Money Mischief_ Episodes in Monetary History - Milton Friedman [84]
Mitigating the Side Effects
I do not know of any example of any inflation that has been ended without an interim period of slow economic growth and higher than usual unemployment. That is the basis in experience for the judgment that there is no way to avoid these side effects of a cure for inflation.
However, it is possible to mitigate the side effects, to make them milder.
The most important mitigating device is to slow inflation gradually but steadily by a policy announced in advance and then adhered to, so that it becomes credible. That is feasible for moderate inflations. It is not feasible for major inflations, let alone hyperinflations. In such cases, only a shock treatment is feasible; the patient is too ill to support a long-drawn-out cure.
The reason for gradualness and advance announcement is to give people time to readjust their arrangements, and to induce them to do so. Many people enter into long-term contracts—for employment, to lend or borrow money, to engage in production or construction—on the basis of anticipations about the likely rate of inflation. These long-term contracts make it difficult to reduce inflation rapidly, because trying to do so will impose heavy costs on many people. Given time, the contracts will be completed or renewed or renegotiated, and they can then be adjusted to the new situation. However, the economic advantage of gradualness is partly or wholly offset by a political disadvantage. A crisis may generate the political will to support a shock treatment. But the political will may disintegrate during a long-drawn-out adjustment.
One other device that has proved effective in mitigating the adverse side effects of curing inflation is the inclusion in longer-term contracts of an automatic adjustment for inflation, or what is known as an escalator clause. The most common example is the cost-of-living adjustment clause that is included in many wage contracts. Such a contract specifies that the hourly wage shall increase by, say, 2 percent plus the rate of inflation or plus a fraction of the rate of inflation. In that way, if inflation is low, the wage increase in dollars is low; if inflation is high, the wage increase in dollars is high. But in either case the wage has the same purchasing power.
Another example concerns contracts for the rental of property. Instead of stating the rent as a fixed number of dollars, the contract may specify that the rent shall be adjusted from year to year by the rate of inflation. Rental contracts for retail stores often specify the rent as a percentage of the gross receipts of the store. Such contracts have no explicit escalator clause, but there is an implicit one, since the store's receipts will tend to rise with inflation.
Still another example is a contract for a loan. A loan is typically for a fixed dollar sum for a fixed period at a fixed annual rate of interest, say, $1,000 for one year at 10 percent. An alternative is to specify the rate of interest not at 10 percent but at, say, 4 percent plus the rate of inflation, so that if inflation turns out to be 5 percent, the interest rate will be 9 percent, and if inflation turns out to be 10 percent, the interest rate will be 14 percent. A roughly equivalent alternative is to specify the amount to be repaid not as a fixed number of dollars but as a number of dollars adjusted for inflation. In our simple example, the borrower would owe $1,000 increased by the rate of inflation plus interest at 4 percent. If inflation turned out to be 5 percent, the amount owed would be $1,050 plus interest at 4 percent; if inflation was 10 percent, $1,100 plus the interest.
Except for wage contracts, escalator clauses have not been common in the United States. However, they began to spread during the 1970s and early 1980s, especially in the form of variable-interest mortgages. And they have been common in almost all countries that have experienced both high and variable rates of inflation over any extended period.
Escalator clauses reduce the time delay between