Vox Nova at the Library: The Great Inflation and Its Aftermath
Robert Samuelson’s The Great Inflation and Its Aftermath tells the story of America’s battle with double digit inflation in the 1970s. As Samuelson tells the story, in the post-WWII period economists and politicians began to think that they could use the insights of Keynesian economics to fine tune the economy. According to Keynes, there was a fundamental economic trade off between inflation and unemployment. By using its control over the money supply, then, the government could induce a small amount of inflation, which would lead to lower unemployment and hence higher overall output.
The problem was that while inflation did in fact lead to a drop in unemployment, the effect was only temporary. At first an infusion of cash into an economy would boost demand for goods and services and lower interest rates (as people mistook the increase in dollars with an increase in wealth). Eventually, however, people would begin to catch on to what was happening, at which point a higher level of inflation would be needed to achieve the same effect. By the early 1970s, the United States was facing both high unemployment, high interest rates, and high levels of inflation, something which according to standard Keynesian theory should have been impossible.
This presented a serious problem for policy makers. In theory, the Federal Reserve had the power to stop inflation by instituting a tighter monetary policy. Doing this, however, would spark an economic downturn, always a dicey proposition politically, and even more so when unemployment and interest rates were already high. While the Fed made several attempts to curb inflation during the 1970s, each time the economic carnage wrought by its policy caused it to relent, and inflation returned.
The hero of Samuelson’s book is Paul Volcker, Chairman of the Federal Reserve from 1979 to 1987. Volcker, who was appointed to the Fed job by Jimmy Carter almost as an afterthought (the previous Fed Chairman had just been appointed as Carter’s new Treasury Secretary). Instead of following a previous Fed policy of targeting interest rates, Volcker targeted the monetary base. And whereas previous Fed officials had buckled under pressure to abandon anti-inflationary policies when times got bad, Volcker was resolved not to stop such measures too soon. The resulting recession was quite possibly the worst since the Great Depression. Unemployment reached 10.8% in 1982, and the prime interest rate exceeded 21%. By late 1982, however, the economy had begun to recover, beginning one of the longest periods of growth in American history.
President Reagan also comes in for some praise, mainly for leaving Volcker alone. While the Federal Reserve is formally independent, history indicates that in practice it is susceptible to political pressures. Both Lyndon Johnson and particularly Richard Nixon exerted pressure on the Federal Reserve Chair, and succeeded in getting them to adopt a more inflationary policy. Even Volcker’s initial attempt at curbing inflation was thwarted by a President Carter initiative to institute credit controls. Volcker’s actions were understandably unpopular, not alone among Democrats but also among many of Reagan’s supply side supporters (who were and are basically right-wing Keynesians).
The last couple of chapters of the book focus on the state of the economy since the 1980s. You get to learn about Samuelson’s opinions on everything from immigration to global warming, which is all well and good, but bears little relation to the larger narrative that is supposed to be at the heart of the book. Still, I found Samuelson’s treatment to be an informative and often entertaining account of an important episode in American economic history (one which, I hope, will remain solely of historical importance).
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I can’t vouch for this guy getting it right, but the part about the targeting of the monetary base being better than interest rate targeting is a bit off. The targeting of monetary aggregates was abondoned pretty early, and many central banks don’t even report that data today. Why? Technically, money demand is unstable, responds to all kinds of financial innovations and many other things – in practice, this means there is no clear relationship between the money supply and inflation (except in the very long term, and I’m talking 7-10 year horizons here).
The bid issue is expectations. I hope Samuelson gets the story right. What happened is the naive Phillips curve (PC) – the reltionship between inflation and unemployment – breaks down pretty easily. Milton Friedman and Ned Phelps developed the expectations-augmented PC (this is what got Milton his Nobel, that and the permanent income hypothesis, not the free market quackery). I’m not going to explain all this now, but this is where we got the whole idea of central bank credibility and the whole inflation targeting framework. Basically it says that if people expect higher inflation, this gets reflected in wage contracts and the relationship with unemployment breaks down.
But if expectations are stable, the PC is stable, and central banks can get inflation – unemployment trade offs. This is the idea behind inflation targeting, something Bernanke is fond of. This is where the notion of central bank credibility comes from — of you believe the CB will deliver a certain inflation rate, you get a good outcome with lower ifnlation and lower unemploymkent.
Back to Volcker. Volcker had the bad luck to lead the Fed at a time when there was no credibility. Policymakers in the 1970s made the fatal mistake of responding to a supply shock (oil prices) nu increasing demand, which is NOT something Keynes would have supported. Thre result was stagflation. Inflation expectations were through the roof. And there was no credibility. If you have no credibility, it becomes incredibly painful to wring inflation out of the system — big recession, high unemployment etc. A Catch 22. But Volcker did it anyway, and – textbook style – it was very painful. The lesson learned from this was that if you had credibility, you could get inflation down at muhc lower cost. It changed central banking and monetary policy.
One final point: the much-touted Reagan boom was in reality a cyclical rebound from the Volcker recession. It was entirely unrelated to his “supply-side” policies as productivity did not change at all.
You’re right about expectations playing a key role. This is a part of Samuelson’s story, and I apologize if it didn’t come through in my summary (I knew I would leave something important out).