SPEECH
SVERIGES RIKSBANK
DATE:
17 May 2022
SE-103 37 Stockholm
SPEAKER: (Brunkebergstorg 11)
Deputy Governor Henry Ohlsson
VENUE:
Department of Economic History, Uppsala University
Tel +46 8 787 00 00
Fax +46 8 21 05 31
registratorn@riksbank.se
www.riksbank.se
Monetary policy and inflation in times
of war*
The 2020s could certainly have begun better. Following a pandemic, which we still
haven't quite seen the end of, another war has broken out in Europe. As
information now spreads faster than ever before, via news channels and social media,
and as it is a country quite close to us that has been affected, the war in Ukraine
has shaken us more than usual in our safe Swedish everyday lives. That, at least, is
how I feel.
However horrific the war in Ukraine may be, it is not the war as such that I
intended to talk about today, but its economic consequences - and those of war in
general. After all, it is in the field of economics that I have my comparative
advantages, and as policy-maker at a central bank, monitoring the economic
consequences is, of course, something that is part of my job. I will focus on the effects
on inflation, as they are particularly important for a central bank.
When major and unusual events such as a war occur, there is no 'manual' for how
to act as an economic policy decision-maker. All wars are different - in terms of
their scale and duration, their location and their impact on the world around
them. Instead, we must brush up on our possible knowledge of history and try to
see if there are past historical episodes from which we can learn something for
the current situation. It is of course also important to study the available literature
on the economic consequences of war to see whether it is possible to find
common denominators that can give clues regarding the situation that has arisen.
What I intend to do today is to first briefly review what research literature has to
say about the connection between war and inflation. Then I will look back at
previous episodes when war was associated with rising inflation in Sweden and draw
some conclusions from this. Finally, I intend to say something about how I view
the current situation from a monetary policy perspective. As usual, it is my
personal views that I am expressing.
War often leads to inflation
The fact that war and inflation often go hand in hand has been known for a very
long time. Back in 500 BC Sun Tzu, Chinese general and author of a book on the
art of war, observed:
"Where the army is, prices are high; when prices rise the wealth of the people is
exhausted."1
What this refers to is, of course, that an army of perhaps tens of thousands of
soldiers requires a lot of resources just to stay alive and these can be difficult to raise
in a geographically restricted area. Demand simply rises in relation to the available
supply of food and other necessities, and this causes inflation to rise. If, as has
often been the case throughout history, the army supports itself by looting, it may
be able to survive for a while, but for the civilian population, prices will rise
because supply decreases. Of course, an army could not survive indefinitely in one
place, because resources sooner or later run out. In his book "Ofredsår" ("Years of
Trouble"), Peter Englund has likened the Swedish army during the Thirty Years'
War to a shark that must be constantly on the move to avoid succumbing.2
Once a war had started, the armies of the time lived partly their own lives,
separated from the state, and largely organised their own supplies, especially of
course during campaigns abroad. Inflation therefore increased more locally
depending on where the armies happened to be, as a result of the demand for food
and other necessities exceeding supply.
Rising demand and printing money
When a country rearms and fights a war, inflation can also rise in the whole
economy for the same reason, that is, demand rises in relation to supply. A sharp
increase in public expenditure as a result of rearmament or war effort increases
capacity utilisation in the economy and can therefore lead to higher inflation. In
connection with the Second World War, the US economy approached full capacity
utilisation, which contributed to a rise in inflation. Some economists argue that it
was the US rearmament in connection with the war that finally put an end to the
1930s depression.3
The way in which a rearmament or war is financed is also of great importance to
the way in which inflation develops. The financing can entail increasing taxes or
decreasing expenditures other than military, by raising loans or by making the
central bank print more money. If a war is financed by increasing taxes or
decreasing other expenditure, public purchasing power will be reduced. This counteracts
the inflationary effect of increased public expenditure. At the same time, tax
financing may be politically difficult to implement.4 In the short term, the politically
easiest way of financing war, but in the longer term perhaps the most harmful, is
through the printing of money, as this almost inevitably results in higher inflation.
A fairly large share of the literature on the effects of war on inflation is about the
financing of war. A review of the effects on inflation of the United States' wars
from the American Revolution to the First Gulf War shows that when the US has
been involved in more limited wars, they have usually been financed through
higher taxes or increased borrowing or a combination of these. However, in the
case of major wars, the point where these two methods of financing have been
considered exhausted has often been reached, and the government therefore
turned to the printing press. The result has often been a considerably higher
inflation rate.5 The two world wars are examples of this.
After a war, sovereign debt has often increased considerably. At the same time, it
may be difficult to raise tax revenue in the same way as before the war. This may
be because the political situation has become more unstable or the economy's
production capacity has declined.
In such a situation, there may be a great temptation for a government to try to
alleviate the situation by using the printing press to finance current expenditure
and pay off the loans. Difficulties in generating sufficient tax revenues are
considered to be an important explanation for the high inflation in countries such as
Germany, Austria, Hungary, Poland and Russia after the First World War and also
for the highest rate of hyperinflation in the modern age, that in Hungary in
19451946.6 According to some estimates, prices at their fastest then doubled in fifteen
hours.7
Inflation often also rises in the rest of the world
The factors I have mentioned so far are those that can contribute to higher
inflation in countries that are, or have recently been, directly involved in a war.
But war can also cause higher inflation in the rest of the world. The war itself can
generate increased demand on the world market for various products such as oil
and certain metals. The warring countries can also be important exporters of
some commodity or product which they can no longer produce or export as a
result of the war. The latter results in lower supply and higher prices on the world
market. Examples include the increases in oil prices that arose in connection with,
for example, the Yom Kippur War, when the oil-exporting countries in the Arab
world decided to cut their exports, and the war between Iraq and Iran. Following
Russia's invasion of Ukraine, rising energy and commodity prices have of course
been an important reason behind the increase in global inflation.
War can also mean that people are forced to flee, which requires increased public
spending in the countries where the refugees are received. This may have some
effects on inflation in the recipient countries. The most significant example of
huge waves of refugees is, of course, in connection with the Second World War. A
more recent example is the people fleeing from the war in Syria, and we are now
seeing a similar development in connection with the war in Ukraine.
Depending on the circumstances, war may also give rise to a period of sharply
increased geopolitical uncertainty. This may mean that countries that are not
directly involved in the war choose to arm themselves and thus increase public
spending.
However, greater uncertainty about the future may also mean that the private
sector chooses to postpone investment and increases its precautionary saving.
There are thus counteracting effects on aggregate demand and thereby on
inflation.
All in all, there are thus a number of different ways in which war can lead to
inflation rising, both in individual countries and in the world economy as a whole.
Four periods of high inflation since 1900
This is something that is quite clear when studying a longer time series for
inflation. Figure 1 shows inflation in Sweden from 1900 onwards.
Figure 1. Swedish inflation 1900-2022
Annual percentage change
60 60
First World War
CPI
50 50
40 40
30 30
Wars in the Middle East
Korean War
20 20
Second World War
and oil crises
10 10
0 0
-10 -10
-20 -20
-30 -30
There are some occasions when it has been higher than 10 per cent, sometimes
much higher. All of them occur in connection with war or some other type of
conflict. Some periods are short peaks, where inflation rapidly falls back again, while
inflation in the 1970s and 1980s was fairly high over a longer period of time.
Although inflation did not always exceed 10 per cent, I have chosen to regard this as
a continuous period.
I intend to go through each of these periods - why inflation rose, why it fell back
again, and how economic policy-makers thought and acted.
Highest inflation in connection with the First World War
So let me then begin with the First World War. The inflation during the First World
War is by far the highest in the whole period and peaked in 1918 at 47 per cent.
This episode is also special because the high inflation was followed by a severe
deflation, that is, a fall in the general price level, 1921-23. Fortunately, we have not
experienced any such dramatic fluctuations in inflation since then.
In his book "Money and Power" on the history of the Riksbank, Gunnar
Wetterberg notes that at this time the Riksbank's governors were faced with a series of
questions that neither they nor most other scholars knew how to deal with. The
war and the first post-war years thus became a difficult time for monetary policy.8
The organisation of the monetary system played a major role in the course of
inflation. Prior to the war, Sweden had a gold standard, which had been introduced
in 1873 in connection with the establishment of the Scandinavian monetary
union. The gold standard meant that the krona was linked to gold and that the
Riksbank had an obligation to exchange notes for gold at a fixed price. This meant that
the krona had a fixed exchange rate against other countries that had the
equivalent system. The gold standard was abandoned in connection with the outbreak of
war in 1914, and the same happened in other countries.
In the countries directly involved in the war, the war efforts required rapid and
immediate funding. Budget deficits grew and were financed by the government
borrowing from the central bank, that is, through printing money. The money
supply and price level thus rose sharply around the world. The war and international
rearmament caused the demand for Swedish products to rise dramatically, and
the increased exports gave a considerable boost to the economy. Swedish
inflation toward the end of, and shortly after, the war has been described as a classic
price, wage and profit spiral in an environment with growing access to money and
bank credits, speculation and a shortage of fuel, commodities and labour.9
As I noted earlier, the Riksbank was uncertain as to how it should act. At this time,
it was mostly academic economists who believed that raising the discount rate,
the period's equivalent to the repo rate, could slow down inflation, while the
Riksbank was more hesitant.10 The fact that economic policy-makers did not share the
view that the interest rate can be used to influence inflation was not, of course, a
good starting point and in itself a partial explanation for the fact that inflation
could rise so sharply.
An interesting, but perhaps not so well-known, event during this period was that
Eli Heckscher, professor at the Stockholm School of Economics and internationally
renowned economist, actually caused a bank run at the Riksbank in 1920.11
Although the inflation peak had passed, inflation at the beginning of 1920 was still
so high that Heckscher thought that the Riksbank should raise the discount rate
significantly. When the Riksbank did not want to do this, Heckscher decided to do
something about it.
The right to exchange notes for gold had ceased in connection with the outbreak
of the war in 1914, but was reintroduced in 1916. However, since an export ban
on gold had been introduced in 1914, this did not mean in practice that the gold
standard had been re-established. The export ban allowed the gold price to differ
between countries and the value of the krona to change against other currencies.
This was also the case as the krona depreciated against the dollar.
At the US Federal Reserve, the price of one kilogram of gold in the depreciated
Swedish currency was SEK 3,600 at the beginning of 1920. At the Riksbank, the
price of one kilo of gold was instead SEK 2,480. If the export ban were to be lifted,
then a considerable arbitrage gain could be made.
Heckscher decided to draw the general public's attention to this fact and did so
through an article entitled "The new price revolution" (Den nya prisrevolutionen),
published in the daily newspaper Stockholms Dagblad on 11 March 1920. The
article was more or less an explicit encouragement to readers to withdraw their
money from the bank and go to the Riksbank to redeem it for gold:
"Anyone who brings SEK 1,000 in banknotes to the Riksbank has the legal right to
receive 50 SEK 20 [gold coins] and these currently have a value of SEK 1,450 - 45%
profit on the most risk-free of investments"12
The final results were indeed an onslaught of people who wanted to redeem their
banknotes at the Riksbank, who were therefore forced to raise the discount rate
in order to defend the gold reserve. In connection with this, the Riksbank
requested release from the obligation to redeem banknotes for gold, which was
subsequently also granted.
...but it was also followed by deflation and recession
However, shortly afterwards the trend was reversed. There were various reasons,
including the weakening of international economic activity. But the most
important reason for the severe turnaround in general prices was connected with
the view of the monetary system that prevailed at the time.
The political view was that Sweden should return to the gold standard as soon as
possible, and to the parity that had applied before the war. To make this possible,
the krona needed to be strengthened, which required bringing down prices and
wages. It was therefore recognised that a period of actual deflation would be
required.
Knut Wicksell, perhaps Sweden's most famous economist, was among those who
argued that the gold standard should not be reintroduced, but should be removed
for all time. He argued instead for a free standard, without any metallic base.13 On
the other hand, he too seems to have supported the idea that the price level
needed to be lowered and that this would not cause any major problems, given
that the policy was expected.14
Swedish monetary policy became more restrictive than in other European
countries and in the United States. The tightening caused real interest rates to rise
sharply and the economy to enter a recession. In 1924, Sweden was the first
European country to return to the gold standard at the pre-war parity. However, the
cost of deflation in the form of unemployment and stagnation had been
extremely high, and this undermined confidence in the gold standard as a monetary
system.15
Second World War and Korean War gave short inflationary peaks
At the time of the Second World War, policy-makers were determined not to
repeat the economic-political mistakes of the First World War. Extensive regulations
such as currency regulation and rent regulation were introduced early on to
dampen expectations of sharply rising inflation.16 Nevertheless, inflation rose
quite a lot during the first years of war, but in 1942 the government approved a
programme drafted by a specially appointed commission. The main objective was
to stabilise prices and the most important means of doing this was a general price
and wage freeze. Interestingly, interest rates were not included in the
commission's report as a means of influencing economic activity and inflation. The view at
this time too, especially from a political point of view, was that the interest rate
was to mainly be regarded as a cost factor.17
Nevertheless, the policy during the Second World War was much more successful
than that during the First World War. There was no post-war recession, and the
inflation peak were short-lived and was not followed by any appreciable
deflation.18
Developments during the Korean War in 1950-53 followed the same pattern, with
a high but short-lived peak in inflation. The upturn was preceded by a devaluation
against the dollar in 1949, which Sweden and a number of European countries
carried out to meet the competition from American industry. After the outbreak
of the war, international inflation rose sharply. The price increases on
commodities were particularly high. Profits in the Swedish manufacturing industry rose
markedly and resulted in a price and wage build-up process, where wage costs
rose by at most about 20 per cent a year.
The Minister of Finance at the time, Per Edvin Sköld, took a number of measures:
Excise duty on sales of cars was raised, building regulations were tightened, the
forest industry had to deposit some of its large profits in special accounts and an
investment tax was introduced.19 The interest rate was also raised by half a
percentage point, which, according to a modern yardstick, may seem rather modest
given the circumstances. Altogether, this meant that inflation was short-lived on
this occasion too, and it is also known in the history books as the 'one-off
inflation' (engångsinflationen).
Expansionary policy during the most recent inflation period
The longer period of high inflation from the early 1970s onwards is, of course, the
first one I remember myself. The link to war is not as obvious as in the previous
episodes, but it is definitely there (see Figure 2). The two oil crises in 1973-74 and
1979-80, often referred to as OPEC I and OPEC II, play quite an important role in
this process OPEC I was preceded by the so-called Yom Kippur War of 1973
between Egypt and Syria on the one hand and Israel on the other. OPEC II is linked to
the revolution in Iran in 1979, which led to a significant loss of oil production that
was not matched by the other oil-producing countries. When Iraq then invaded
Iran in 1980, the situation deteriorated even further. The price of oil also rose, but
very briefly, when Iraq attacked Kuwait in 1990.
Figure 2. Real oil price
USD/barrel
150 150
Iran-Iraq War
125 125
100 100
Revolution Gulf War
in Iran
75 75
50 50
25 25
Iraqi invasion
Oil embargo in connection
of Kuwait
with the Yom Kippur War
0 0
1965 1970 1975 1980 1985 1990 1995
Note. Real prices have been computed with the CPI in United States.
Souces: U.S. Bureau of Labor Statistics (BLS), U.S. Energy Information Administration and the
Riksbank
However, the policy that was conducted during this period also played a
significant role. It became, for various reasons, on average too expansionary or, as it is
called, too accommodating. In economic textbooks, this period of high and
longterm inflation in the world is known as 'The Great Inflation'. This usually refers to
the period 1965-1982, where 'the Volcker disinflation', the tight monetary policy
conducted by then head of the Federal Reserve Paul Volcker to curb inflation in
the United States, is regarded as the endpoint.20 For Sweden, it is more
appropriate to refer to a period that both starts and ends about ten years later.
The Swedish economy was wrestling with serious economic problems during this
period. Perhaps the main concern was the strong domestic inflation trend with
price and wage spirals that collided with attempts to maintain a fixed exchange
rate, and therefore led to recurring cost crises and devaluations. Another concern,
which was partly connected to this, was that fiscal policy was often too
expansionary, with rapidly rising public spending and tendencies toward structural deficits
as a result. In addition, there was a deregulation of the credit market in the
mid1980s, which would lead to far greater problems than were anticipated when the
reform was implemented.21
In the early 1990s, these and other ingredients contributed to another domestic
cost crisis, which also coincided with a financial crisis largely caused by excessive
lending to households and companies. Unemployment rose sharply and public
finances deteriorated dramatically. The krona was put under strong pressure by
investors who expected Sweden to devalue again soon and, in November 1992, the
Riksbank was forced to give up its defence of the fixed exchange rate.
It had become clear that the type of policy Sweden had pursued for a number of
decades had reached the end of the road, and needed to be fundamentally
reshaped. Instead of defending a fixed exchange rate, the task of monetary policy
from now on would be to keep inflation low and stable around 2 per cent. For its
part, fiscal policy would focus considerably more than previously on keeping
public finances in good condition so as to maintain market confidence. Looking back
now, around thirty years later, the restructuring was successful. We have not had
any problems with excessive inflation since then, until perhaps now. The problem
has usually been the reverse, that is, that inflation has been lower than the target.
Some conclusions from the history of inflation
So what conclusions can be drawn from this review of Swedish inflation history
since 1900? One conclusion, which was also in some way the starting point, is that
inflation tends to rise in connection with war, and that this also applies in
countries like Sweden, which has been fortunate not to be directly involved in any war
during this period.
Another conclusion is that the first three inflation peaks in the 1900s were so
short-lived that expectations of higher inflation in the longer term were never
built into price- and wage formation.
A third conclusion is that the reason why high inflation was so short-lived on these
occasions was either that politics - in connection with the First World War -
became too tight and caused a recession; or - in connection with the Second World
War and the Korean War - that inflation could be parried by far-reaching
regulation and direct control of price-setting and wage-formation. The latter tools are
hardly available any longer as alternatives in the political toolbox.
It is sometimes said that economic policy-makers often base their actions during a
crisis on the interpretation that has been made of the previous crisis.22 This can
mean that one sometimes gets things wrong and tends to, so to speak, 'fight the
last war'. But in this case I am quite sure that, if we are at the beginning of
something that turns out to be a longer period of more persistent higher global
inflationary pressures, it is the last period of high inflation, the one in the 1970s and
1980s, from which we have the most to learn. That is my fourth conclusion.
More difficult for monetary policy to deal with supply
shocks
For my continued reasoning, I need to refer to some economic theory. An
economy is constantly exposed to what in economist speak are called shocks, which in
principle means a rapid and unexpected development. Some shocks are positive
and mean, for example, that economic activity improves and unemployment
decreases. Other shocks are negative and lead to recession and higher
unemployment. Shocks can be divided into demand shocks and supply shocks, depending
on whether demand or supply is developing unexpectedly.
The economic impact of the war in Ukraine can be described as what textbooks
call a negative supply shock. This means that activity in the economy is declining,
at the same time as prices are rising. In other words, the effect will be
stagflationary, that is, we will have a combination of lower growth and upward pressure on
inflation.23 Earlier examples of negative supply shocks are the oil crises in the
1970s. In addition, the war in Ukraine was preceded by another supply shock -
the pandemic - when large parts of the world economy closed down and
distribution chains were broken. As I just described, war does not always entail a negative
supply shock. In connection with the Korean War, for example, there was talk of
the 'Korea boom', because inflation was then largely due to increased demand for
Swedish goods.
For a monetary policy decision-maker, supply shocks are more difficult to deal
with than demand shocks. If inflation rises because demand has risen
unexpectedly, the remedy is simple: The central bank raises the policy rate and thus
suppresses both inflation and demand, thereby reducing the risk of the economy
overheating.
But if inflation rises as a result of a negative supply shock, the problem is more
complex. If most people assume that the effect on inflation is transitory, the
problem does not need to be so great. The central bank can then simply wait until
inflation falls back again. However, one risk that is always present is that price
impulses spread to other prices and start to affect economic agents' expectations.
These may then expect inflation to remain high, or even rise further. The signs of
such second-round effects have now begun to increase in many economies.
This creates a tricky balancing act for monetary policy: At the same time as one
wants to maintain confidence in the inflation target and prevent inflation from
becoming entrenched at a high level, one wants to avoid pursuing a policy so tight
that the economy enters a recession. As we saw, this was what happened after
the First World War, although the motive then was to return to the previous price
level rather than bring down inflation. To be a little drastic, one can say that the
task facing the central banks is to avoid 'The Great Inflation 2.0', and to do so at
the lowest possible cost in terms of lower production and higher unemployment.
The conditions are better than before
I intend to stick my neck out a bit here and say that the conditions for coping with
this balancing act are quite good for Sweden and at least considerably better than
they were when inflation began to rise in the mid-1970s. There are several
reasons for this. None of these are news, but it is still worth reminding ourselves of
them.
Firstly, since 1993, we have had an inflation target in the Swedish economy.
During the most recent period of lastingly high inflation, the idea was that inflation
would be kept down by means of the fixed exchange rate. The fixed exchange rate
was expected to have a disciplinary effect on price-setting and wage-formation, as
excessive inflation in relation to the rest of the world would lead to difficulties for
the export industry and increased unemployment. However, as I have pointed
out, this did not work very well. Expressed in economist terms, there was no
credible nominal anchor in the economy, that is, a clear, quantified benchmark for
price-setting and wage-formation. Today, we have one in the form of the inflation
target. During the period of inflation targeting, long-term inflation expectations, in
the way we can measure them, have remained fairly stable at around 2 per cent.
This does not, of course, mean that the Riksbank can always sit with its arms
folded when inflation rises and expect inflation to return to the target 'by itself'. It
is reasonable to assume that the fact that long-term inflation expectations are
firmly anchored to the target is because economic agents expect the Riksbank to
act when needed. But the fact that there is a credible nominal anchor today does
of course make things easier, even though it ultimately hinges upon the way
monetary policy is conducted.
Secondly, Swedish wage-formation works in a completely different way than in
the 1970s and 1980s. One important reform was the so-called Industrial
Agreement, under which the manufacturing industry has set the benchmark for wage
negotiations and ultimately steered wage cost increases in the entire economy for
over twenty years. The relationship between this benchmark and the inflation
target has not always been crystal clear. For instance, employers' representatives
have sometimes expressed the view that the inflation target is obsolete and
should not be used as a base in wage negotiations. However, this was during the
extended period when inflation tended to be at the lower end of the target.
However, as developments now show, we must assume that inflation will sometimes
be above the target as well. Hopefully, this will further underline the importance
of the inflation target as a nominal anchor for the Swedish economy, both
upwards and downwards, so to speak. Should it now be the case that we are
entering a longer period of persistently higher inflationary pressures - which we do not
know yet, of course - then my assessment is that the framework of
wage-formation we have today will act as a built-in and useful brake in the system.
Thirdly, a stricter and more robust fiscal policy framework was introduced after
the crisis in the early 1990s. This has contributed to public finances now being in a
much better shape than they were in the 1980s and 1990s. A large and growing
sovereign debt may raise inflation expectations, if agents suspect that the
government may eventually try to solve the problem of by inflating the debt away. This
means is that the central government reduces the real value of the debt by letting
inflation rise. However, unlike in the 1970s and 1980s, we have now a number of
control mechanisms in place, which means that this potential source of excessive
inflation has in practice been eliminated.
My reflections on the current situation
So, in conclusion, how do I view the current situation more specifically? And what
can we learn from history? During many of the periods of high inflation in
connection with war, the effects of monetary policy have been heavily dependent on the
expectations of companies and households regarding future economic
developments. There is an example of a deflation spiral after the First World War when
expectations of lower prices in the future led to falling aggregate demand. And
there are examples of price and wage spirals, when expectations of higher prices
in the future led to higher wage increases that eventually forced a change from a
fixed exchange rate to a floating exchange rate. The inflation target was
introduced in connection with this changeover. Economic agents' expectations of
future inflation are an important element in assessing the credibility of monetary
policy with regard to attaining the inflation target.
What is the situation today? Five-year inflation expectations among money
market participants have long been close to 2 per cent. The most recent quotation
available at our meeting in April was 2.2 percent on average. In May, it rose to just
under 2.4 percent. Expectations have thus risen, albeit not to any alarming levels.
It should also be added that the median, that is, the middle observation, is still at
2 percent.
It is important to point out that money market participants' inflation expectations
are not formed in a vacuum. These actors at the same time form expectations of a
number of macroeconomic key variables. This includes expectations of the coming
monetary policy. In April 2022, money market participants expected a repo rate of
rounded 0.8 per cent twelve months ahead and a repo rate of 1.1 per cent 24
months ahead from April 2022. In May, the corresponding expectations were
approximately 1.3 and 1.6 per cent. In other words, money market participants'
expectations of inflation are based on the expectation of a less expansionary
monetary policy.
I consider that an important conclusion can be drawn from this: Merely because
inflation expectations are close to the