notes were to be recalled and redeemed for copper coins every three years. This was a system that held until, once again, the need to finance military activity saw a relaxing of these rules and the printing of paper notes rose again. By the time of Marco Polo's travels, the now dominant Yuan Dynasty had issued national paper currency, with which it guaranteed convertibility into silver, and banned the use of coins in trading, forcing the use of the new currency.

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