FRBSF Economic Letter
98-14; May 1, 1998
The Shadow of the Great Depression and the Inflation of the 1970s
The inflation of the 1970s was a time when uncertainty about prices
made every business decision a speculation on monetary policy. During
that decade, the annual U.S. inflation rate rose in the 5-10% range, compared
to a 0-3% range typical of peacetime America.
If you asked a representative sample of economists why there is inflation,
many would refer you to Kydland and Prescott (1977). They argue that higher
than desirable inflation springs from the inability of central bankers
to commit themselves to low-inflation policies. Central banks benefit
when workers, firms, and investors have confidence that inflation will
be low; but they also benefit--production is higher and unemployment is
lower--when inflation turns out to be a little bit higher than expected.
Thus workers, firms, and investors lack complete confidence in declarations
that policy is to keep inflation low.
But this explains why inflation might be higher than desirable in
general. It does not explain why inflation would be higher than desirable
for one particular decade--the 1970s--while remaining low in the surrounding
decades of the 1950s, the 1960s, the 1980s, and the 1990s.
Thus, it is necessary to look elsewhere, and looking elsewhere leads
to the conclusion that the inflation of the 1970s had three causes, depending
on how deeply one wishes to look at the underlying situation. (These issues
and more detail on the history of the period are in DeLong 1997.)
At the first surface level, the U.S. had a burst of inflation in the
1970s because until the 1980s no influential policymakers--until Paul
Volcker became Chairman of the Federal Reserve-placed a sufficiently high
priority on stopping inflation; other goals took precedence. At the second
deeper level, the U.S. had a burst of inflation in the 1970s because economic
policymakers during the 1960s dealt their successors a bad hand. And bad
cards coupled with bad luck made inflation in the 1970s worse than anyone
expected it might be. At the third level, the most profound cause of the
inflation of the 1970s was the shadow cast by the Great Depression-an
event that made it impossible for a while to believe that the business
cycle was a fluctuation around, rather than a shortfall below,
potential output and employment. Only after the experiences of the 1970s
were policymakers persuaded that the minimum sustainable rate of unemployment
attainable by macroeconomic policy was relatively high, and that the costs-at
least the political costs-of even moderately high one-digit inflation
were high as well.
Inflation reduction: A low
priority
By the end of the 1960s, the U.S. had finished its experiment to see
if it was possible to push unemployment below 4% without accelerating
inflation. The answer was "no." Nonfarm nominal wage growth
had fluctuated around or below 4% per year between the end of the Korean
War and the mid-1960s, and by 1968 it was more than 6% and rising.
Could U.S. monetary policy have responded to rising wage inflation at
the end of the 1960s, and ended the inflation of the 1970s before it started?
At a technical level, yes. For example, Germany managed it: Germany's
inflation peaked at the very beginning of the 1970s, at which point the
Bundesbank made inflation reduction its first priority; by the mid-1970s,
its cyclical peak was lower than the 1971 peak, and the early 1980s peak
is invisible.
But in the U.S. there were obstacles. One was Richard Nixon, who was
wary of policies to reduce inflation at the potential cost of higher unemployment.
Nixon attributed his defeat in 1960 to Eisenhower's unwillingness to stimulate
employment at the risk of increasing inflation (Nixon 1962). Thus, during
his presidency he authorized his labor secretary to declare that his administration
would "control inflation without a rise of unemployment" (Stein
1984).
A second obstacle was that Federal Reserve Chair Arthur Burns was skeptical
about the value of using monetary policy to control inflation in the postwar
era. In Burns (1960), he noted that "During the postwar recessions
the average level of prices in wholesale and consumer markets has declined
little or not at all," and he cited several factors-including a sharp
rise in long-term interest rates and an "abnormally low" yield
on stocks relative to bonds-that appeared to be "symptoms of a continuation
of inflationary expectations or pressures." Before World War II such
inflationary expectations and pressures would have been erased by a severe
recession and by the pressure put on workers' wages and manufacturers'
prices by falling aggregate demand. But Burns could not see how such pressures
to moderate wage increases could be generated in the postwar world in
which workers and firms rationally expected recessions to be short and
shallow.
Third, there was no political support anywhere else for a policy of
reducing inflation first. Congressional Republicans did not call for more
aggressive fights against inflation. And Democrats complained that the
Nixon administration policy was too contractionary.
Indeed, only with the acceleration of inflation at the end of the 1970s
did political sentiment begin to shift. By the time Paul Volcker became
Chairman of the Federal Reserve, inflation reduction-rather than full
employment-had become the highest priority. The Volcker-led Fed quickly
signaled its intention to place first priority on controlling inflation
by shifting its operating procedures to place a greater emphasis on money
supply targets.
Bad luck during the 1970s
On top of the unwillingness to give inflation reduction high priority
came bad luck. Alan Blinder (1982) has argued that double-digit inflation
in the 1970s had a single cause: supply shocks that sharply increased
the nominal prices of a few categories of goods. But those in the monetarist
tradition never found this explanation convincing. As Milton Friedman
(1975) said: "The special conditions that drove up the price of oil
and food required purchasers to spend more on them, leaving them less
to spend on other items. Did that not force other prices to go down, or
to rise less rapidly than otherwise? Why should the average level
of prices be affected significantly by changes in the price of some things
relative to others?"
Ball and Mankiw (1995) believe the missing link is to be found in menu-cost
models of aggregate supply. Firms and workers adjust their prices and
wages to large economic changes, but ignore small ones because it is not
worthwhile to figure out how to respond to them. Thus, a concentrated
sharp increase in the nominal prices of a few commodities produces a much
larger effect on the average level of prices and inflation than a more
diffused increase in the nominal prices of money commodities.
But U.S. inflation in the 1970s was not solely the result of supply
shocks. Taking the rate of wage inflation at the start of the 1970s and
adding the effects of the 1970s productivity slowdown on the difference
between wage and price inflation gives a baseline price inflation rate
of 7% per year at the end of the 1970s without including any persistent
effect of supply shocks. The contribution of bad luck during the 1970s
is less than the contribution of the situation at the start of the decade.
The shadow of the Great Depression
It is not enough to explain the inflation of the 1970s to say that the
U.S. economy had bad luck during the 1970s, that the political consensus
to support a policy of inflation reduction did not exist until the very
end of the 1970s, and that economic policymakers in the 1960s dealt their
successors a bad hand. The questions remain: Why did the political consensus
to reduce inflation not exist until the end of the 1970s? And why did
makers of economic policy during the 1960s watch with little concern as
inflation crept upward, and as expectations of rising rates of price inflation
became embedded in labor contracts and firm operating procedures?
The source of these attitudes and frames of mind is, in a strong sense,
the most profound cause of the inflation of the 1970s. And that source
is the shadow cast by the Great Depression. The extraordinarily high unemployment
of the Great Depression made it very difficult to believe that the business
cycle was a fluctuation around a growing level of potential output and
sustainable employment. Instead, the Great Depression created a strong
presumption that business cycles were shortfalls below potential output
and sustainable employment. In the context of the Great Depression, it
seemed absurd to take the average level of capacity utilization or unemployment
achieved as a measure of the economy's sustainable productive potential.
In the shadow of the Great Depression, economists thought of fiscal
and monetary policy in terms of "closing the gap" between actual
and potential output, not in terms of moderating fluctuations around some
long-run trend. But how were makers of fiscal and monetary policy to know
when they had "closed the gap" and attained the maximum sustainable
level of employment and capacity utilization? Neither economic theory
nor economic history gave guidance, so there was a strong tendency to
rely on hope and optimism.
Thus, in the early 1960s, economists as prominent as Paul Samuelson
and Robert Solow (1960) could write of a 4% "interim" target
for the unemployment rate that should be achieved. Moreover, they saw
no reason that the "final" target for unemployment might not
be even lower. The hope that unemployment could be pushed lower than the
U.S. economy had ever achieved before without producing unacceptable consequences
for the rate of inflation was reinforced by A.W. Phillips's study of inflation
and unemployment in the United Kingdom late 1950s. This "Phillips
curve" appeared to show a stable, unchanging relationship between
inflation and unemployment.
The temptation to believe that Phillips's results were robust and could
be generalized was very strong. The average level of capacity utilization
and the unemployment rate were not guides to the long-run sustainable
level, so there was an overwhelming temptation to "close the gap"--to
see if unemployment could not be pushed even lower and capacity utilization
higher. Politicians and their advisors had very strong incentives to believe
that the Phillips curve taught that unemployment below 4% could be sustained
indefinitely. Only the experience of the end of the 1960s and 1970s--when
attempts to sustain low unemployment generated strongly accelerating inflation,
as Milton Friedman (1968) had predicted it would--could change people's
minds.
Thus there is a strong sense that something like the inflation of the
1970s was nearly inevitable. Had macroeconomic policy been less stimulative
in the 1960s, and had inflation been lower at the end of that decade,
there still would have been calls for increasing efforts to reduce
unemployment in the 1970s.
Only after the experiences of the 1970s were policymakers persuaded
that the flaws and frictions in American labor markets made it unwise
to try to use stimulative macroeconomic policies to push the unemployment
rate down to a very low level and to hold it there.
J. Bradford DeLong
Associate Professor, U.C. Berkeley
and Visiting Scholar, FRBSF
References
Ball, Laurence, and N. Gregory Mankiw. 1995. "Relative Price Changes
as Aggregate Supply Shocks." Quarterly Journal of Economics
110, pp. 161-193.
Blinder, Alan. 1982. "The Anatomy of Double-Digit Inflation in
the 1970s." In Inflation: Causes and Effects, ed. R.E. Hall,
pp. 261-282. Chicago: University of Chicago Press.
Burns, Arthur. 1960. "Progress towards Economic Stability."
American Economic Review 50, pp. 1-19.
DeLong, J. Bradford. 1997. "America's Peacetime Inflation: The
1970s." In Reducing Inflation: Motivation and Strategy, eds.
Christina Romer and David Romer. Chicago: University of Chicago Press.
Friedman, Milton. 1975. "Perspectives on Inflation." Newsweek
(June 24) p. 73.
. 1968. "The Role of Monetary Policy." American Economic
Review 58 (1) pp. 1-17.
Kydland, Finn, and Edward Prescott. 1977. "Rules Rather Than Discretion:
The Inconsistency of Optimal Plans." Journal of Political Economy
87 (June) pp. 473-492.
Nixon, Richard. 1962. Six Crises. New York: Doubleday.
Samuelson, Paul, and Robert Solow. 1960. "Analytical Foundations
of Anti-Inflation Policy." American Economic Review 50 (May)
pp. 185-197.
Stein, Herbert. 1984. Presidential Economics. New York: Simon
and Schuster.
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