Inflation and Industrial Revolution

This is an edited version of an article originally published on The Persistent Ruminator substack.

Everyone was poor and then many people became rich. That is the story of the Industrial Revolution. Why did it happen?

There are a number of explanations, including:

• Coal - easy access to energy;

• Wages - high English wages incentivised finding ways to increase productivity (and therefore save on wages);

• Finances - developing a more sophisticated financial system (e.g., establishing the Bank of England) helped ensure resources could be allocated to growth (innovation and capital creation);

• Trade increased trade increased resources and access to helpful ideas;

• And various miscellaneous factors

What is rarely discussed as a factor of the industrial revolution is inflation. The introduction of Spanish gold and silver created small but persistent inflationary pressure across Europe (the Price Revolution). This was very severe in Spain - such that it caused major instability in the Spanish economy, and is widely considered to be a key factor in the decline of Spain as a great power. But elsewhere in Europe, the resulting inflation was at once a) sustained and b) not sufficient to destabilise the economy. Sustained inflation hadn’t really been seen before - supply shocks were common in more primitive economies, but they would not be sustained for decade upon decade.

The steady influx of gold and silver from the Americas through the Spanish Empire changed this by introducing a permanent growth in the supply of money year after year. Before, most people were mercantilists who supposed that money — or gold and silver as it was then — was the best way to store and preserve wealth. Inflation challenged this attitude and invited people to take risks in order to try to maintain their same level of wealth. Mercantilists were not misguided; before inflation, holding gold and silver was the best way to store wealth in the long run. Only its devaluation, with sustained inflation, changed that and precipitated the search for other means of storing value.

Inflation is required to substantially raise investment since people are generally speaking both risk and loss averse, as empirically verified in Kahneman and Tversky’s seminal Prospect Theory (1979). In the absence of the devaluation of money, people will often prefer to save and have certainty in storing value over taking the risk of an investment, even if the investment has positive expected returns. Sustained inflation changes this situation, by guaranteeing losses if people hold onto their money. It makes people a lot more likely to take the risk of an investment, since the alternative guarantees loss.

Central banks currently manipulate interest rates with this intention. When setting below-inflation interest rates, central banks are daring people to use their money rather than hoard it, since they will otherwise lose value. This piece advances the conjecture that the beginning of sustained inflation raised the incentive for the development of a financial system in the pursuit of returns, which prospered at first in the Netherlands and then in England. The growth of the English financial sector was crucial in raising the capital for industrial ventures, and the Industrial Revolution went underway. Given the role of moderate inflation in the start of the growth of finance and the role of the growth of finance in funding industrial innovation and venture, moderate inflation is most likely a cause of the Industrial Revolution.

Another causal mechanism of inflation to industrialisation is natural selection. In a world where money keeps its value, those who hold money instead of risking their capital still maintain their wealth and buying power, so remain influential people in an economy. In a world of inflation, those who grow in influence (i.e., wealth) in an economy are those who are good at investing their wealth - and those who just hold money fall behind in relative wealth as others’ grows. Inflation rewards those who have the risk appetite to put money to work over those who hold it - and therefore inflation reallocates purchasing power towards those who will use it to invest. As this continues, the amount being invested in productive ventures will increase over time in an environment of moderate inflation. This is another mechanism by which inflation contributed to the growth of finance necessary for the Industrial Revolution.