The Concept of lndexation in the History of Economic Thought Periods of severe monetary disturbance tend to justment of tax brackets, personal exemptions, asset spawn unorthodox and often ingenious stabilization depreciation schedules, and capital gains. schemes. During such episodes, conventional policies Such comprehensive indexing, Friedman claims, often appear inadequate and the situation seems to would have at least two therapeutic effects. First, he call for extraordinary remedies. Thus, for example, says, “it would reduce the revenue the government the Great Depression of the 1930’s inspired a host of acquires from inflation” thus weakening the govern- novel schemes-including stamped money, taxation of ment’s “incentive to inflate.” Second, and more im- idle hoards, 100 percent reserve requirements behind portant, indexation, in his words, “would reduce the demand deposits, security reserve proposals, com- adverse side effects that effective measures to end modity reserve currency, “social credit” remedies, and inflation would have on output and employment.” the like-all designed to promote the recovery that [8 ; 94] Constituting the most serious obstacle to monetary policy was thought incapable of accomplish- the ending of inflation, these harmful side effects ing by itself. Currently the major economic problem stem from institutional and expectational rigidities is inflation, virulent double-digit inflation seemingly built into the structure of commodity and factor unstoppable by orthodox measures alone. Predict- prices. By preventing some prices from adjusting ably, several inflation-combating expedients have as fast as others to policy-induced declines in the been suggested. These include such prescriptions as : rate of total spending, these rigidities act to distort the reinstitution of wage and price controls, the or alter relative prices (i.e., market exchange ratios levying of profit surtaxes on corporations granting or relationships among individual commodity and “excessive” or “inflationary” wage increases, and factor prices), thus influencing quantities of real the institution of so-called “social contract” arrange- variables. For example, such influences as long-term ments whereby labor would agree to restrain its wage labor and debt contracts; lags in the adjustment demands in return for a reduction in its tax burden. of price expectations, and money illusion may cause Perhaps the most controversial proposal for fight- nominal wage and interest rates to lag behind ing inflation, however, is indexation, i.e., the idea of changes in product prices. The failure of these inflation-proofing the economy by tying monetary money costs to adjust fully and instantaneously to contracts to a general price index. Under compre- price level changes would result in an alteration of hensive or widespread indexation, most nominal real wage and interest rates, thereby affecting em- values would be adjusted automatically to compen- ployers’ demands for labor and capital. Indexation, sate for inflation. Currently, indexation is being Friedman argues, would eliminate these inflexibili- touted in some quarters as the best means of helping ties, thus rendering relative prices (e.g., real wage monetary and fiscal policy bring inflation under con- and interest rates) and the corresponding real eco- trol. Led by Milton Friedman, proponents of index- nomic variables (output, employment, and the rate ation propose that escalator clauses be applied volun- of capital accumulation) immune from policy-engi- tarily in the private sector to all contractual debts neered changes in the rate of inflation. In short, with and to most incomes, whether labor (wage and indexing, the economy could move swiftly to a lower salaries) or investment (interest and dividend) in- inflationary equilibrium without having to endure a comes. Moreover, Friedman urges that mandatory prolonged transitional period of low economic growth indexation be applied to the borrowing and taxing and high unemployment. arrangements of the federal government. Specifi- It should be emphasized that Friedman does not cally, Friedman would require that all government claim that indexation by itself would lower the rate securities contain purchasing-power guarantees and of inflation. Instead, he argues that indexation would that the personal and corporation income tax systems augment the effectiveness of existing anti-inflationary include compulsory and automatic inflationary ad- monetary and fiscal policies. That is, by alleviating FEDERAL RESERVE BANK OF RICHMOND 3 the unemployment cost of fighting inflation, index- modity, such as wheat or gold, whose value presum- ation would increase the willingness of the authori- ably varies less than that of money. This solution is ties to employ conventional demand-management tantamount to guaranteeing payment in terms of a policies. fixed amount of the commodity. For while the price- Friedman’s controversial proposal has been widely linked money payments may vary, they would always hailed as both novel and radical. As Friedman him- be just sufficient to purchase a constant quantity of self acknowledges, however, the truth is that pro- the specified commodity. posals to link money payments to a cost-of-living index are neither radical nor new. Such proposals The practice of linking contractual payments to a have a long history, dating back at least to the mid- specific price has a long tradition extending back at 18th century. Thus, for example, the idea of index- least to Elizabethan times. Thus, William Stanley ation received official endorsement and was embodied Jevons remarks that during the reign of Elizabeth I, in Massachusetts legislation in the 1740’s. And as the colleges of Oxford, Cambridge, and Eton were early as the 1780’s, indexation was actually employed required by law to lease out their lands for corn as a policy experiment when the Massachusetts gov- rents, i.e., variable money rents linked to the price ernment attempted to link soldiers’ wages to an aver- of corn. [9 ; 326] Irving Fisher notes that corn age of the prices of four staple commodities. More- rents were fairly well established in Scotland by the over, the concept appears prominently in the writings end of the 17th century. [3 ; 334] And Alfred of 19th and 20th century classical and neo-classical Marshall refers to the linking of church tithes to the economists who analyzed it under the heading of the price of grain. [12; 197] Moreover, during the so-called “tabular standard of value,” referring to post-World War I hyperinflation in Germany in the the table or list of specific commodities whose prices early 1920’s, contracts of all types were tied to the were to enter the cost-of-living index serving as the price of rye. As another example, bonds containing standard of deferred payments. Even the more so-called gold clauses linking principal and interest unusual features of Friedman’s proposal-e.g., his to the price of gold were in common use during the plan to index taxes and the government debt and his 19th and early 20th centuries. In short, the use of vision of a comprehensively-indexed as distinct from purchasing-power guarantees stipulated in terms of a a partially-indexed economy-were fully anticipated single specific commodity is a fairly old practice. in earlier writings, as were his arguments (1) that The linking of debt payments to one particular indexation insulates employment and production from price, however, does not constitute true indexation, the harmful effects of unanticipated changes in the the essence of which is the use of a price index, or price level or its rate of increase, and (2) that index- weighted average of many prices, as the standard of ation prevents the government from diverting via deferred payments. The genesis of the indexation taxation an increasing share of resources from concept can be traced to Bishop William Fleetwood’s the private sector. In short, neither the idea of pioneering study, Chronicon Preciosum: or, an Ac- indexation nor the arguments offered in support of count of English Money (1707). In that work Fleet- it are new. wood made at least two original contributions. He The purpose of this article is to document this was the first to make systematic use of several prices latter assertion. Accordingly, following a brief de- to measure changes in the value of money. Observing scription of some early experiments with index- that the particular prices of corn, meat, drink, and linking arrangements, the article will examine the cloth had all shown a roughly six-fold increase during writings of pertinent classical and neoclassical econ- the preceding two-and-a-half centuries, he concluded omists to see what they had to say about the subject. that the value of money had depreciated in the ratio Finally, a concluding section compares Friedman’s of six to one. Here is the origin of the concept of a propositions regarding indexation with those of his cost-of-living index as a measure of changes in the classical, neo-classical, and modern predecessors in purchasing power of money. Second, Fleetwood sug- order to demonstrate their essential similarity. gested that the index number could be used to deter- mine the amount of nominal income corresponding to any given fixed real income. This suggestion emerged INDEXATION IN THE EIGHTEENTH CENTURY from his attempt to establish the maximum money Means have long been sought for protecting the income a person could receive and still be eligible for real value of time contracts from fluctuations in the a certain fellowship. The fellowship was limited to value of money. One solution is to tie contractual those with real incomes not exceeding the purchasing payments to the particular price of a specific com- power of £5 in 1450, the year the scholarship was 4 ECONOMIC REVIEW, NOVEMBER/DECEMBER 1974 founded. Hence, Fleetwood’s problem was simply wages to a crude index comprised of an average of that of finding the current nominal income whose the prices of four staple commodities-namely, “Beef, price-deflated or real value was equivalent to a given Indian Corn, Sheeps Wool and sole Leather.” [5 ; constant-dollar base or reference period sum of £5.