The “Great Inflation” Arrives

Abstract

Overlapping with the latter part of the very gradual demise of gold-backed or gold-pegged monetary systems, the so-called Great Inflation was one of the defining macroeconomic period of the second half of the twentieth century in the US (and, by extension, of the rest of the world). Usually dated as having lasted from 1965 to 1982—albeit initial signs of an inflationary acceleration were already observable as of the early 1960s, it ultimately led to (another) revision of global monetary policy frameworks. Given the centrality of the US dollar to the global monetary system, and the large share of US GDP in global terms, this chapter will initially describe this process with a US focus, later covering other economies.

3.1 The “Great Inflation” and Domestic US Policies

Overlapping with the latter part of the very gradual demise of gold-backed or gold-pegged monetary systems, the so-called Great Inflation was one of the defining macroeconomic period of the second half of the twentieth century in the US (and, by extension, of the rest of the world). Usually dated as having lasted from 1965 to 1982—albeit initial signs of an inflationary acceleration were already observable as of the early 1960s, it ultimately led to (another) revision of global monetary policy frameworks. Given the centrality of the US dollar to the global monetary system, and the large share of US GDP in global terms, this chapter will initially describe this process with a US focus, later covering other economies.

While Chap. 2 described the policy mistakes and external framework and constraints for monetary policy due to the usage of gold-derivate monetary systems, inflationary pressures in the US were also linked to purely domestic economic policy choices and their direct and indirect effects on price dynamics and monetary policy: those would lead US inflation to go from below 1% pa (per annum) in 1959 to almost 14% in 1984 (Fig. 3.1).

Fig. 3.1

US CPI inflation, eoy. (Source: US Bureau of Economic Analysis [BEA])

But let’s start with a little more on the history of the US institutional framework for monetary policy. As said previously, the Federal Reserve, a US federal body, was only created in 1913, after a series of bank panics in 1873, 1884, 1890, 1893 and finally 1907 (when a single private citizen, namely, J. P. Morgan, used its personal resources to stabilize the whole US financial system)¹ made apparent the need of a “central bank”, for example, a body to assure financial and banking stability (as the US was then still under the gold standard, the automatic mechanism of that system determined price dynamics, see Annex 2.A), which happened with the “Federal Reserve Act” of 1913²: this parallels the large expansion of Government powers in many different areas throughout the 20th Century. Importantly, the Fed was created as a “system” of largely autonomous regional “reserve banks” that would be coordinated by a secretariat-like body, based in Washington, DC.

After the initial bouts of large Great Depression–related institutional changes mentioned earlier, the Fed would experience further major changes with the “Employment Act” of 1946, which still largely defines its current institutional features: namely, this act declared it a responsibility of the US federal government “to promote maximum employment” (beyond price and financial stability), which is the basis for the Fed somewhat unusual “dual mandate” (only in 1977 the US Congress actually amended the original Fed 1913 Act with the so-called Humphrey-Hawkins Act specifying explicit unemployment and inflation goals: this is the formal basis for the Fed dual mandate).

Now, the dominant economic policy framework used in most market economies—including the US, since the Great Depression was the active management of the business cycle by fiscal policies (usually referred to as Keynesian policies, in a reference to John Maynard—Baron—Keynes and his “opus magnum”, and which provide one of the key analytical justifications for the expansion of Government powers in the economic arena mentioned above).³ One of the erroneous assumption of those policies was that there exists a stable “Phillips curve”⁴ that could be exploited to deliver the dual mandate of maximum unemployment and price stability. However, the empirical observation of increasing inflation mentioned above led to two separate but almost simultaneous analytical breakthroughs by US economists Edmund Phelps and Milton Friedman, who explained this dynamics via the embedding of expectations into the behavior of economic agents.⁵ Therefore, mistakenly attempting to exploit an incorrectly assumed lack of trade-off between unemployment (“managed” largely via fiscal-side Keynesian policies) and prices would ultimately lead to inflationary spirals. Crucially, for this to happen, one would need accommodative policies by a monetary authority.

How did it actually happen? First, US government expenditures increased constantly, from around a quarter to a third of US GDP,⁶ between the early 1960s and the early 1980s (while receipts remained largely constant: Fig. 3.2).

Fig. 3.2

Total US Government expenditures and receipts (% of GDP). (Source: US Office of Management and Budget [OMB])

It is worthwhile to point out that these developments were largely driven by a very significant expansion of social policies (and not by military expenditures, even as the US was involved in major military operations in Northeast and Southeast Asia from the 1950s till mid-1970s): from 1960 to 1980, expenditures with social policies in the US increase by a factor of 12 in nominal US dollars, roughly doubling as a share of government expenditures and reaching over 53% of the total (Fig. 3.3).⁷

Fig. 3.3

Total US Government military and social expenditures ($ billions). Source: OMB *This aggregate budget item includes education, training, employment, social services, health, Medicare, income and social security programs.

As Phelps and Friedman could have said, it takes two to tango: faced with these fiscal developments, the US monetary authority openly pursued a deliberately accommodative behavior, formalized in the so-called even-keel policy, which effectively meant not rising rates as not to disrupt the (now larger and more frequent) issuance of US federal debt necessary to finance those bigger fiscal expenditures.⁸

3.2 External Price Shocks

Added to this domestic policy developments (and choices) were the effects of two external energy price shocks caused by actions of major oil-producing countries in the Middle East.⁹ The first one started from an oil export embargo that began in October 1973 by the members of the Organization of Arab Petroleum Exporting Countries (OAPEC, the forebear of OPEC), initially targeted at the nations that had supported Israel during the Yom Kippur War (which was fought that year between Israel and a coalition of Arab states)—for example, Canada, Japan, the Netherlands, the UK and the US: the upshot was that between 1972 and 1974 average global oil prices increased by a factor of 6. This was followed by a second oil price shock in 1979, this one brought about by the so-called Iranian revolution, where the Imperial State of Iran was replaced by the theocratic Islamic Republic of Iran, which further increased oil prices by a factor of 3. As a result, between 1972 and 1980 nominal oil prices grew over 20 times (Fig. 3.4). These were truly global shocks, with inflationary implications throughout the world (Annex 3.A).

The fiscal policy actions of the US government described in Sect. 3.1 were what economists would now call a “demand side” shock, which resulted from policies that created a level of demand in excess of what the economy could supply—an apparent case for a straightforward non-accommodative monetary policy stance. However, if oil price shocks were interpreted as global exogenous “supply shocks”, those could present a more complex analytical case, especially in the case of a monetary authority with a dual mandate¹⁰: namely, as global supply shocks, they reflected one-off changes in relative prices outside of the control of monetary authority, so a case could potentially be made for policy inaction (or “looking through”), while, on the other hand, potential long-lasting increases in unemployment resulting from these relative price changes could call for a more accommodative response, but, however, second-round effects in terms of wages and price increases could suggest a non-accommodative policy (so, to the further distress of former US President Harry Truman, who once famously clamored for a one-handed economist, this central banking advisor unfortunately had three).

Fig. 3.4

Crude oil, average ($/barrel). (Source: World Bank)

3.3 Domestic US Monetary Policy Responses

Leaving aside those admittedly complex analytical considerations, the US Federal Reserve policy choice was to expand money supply, ultimately leading to an inflationary spiral (while, incidentally—dixit Phelps and Friedman—failing to reduce unemployment). This happened notably during the Chairmanships of William McChesney Martin Jr., who remained as Chairman of the Federal Reserve for almost 20 years, from 1951 to 1970, and of Arthur Burns (of business cycle fame, as described earlier), Chairman of the Federal Reserve from 1970 to 1978.

Martin¹¹ (who famously would frequently make a point of saying “I am not an economist”), while a fiscal conservative who understood the needs of stable money and external balance, did not follow formal models to guide policy actions: the same is true in general for the Fed Board secretariat and its Members, the district Governors.¹² A tendency to short-term “data dependency” on potentially random movements and a lack of reflection on how their short-term decisions related to the Fed long-term aims compounded the earlier largely atheoretical approach.¹³ Finally, governance frameworks, namely, Martin’s belief in the importance of coordinating Fed actions with the US Government—mainly the Treasury and the President’s office, leading to a progressively overriding importance of the “maximum employment” component of the Fed’s 1946 Employment Act dual mandate (Martin’s prized policy coordination became “one sided”, that is, the US President and its Treasury expected the Fed to coordinate its actions with theirs, but not necessarily the other way around…).¹⁴ Ultimately, the combination of those three elements, especially notable during the final five years of Martin’s mandate (e.g., 1965–1970) led to the start of the Great Inflation (and the run on the US dollar that led to the ultimate collapse of the Bretton Woods system).¹⁵

How the “Great Inflation” continued (and grew…) after starting is a different but related story. Burns became Chairman of the Fed in February 1970, and he was the first economist to hold that position (and a distinguished one at that). However, as a policy maker in this function, he was notable for his effective adherence to “maximum employment” as the main mandate of the US monetary authority and for a seemingly limited concern with the independence of the central bank.¹⁶ Contrary to Martin’s atheoretical approach, Burns, like the “New Economics” group, also did have a model for assessing monetary policy actions, albeit one that also reflected his personal and political beliefs and that unfortunately was incorrect: the same Keynesian model based on a stable “Phillips curve”. This, among other things, led him to interpret the energy price shocks (endogenous or exogenous) not as one-off relative price adjustments but as causing long-lasting unemployment increases that “needed” to be counteracted.

The eventual (in the US English usage of the word, therefore as a process “ultimately resulting” in an outcome, and not as a probabilistic, possible result) consequence was that economic agents of all types now expected prices to continue to increase and adjusted their behavior accordingly (in central bank lingo, their inflation expectations had become “unanchored”). So, a prolonged and significant domestic fiscal expansion and large and persistent external price shocks were both consistently accommodated by US monetary policy decisions, resulting in changes in agents’ expectations: with this, the “Great Inflation” was now in full swing.

Annex 3.A Was the “Great Inflation” Global?

Yes, to a degree, at least when it comes to the (global…) oil price shocks, be those endogenous or exogenous: to show that, the graph below compares the CPI dynamics in the US with the other developed economies of the OECD and developing regions for the period 1970–1983 (Fig. 3.5).

Fig. 3.5

CPI in different regions of the world. (Sources: OECD and World Bank)

As one can see, the price increases linked to the two global oil price shocks are indeed largely common among the depicted countries/regions, both Developed and Developing ones. However, there are important differences on the persistence of the shock: for instance, in Germany—where the (then west) German monetary authority, the Deutsche Bundesbank, run a more non-accommodative policy, with the result that the effects of the price shocks were considerably more muted¹⁷—and in Japan,¹⁸ where, after a punctual jump during the first oil shock, inflation was speedily brought under control (additionally, one must remember that both these countries are much more dependent on energy imports than the US was or is).

Also noteworthy is the continued increase of inflation in some Developing regions, and notably in Latin America and the Caribbean after the oil price shocks. This is another significant observation that points to the importance of specific regional/national dynamics, and will be elaborated on in Chap. 4, which discusses the so-called Great Moderation.