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.

Robert J. Samuelson from the January 2009 issue

(Page 3 of 4)

How Inflation Was Subdued

The subjugation of inflation was principally the accomplishment of two men: Paul Volcker and Ronald Reagan. If either had been absent, the story would have unfolded differently and, from our present perspective, less favorably. Reagan, president from 1981 to 1989, and Volcker, chairman of the Federal Reserve Board from 1979 to 1987, forged an accidental alliance that was largely unspoken, impersonal, and misunderstood. There was no particular personal chemistry between the men. Nor was there any explicit bargain—you do this, and I’ll do that. Although Reagan supported Volcker, many officials in his administration openly criticized him. Even while the alliance flourished, it sometimes seemed a mirage.

But the alliance was genuine, a compact of conviction. Both men believed that high inflation was shredding the fabric of the economy and of American society. The country could not thrive if it persisted. Buttressed by these beliefs, they broke with the past. Each had a role to play, and each played it somewhat independently of the other.

Volcker took a sledgehammer to inflationary expectations. He raised interest rates, tightened credit, and triggered the most punishing economic slump since the 1930s. In December 1980, banks’ “prime rate” (the loan rate for the worthiest business borrowers) hit a record 21.5 percent. Mortgage and bond rates rose in concert. By the summer of 1981, consumers had trouble borrowing for homes and cars. Many companies couldn’t borrow for new investment. Industrial production dropped 12 percent from mid-1981 until late 1982. In many industries, declines were steeper. In autos, it was 34 percent (from June 1981 to January 1982), and in steel it was 56 percent (from August 1981 to December 1982). By 1982 the number of business failures had tripled from 1979. Construction starts of new homes in 1982 were 40 percent below the 1979 level. Worse, unemployment exploded. By late 1982, it was 10.8 percent, which remains a post–World War II record.

It is doubtful that, aside from Reagan, any other potential president would have let the Fed proceed unchallenged. Certainly Carter wouldn’t have, had he been re-elected, nor would his chief Democratic rival, Sen. Edward M. Kennedy (D-Mass.). Both would have faced intense pressures from the party’s faithful, led by unionized workers—especially auto- and steelworkers—who were big victims of Volcker’s austerity. Nor is it likely that any of the major Republican presidential contenders in 1980 would have acquiesced, including George H.W. Bush, Howard Baker, and John Connally. Reagan’s initial economic program promised to reduce the money supply to curb inflation. He was the first president to make that part of his agenda, and he never retreated from it. As the economy deteriorated, he kept quiet. He refused to criticize Volcker publicly, to urge a lowering of interest rates, or to work behind the scenes to bring that about.

When the president did speak, he supported Volcker. At a press conference on February 18, 1982—with unemployment near 9 percent—Reagan called inflation “our No. 1 enemy” and referred to fears that “the Federal Reserve Board will revert to the inflationary monetary policies of the past.” The president pledged that this wouldn’t happen. “I have met with Chairman Volcker several times during the past year,” he said. “We met again earlier this week. I have confidence in the announced policies of the Federal Reserve.” Reagan’s patience enabled the Federal Reserve to maintain a punishing and increasingly unpopular policy long enough to alter inflationary psychology.

There was an outpouring of bills and resolutions to impeach Volcker, roll back interest rates, or require the appointment of new Fed governors sympathetic to farmers, workers, consumers, and small businesses. Rep. Jack Kemp (D-N.Y.), a prominent Republican “supply-sider,” wanted Volcker to resign. In August 1982, Sen. Robert C. Byrd of West Virginia, the Democratic floor leader, introduced the Balanced Monetary Policy Act of 1982, which would have forced the Fed to reduce interest rates.

Reagan’s popularity ratings collapsed. In May 1981, early in his presidency, Reagan’s approval had reached a high of 68 percent. By April 1982, it was 45 percent (46 percent disapproved); by January 1983, it was 35 percent, the low point (56 percent disapproved). As the economy sank, Reagan was advancing an economic program of across-the-board tax cuts, widely portrayed as favoring the rich, and spending cuts, widely portrayed as hurting the poor. He was portrayed as spearheading an economic assault against ordinary Americans.

On inflation, Reagan was clear-eyed. “Unlike some of his predecessors, he had a strong visceral aversion to inflation,” Volcker later said. Reagan was “influenced by people like Milton Friedman and understood that inflation was always a monetary phenomenon,” that it was “too much money chasing too few goods,” said William Niskanen, a member of Reagan’s Council of Economic Advisers. “He was the first president who understood that.…He knew that controlling inflation by regulation [controls] was absurd.”

Even now, the social costs of controlling inflation seem horrendous. Over a four-year period (1979–82), the U.S. economy’s output barely increased. It nudged ahead in the first two years and then fell back in the last two. Since 1950, there had been nothing like that. Unemployment peaked in 1982 near 11 percent—a figure that, a few years earlier, would have been widely judged inconceivable. Although lower inflation benefited most people, the casualties were numerous and broadly dispersed geographically and socially: small business owners, overextended farmers, industrial workers. The number of business failures in 1982 (24,908) was nearly 50 percent higher than in any other year since World War II, and it would double to 52,078 by 1984. From 1979 to 1983, farm income declined almost 50 percent.

But against these heartbreaking costs, there were larger long-term gains. Once the recession lifted, the economy and productivity growth revived impressively. When Reagan left office, Americans still worried about inflation, but it no longer gripped them with fear. Inflation was one problem among many, not a scourge shredding the social fabric. The taming of inflation reinvigorated the economy as nothing else; the expansion lasted from early 1983 until the late summer of 1990. At the time, it was the second longest peacetime expansion in U.S. history.

The Volcker-Reagan campaign discredited many of the ideas that had misgoverned national economic policy for nearly two decades. The notion that the Federal Reserve couldn’t control inflation was discredited. The notion that a little less unemployment could be exchanged for a little more inflation was discredited. In their place, a consensus slowly developed that “price stability”—a vague term that both Volcker and his successor, Alan Greenspan, defined as inflation so low that it barely affected people’s decisions—was desirable and would promote a more stable and productive economy.

The Forgotten Crisis

One of the dilemmas of a democratic society is how to take actions that, though immediately painful and unpopular, seem essential to the society’s long-term well-being. Coping with double-digit inflation posed precisely this problem. Any realistic program was bound to hurt millions of Americans, almost all innocent victims. This was so obvious that in the late 1970s a frontal assault on inflation seemed impossible.

What Volcker and Reagan wrought now seems ancient history: an isolated episode with little relevance to our present condition. This is utterly wrong. For every nation, there are crucial demarcation points that fundamentally alter society. The greatest of these for the United States was the Civil War. The Great Depression and World War II created another massive chasm. In our era, the fall of double-digit inflation is one of those separation points, though on a smaller scale—a gorge, not a canyon. Something profound and pervasive occurred: what I call the restoration of capitalism. Much of what we now consider routine and normal originated in the tumultuous transition from high to low inflation.

Comments

|12.18.08 @ 12:23PM|#

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.

|12.18.08 @ 12:26PM|#

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|12.18.08 @ 12:28PM|#

Prosperity in our time!

Erm|12.18.08 @ 12:39PM|#

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

|12.18.08 @ 12:54PM|#

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?

|12.18.08 @ 12:59PM|#

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.

|12.18.08 @ 1:06PM|#

How did Dorothy get home?

squarooticus|12.18.08 @ 1:08PM|#

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.

|12.18.08 @ 1:09PM|#

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.

|12.18.08 @ 1:12PM|#

"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|12.18.08 @ 1:15PM|#

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.

|12.18.08 @ 1:15PM|#

How did Dorothy get home?

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

|12.18.08 @ 1:22PM|#

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.

squarooticus|12.18.08 @ 1:27PM|#

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|12.18.08 @ 1:35PM|#

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.

|12.18.08 @ 1:38PM|#

Since when is Robert J. Samuelson an economist?

|12.18.08 @ 2:09PM|#

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|12.18.08 @ 2:19PM|#

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)

§|12.18.08 @ 2:20PM|#

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

squarooticus|12.18.08 @ 2:22PM|#

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

The intarwebs are a wonderful thing, them tubes are.

|12.18.08 @ 2:24PM|#

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|12.18.08 @ 2:27PM|#

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|12.18.08 @ 2:29PM|#

But Bingo . . . what are about the children?

Bingo|12.18.08 @ 2:32PM|#

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|12.18.08 @ 2:49PM|#

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?

|12.18.08 @ 3:09PM|#

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

I'm confused...

Neu Mejican|12.18.08 @ 3:18PM|#

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|12.18.08 @ 3:52PM|#

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

|12.18.08 @ 3:59PM|#

...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|12.18.08 @ 4:58PM|#

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!

|12.18.08 @ 5:19PM|#

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

How is "price fixing" libertarian?

|12.18.08 @ 5:31PM|#

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?

|12.18.08 @ 6:02PM|#

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|12.20.08 @ 1:23AM|#

"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.