Lessons From the Great Inflation

Paul Volcker and Ronald Reagan's forgotten miracle created a quarter century of prosperity--and a dangerous bubble of complacency.

If you asked a group of scholars to name the most important landmarks in the American story of the last half-century, they would list some or all of the following: the war in Vietnam, the civil rights movement, the assassinations of the Kennedys and Martin Luther King, Watergate, the sexual revolution, the invention of the computer chip, Ronald Reagan’s election in 1980, the end of the Cold War, the creation of the Internet, the emergence of AIDS, the terrorist attacks of September 11, and the two wars in Iraq. Looking abroad, these scholars might include other developments: the rise of Japan as a major economic power in the 1970s and ’80s, the emergence of China in the 1980s from its self-imposed isolation, and the spread of nuclear weapons.

Missing from most lists would be the rise and fall of double-digit U.S. inflation. This would be a huge oversight.

We have arrived at the end of a roughly half-century economic cycle dominated by inflation, for good and ill. Its rise and fall constitute one of the great upheavals of our time, though one largely forgotten and misunderstood. From 1960 to 1979, annual U.S. inflation increased from a negligible 1.4 percent to 13.3 percent. By 2001 it had receded to 1.6 percent, almost exactly what it had been in 1960. For this entire period, inflation’s climb and collapse exerted a dominant influence over the economy’s successes and failures. It also shaped, either directly or indirectly, how Americans felt about themselves and their society; how they voted and the nature of their politics; how businesses operated and treated their workers; and how the American economy was connected with the rest of the world. Although no one would claim that inflation’s side effects were the only forces that influenced the nation during these decades, they counted for more than most historians, economists, and journalists think. It’s impossible to decipher our era, or to think sensibly about the future, without understanding the Great Inflation and its aftermath.

Stable prices provide a sense of security. They help define a reliable social and political order. Like safe streets, clean drinking water, and dependable electricity, their importance is noticed only when they go missing. When they did just that in the 1970s, Americans were horrified. From week to week, people couldn’t know the cost of their groceries, utility bills, appliances, dry cleaning, toothpaste, and pizza. People couldn’t predict whether their wages would keep pace with prices. People couldn’t plan; their savings were at risk. And no one seemed capable of controlling inflation. The inflationary episode was a deeply disturbing and disillusioning experience that eroded Americans’ confidence in their future and their leaders.

There were widespread consequences. Without double-digit inflation, Ronald Reagan almost certainly would not have been elected president in 1980; the conservative political movement that he inspired would have emerged later or, conceivably, not at all. High inflation incontestably destabilized the economy, leading to four recessions (those of 1969–70, 1973–75, 1980, and 1981–82) of growing severity. High inflation stunted the increase of living standards through lower productivity growth. High inflation caused the stock market to stagnate; the Dow Jones Industrial Average was no higher in 1982 than in 1965. And it led to a series of debt crises that afflicted American farmers, the U.S. savings and loan industry, and developing countries.

(Story continues after the video.)



Click above to watch Robert Samuelson discuss this story.

Afterward, declining inflation—“disinflation”—led to lower interest rates, which led to higher stock prices and, much later, higher home prices. This disinflation promoted the last quarter century’s prosperity. In the two decades after 1982, the business cycle moderated so that the country suffered only two relatively mild recessions (those of 1990–91 and 2001), lasting a total of 16 months. Monthly unemployment peaked at 7.8 percent in June 1992. As stock and home values rose, Americans felt wealthier and borrowed more or spent more of their current incomes. A great shopping spree ensued, and the savings rate declined. Trade deficits—stimulated by Americans’ ravenous appetite for cars, computers, toys, and shoes—ballooned. At the same time, this prolonged prosperity helped spawn complacency and carelessness, which ultimately climaxed in a different sort of economic instability and the financial turmoil that assaulted the economy in 2007 and 2008.

Who Was to Blame?

Double-digit inflation was not an act of nature or a random accident. It was the federal government’s greatest domestic policy blunder since World War II, the perverse consequence of well-meaning economic policies, promoted by some of the nation’s most eminent academic economists. These policies promised to control the business cycle but ended up making it worse.

The episode invites comparison with the war in Vietnam, the biggest foreign policy blunder in the post–World War II era. Both arose from good intentions: The one would preserve freedom; the other would expand prosperity. Both had intellectuals as advocates, whether economists or theorists of limited war. Both suffered from overreach and simplification; events on the ground constantly confounded expectations. But there is a big difference. One (Vietnam) occupies a huge space in historic memory. The other (inflation) does not.

This inflation had no comparable precedent in American history. Sudden bursts of inflation had occurred before, almost always during wars when the government printed more money to pay for guns, soldiers, ships, and ammunition. What happened in the 1960s and ’70s was different. America’s most protracted peacetime inflation was the unintended side effect of policies designed to reduce unemployment and eliminate the business cycle. It was a product of the power of ideas.

In the 1960s, academic economists argued—and political leaders accepted—that the economy could be kept permanently near “full employment” (initially defined as 4 percent unemployment). Booms and busts, recessions and depressions, had long been considered ugly and unavoidable aspects of industrial capitalism. But once people accepted the idea that the business cycle could be mastered, the self-restraint that had silently kept prices and wages in check gradually crumbled. New assumptions emerged. If government could prevent recessions, then companies could always count on strong demand for their products. All higher costs (including higher labor costs) could be recovered through higher prices. Similarly, if the economy was always near “full employment,” then workers could press for higher wages without facing job loss. If their current employers wouldn’t pay, someone else would. Government wouldn’t tolerate substantial unemployment; that was its promise. The result was a stubborn wage-price spiral. Wages chased prices, which chased wages. Inflation became self-fulfilling and entrenched.

Everything rested on an illusion, the Phillips Curve: the notion that there was a fixed tradeoff between unemployment and inflation. If true, that meant a society could consciously decide how much of one or the other it wanted. If, say, 4 percent unemployment and 4 percent inflation seemed superior to 5 percent unemployment and 3 percent inflation, then we could choose the former. The trouble was that the tradeoff didn’t exist, except for brief periods. In an important 1968 paper, the economist Milton Friedman explained that, if government tried to hold unemployment below some “natural rate,” the result would simply be accelerating inflation. Another economist, Edmund Phelps of Columbia University, developed the concept almost simultaneously. By their logic, governmental efforts to push unemployment down to unrealistic levels were doomed to failure.

What would actually happen in the 1970s—the constant acceleration of inflation—was foretold by Friedman and Phelps. But good ideas could not spontaneously displace the bad until actual experience demonstrated the differences, especially because the bad ideas were more politically attractive. For inflation to be reversed, the underlying politics and psychology had to change.

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  • ||

    I just want to point out that Ronald Reagan's forgotten miracle is revisionist history. RR was an R, hence he stole from the poor to give to the rich.

    There is a new sheriff in town and he is a D. Miracles, real ones, will soon follow.

  • ||

    Amazing, an entire "Who was to blame?" section on 70's inflation without a mention of the defining moment - Nixon unpegging gold from a fixed price of $35 an ounce.

    That event took many years to settle in the currency market. Inflation was raging well before Carter took office - Whip Inflation Now was an empty slogan before the GOP became the official standard-bearer of empty slogans.

  • ed||

    Prosperity in our time!

  • Erm||

    The sad thing about wayne's comment is how spot-on he is with his impression of a dim-witted partisan.

  • ||

    Amazing, an entire "Who was to blame?" section on 70's inflation without a mention of the defining moment - Nixon unpegging gold from a fixed price of $35 an ounce.

    That event took many years to settle in the currency market. Inflation was raging well before Carter took office - Whip Inflation Now was an empty slogan before the GOP became the official standard-bearer of empty slogans.


    RTFA.

    Samuelson states:

    From 1960 to 1979, annual U.S. inflation increased from a negligible 1.4 percent to 13.3 percent.

    Nixon is included in that isn't he?

  • ||

    The inflationary episode was a deeply disturbing and disillusioning experience that eroded Americans' confidence in their future and their leaders.

    All very true. Ultimately the Fed, however, has no more of a role in real economic growth and prosperity than the Wizard had in getting Dorothy home. They are masters of a monetary illusion. We offer far too much deference to the institution's ability to do much more than make things worse in the long run by trying to manage the business cycle in the short run.

  • ||

    How did Dorothy get home?

  • squarooticus||

    TANSTAAFL. That's the lesson to learn from this recession, the imminent collapse of the dollar, and the very high probability of a hyperinflationary depression.

    We thought we could finance our standard of living by replacing gold with the dollar as the universal store of value, and then debasing the dollar to our advantage. As with all schemes that depend on the blindness of others to succeed, it worked for a while... but the day of reckoning, put off several times already, was always inevitable.

    From the future, we borrowed a nearly 40-year advantage over historically-sustainable rates of economic growth; now, it's payback time, which will result in several decades of regression to the mean. The Great Inflation is now underway, and I see no way that this ends well for the majority of people.

    Cue Warren.

  • ||

    It is a good rule to remember that anytime an economist tells you that he has found a way to avoid the business cycle, he is selling you fools gold. What the great inflation and the last 10 years have in common is the idea that monetary and fiscal policy could prevent recessions from ever happening. There should have been a serious recession after the tech bubble burst. But, Greenspan used monetary policy to blow up the real estate bubble and forstall a resession. We are now having to take our medicine in double doses because of that decision.

  • ||

    "The Great Inflation is now underway, and I see no way that this ends well for the majority of people."

    I disagree. I think the danger now is deflation. The fed is pumping dollars into a system that is losing value. Asset values and commodity values are falling. That means that the danger is deflation not inflation. In fact, delfation is even worse than inflation. Despite their glee, the goldbugs are still wrong.

  • ed||

    Indeed, business cycles are inevitable in a truly free economy, but they tend to be brief and self-correcting. It's government intrusion into the marketplace that causes catastrophic swings, often with deadly, irreversible consequences.

  • ||

    How did Dorothy get home?

    Exactly! It was all a dream. How I wish the same was true of our current nightmare.

  • ||

    From 1960 to 1979, annual U.S. inflation increased from a negligible 1.4 percent to 13.3 percent.

    That is miserly information for such a lofty section header. You may be satisfied but I like more depth.

    I suppose that JFK is as culpable as Nixon?

    Yeah, right.

  • ||

    I think the point of the article was that the consensus of the economists from 1960-1980 was to blame. He doesn't seem to be particularly partisan in his analysis - pointing out that no republicans other than Reagan were on board with this philosophy. His argument seems to be particularly specific - that it is Volker and Reagan - not any old Republican or Democrat - that made the change. After all, it is not like a Republican administration nominated Volker in 1979.

  • squarooticus||

    I disagree. I think the danger now is deflation. The fed is pumping dollars into a system that is losing value.


    I agree that's exactly what they're doing, and that is precisely what will result in the Great(er) Inflation. I fail to see how pointing out that we are currently in deflation---from illusory capital disappearing back into the ether---somehow negates the argument that hyperinflation will follow.

    Hyperinflation historically results from central bank reactions to deflation. Increased prices across-the-board are caused by an increase in overall demand, but the cause of this increase in demand isn't magic: what other than an increase in the money supply beyond the rate of actual wealth creation would raise aggregate demand in such a way as to force producers to raise prices without rationing?

    You can argue that the central bankers are doing a good job and won't inflate too much, a point with which I'd heartily disagree based simply on historical precedent; but that's completely different from dismissing the danger of hyperinflation by saying that currently there is deflation. I mean... duh. Deflation is always the precursor to hyperinflation, the latter of which is purely a central banking phenomenon.

    Despite their glee, the goldbugs are still wrong.


    I would hardly call Mises a "goldbug", but he has still been spot-on in predicting this crisis. I suspect we are seeing the start of the crack-up boom. But I've given up trying to convince the deflationistas and monetarists. Time will tell who's right. My money is where my mouth is.

  • Sam Grove||

    The fed is pumping dollars into a system that is losing value. Asset values and commodity values are falling.

    Pumping dollars into the system sounds a lot like monetary inflation.

    Whether deflation is a negative or a positive depends on its cause.

    When prices go down because of a market correction, that is a necessary, if unpleasant for some, function signaling mal-investment due to previous stimulation.

    However, if the value of the dollar goes down even more, some things will increase in price, provided those prices were not previously inflated.

    Deflation is a positive provided that it is caused by increasing productivity and not by monetary contraction.

  • ||

    Since when is Robert J. Samuelson an economist?

  • ||

    Despite their glee, the goldbugs are still wrong.

    John,
    Speaking as a certified "goldbug"; First of all I'm not in the least bit gleeful. Believing that the dollar should be on the gold standard hasn't motivated me to hoard gold (though I now have a small pile of silver). But even if I did, gold is still way off it's highs from earlier in the year. The prospect of runaway inflation frightens me greatly. If I'm right and next year inflation hits and gold prices soar, having gold only means you're not loosing as much value as everyone else. But I'd rather be middle class in a vibrant economy than an aristocrat in a feeble one. Inflation is going to hurt everyone, even those who guess right about where to put their savings.

    Second of all, I see nothing in what you've said that contradicts the thesis that we should back our currency with gold.

  • Naga Sadow as Henry Paulson||

    FOOLS!!! All fools!!! This is the time for a bold new experiment! The market is not functioning correctly and old methods don't work anymore! Give me 10 trillion dollars and I will save the economy! (immitates Dr. Evil by lifting pinky to lips)

  • §||

    TANSTAAFL
    There are no such thing as a free lunch? Am?

  • squarooticus||

    http://en.wikipedia.org/wiki/Tanstaafl

    The intarwebs are a wonderful thing, them tubes are.

  • ||

    blockquote>In fact, delfation is even worse than inflation.

    Monetary deflation is no worse than inflation, int he long term. Changes in the money supply, whether natural or artificial, affect different sectors of the economy differently. They affect earlier stages of production first, and consumers last. We see the bad effects of deflation before we see the good effects, which is opposite of inflation. With deflation we see unemployment right off the bat, while under monetary inflation we don't see the price increases until later.

    But in the long run one is no better or worse than the other. How is the scaling back of production under deflation worse than the inevitable bust in production under inflation?

    Setting a small but positive inflation target is good, but only because a small deflation is natural.

    p.s. Just to mollify the goldbugs, I think the gub'ment should get out of the money business altogether, but if it's going to meddle around, I would prefer a firm inflation target than the arbitrary whims we have today.

  • Bingo||

    How about a compromise:

    Uranium instead of gold! Benefits are that you will want to spend it as soon as you get it or you will want put it in a bank... so much for hoarding coins in your house. It increases both consumption and saving! Additionally, economic superpowers become nuclear superpowers - but only if they keep actual reserves on hand. Plus there's the small chance that we all become superheroes every time we grab change from a vending machine.

    Win-Win-Win

  • Naga Sadow||

    But Bingo . . . what are about the children?

  • Bingo||

    Our extra-limbed children will be so much more productive with their additional extremities that we will be able to pay for social security and universal healthcare and as many financial institutions as our heart desires.

  • Naga Sadow||

    I'm with ya Bingo. Though a reorganization of the Justice Department will be necessary. Toddlers running around spreading doom where ever they decide to play. Plus . . . who will handle their radioactive diapers?

  • ||

    "Jack Kemp (D-N.Y.), a Republican supply-sider..."

    I'm confused...

  • Neu Mejican||

    Somehow this made me think of this article at Edge.org*

    http://www.edge.org/3rd_culture/brown08/brown08_index.html

    Be sure to read the comments.

    I liked Douglas Rushkoff's response in particular.

    *I believe this has been posted on H&R previously.

  • Kolohe||

    Bingo-
    The problem with a uranium standard is that it's naturally deflating. Unless you do some sort of uranium-lead bimetalism.

  • ||

    ...I think the gub'ment should get out of the money business altogether...

    The US constitution specifies how the government should be in the money business, and precisely what constitutes money: gold and silver.

  • Jay1||

    Reading the article you forget that Carter was President for the first 2 years of Volker's interest rate hikes.

    Samuelson says that most Presidents wouldn't have accepted Volker's 'plan'....ignores that Carter did just that.

    Revisionist deification of Reagan is a full time job. Keep it up Bob!

  • ||

    Nixon unpegging gold from a fixed price of $35 an ounce.

    How is "price fixing" libertarian?

  • ||

    You can argue that the central bankers are doing a good job and won't inflate too much, a point with which I'd heartily disagree based simply on historical precedent; but that's completely different from dismissing the danger of hyperinflation by saying that currently there is deflation. I mean... duh. Deflation is always the precursor to hyperinflation, the latter of which is purely a central banking phenomenon.

    Squarooticus, my old monetary adversary...

    At least now you are acknowledging deflation as being real and worrisome. Now, the question of whether this inevitably leads to massive government spurred hyperinflation can be properly addressed from a realistic reference frame.

    The only fiat currency inflationary episode under the current system was the 70's. It was effectively quelled by tightening rates. At the time, this was a controversial notion, but no longer. Even when people were still using artificially low (but politically popular) unemployment and the fallacy of the Phillips curve to justify inflation - it didn't get over 20 odd percent. Don't get me wrong, that's BAD. But it's not Zimbabwe bad, or even Turkey bad. And that was when we lacked the political will to fix it, and few people in power understood the cause and the solution. Why do you assume this time will be much much worse?

  • ||

    Brandybuck,

    But in the long run one is no better or worse than the other. How is the scaling back of production under deflation worse than the inevitable bust in production under inflation?

    Deflation as a natural state under a fixed sized currency is not conducive to any type of credit. Say you want to buy a 100,000 house. You borrow your 80k and pay 0% interest. Over the thirty year loan life, you have 3% deflation. Now your house has decreased in value (to around 40k - which will buy the same stuff as 100k did 30 years ago) and you have payed back 80k in dollars that were 3% sucessively harder to earn every year you have paid a 3% real interest rate. This is exactly the same as if you paid 6% interest, with 3% inflation.

    People go around talking about nominal interest rates (0% and 6% in the above example) like they know what they are talking about. Rubbish - the two cases are economically identical. The supply and demand for credit sets the real interest rate given a rational expectation of in/deflation. In a world where 3% deflation was the steady norm and rates were 0%, it's not hard to imagine that people would bake in an assumption that this trend would continue.

    Now here is the problem: Lets say, for whatever reason, that demand for credit went down. Maybe some banks screwed up, maybe there was uncertainty politically, maybe there is a dry spell where few technological innovations occurred. Whatever. Even though the demand for credit should reduce the interest rate banks can charge - it's already at 0%. They cannot reduce it any further, because no lender would consent to lending unencumbered cash for less than a 0% nominal rate of interest - they could always do better in their mattress. Therefore there is a market failure whereby lenders refuse to lend because the market clearing rate is too low (

  • Ken Braun||

    "The US constitution specifies how the government should be in the money business, and precisely what constitutes money: gold and silver."

    This is a popular misconception stoked by some politicians who profess to adhere to the constitution, but don't necessarily read it.

    In fact, the words "gold" and "silver" make just one appearance in the document: Art 1, Sec 10:

    "No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts..."

    And on it goes, laying out several other restrictions on the power of STATES. Not rules for the FEDERAL government, mind you, but rules for the STATES.

    Some powers of the federal government, namely Congress, are detailed just two sections earlier in Art 1, Sec 8. Among those, interestingly, are...

    "To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures..."

    So, Congress has the power not only to create money, but also to regulate what it is worth. Imagine Congress exercising this to the letter and voting on what the dollar should be worth. Wouldn't THAT be neat?

    Instead, by some miracle, the looters decided to create the Fed and delegate a lot of this "money" authority to it. Constitutionally, they could seize the authority back, but they have not done so.

    The results, while they could certainly be improved upon, have hardly been the nightmare that is often portrayed.

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