The Great Inflation and Its Aftermath

Robert J. Samuelson, “The Great Inflation And Its Aftermath” (The Past and Future Of American Affluence), Random House, 2008, 258 Pages

The Great Inflation refers roughly to the period from the mid-1960s to the early 1980s, when inflation was rising from negligible to double-digit levels. Samuelson clearly describes how our entire financial system is built on the premise of low inflation and that a deviation from this premise will always severely disrupt the structure.

The bad guys in Samuelson’s tale is a group of intellectuals who came into power with the Kennedy administration. Samuelson claims JFK had sound economic instincts but he was seduced by his chief economic adviser, Walter Heller, who argued that more rational management of the economy would produce permanently higher growth. “Heller was an aggressive salesman for what ultimately became known as the ‘new economics,’ and he was supported by most academic economists of the time. (This is kind of like blaming the Vietnam war on McNamara).

At the heart of the “new economics” was a concept called the Phillips Curve, which summarized the trade-off between unemployment and inflation. The idea was that an economy could experience very low unemployment and high inflation, or very high unemployment and low inflation, or any combination therein. Heller persuaded Kennedy to accept higher inflation in exchange for more jobs.

It worked for a time. The economy flourished; inflation inched up only marginally. But as the Kennedy administration became the Johnson administration became Nixon became Carter, growth stagnated and inflation skyrocketed. It was clear that, over the long term, the government could no more trade “a little inflation” for sustained growth than a drug addict could use “a little heroin” for a sustained high. Achieving the same economic payoff required ever more stimulus. Some presidents struggled to control their addictions, while others didn’t even try. “Nixon frequently reminded Burns,” Samuelson writes, referring to Arthur Burns, then the chairman of the Federal Reserve Board, that the president’s political fortunes depended heavily on the Fed’s ability to increase economic growth.”

What the new economists didn’t realize was that inflation accelerates: workers demand raises to keep up with higher ¬prices; companies raise prices to keep up with rising wages; the process spirals upward. The only way to break the cycle is with a deep recession, which creates vast surpluses of goods and labor. Companies with lots of inventory eventually lower prices. High unemployment makes ¬workers less pushy.

Which is essentially what happened in the early 1980s. Between 1980 and 1982, Paul Volcker, the Federal Reserve chairman, raised interest rates so abruptly he knocked the economy out cold. Ronald Reagan’s support of Volcker was probably the most courageous political act of the twentieth century. When the nation emerged from the long, dark night, its inflation habit had been kicked. The upshot, according to Samuelson, was a quarter-century of nearly uninterrupted prosperity.

Samuelson’s story is incomplete. Over the last decade, American policy makers — Alan Greenspan chief among them — came under the sway of the same old song: the belief that rational economic management could avert the pain of unemployment. And yet, the same problems Samuelson diagnoses in an earlier generation he almost com¬pletely ignores today. I suspect that even though this book was published in 2008, he had it completed earlier and just went ahead with publication as he did not see the cliff we were already going over.

It seems unfair to skewer Walter Heller and not Alan Greenspan.

My Notes:

Pg. 4: Stable prices provide a sense of security. They help define a reliable social and political order. They are like safe streets, clean drinking water and dependable electricity. Their importance is noticed only when they go missing. When they went missing in the 1970s, it was a deeply disturbing and disillusioning experience that eroded Americans’ confidence in their future and their leaders. And high inflation caused the stock market to stagnate—the Dow Jones Industrial Average was no higher in 1982 than in 1965—and led to a series of debt crises that afflicted American farmers, the U.S. savings and loan industry and developing countries.

Pg. 11: the 1970s double-digit inflation was not an act of nature or a random accident. It was the federal government’s greatest domestic policy blunder since WWII: 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 by making it worse.

Pg. 33: The S&L crisis is typically cat as a tale of inept government regulation and corrupt lending. S&Ls squandered their funds on ill-conceived housing projects, shopping malls and resorts. But the main story involves inflation’s destructiveness. By 1981, 85% of thrifts were unprofitable. As short-term interest rates rose, they faced a dilemma: either raise their own deposit rates, which might make them unprofitable, or face a huge outflow f deposits, which would make them insolvent. The advent of money-market mutual funds in the late 1970s rendered government interest-rate ceilings on deposits at banks and S&Ls ineffective; savers could move their money elsewhere. Only after S&Ls faced this squeeze did inept regulation and lending mushroom. Government liberalized S&Ls’ lending authority in the hope that ;profits on new loans for commercial real estate would offset losses on old mortgages’ but speculative new loans simply compounded the losses. The S&L’s collapse cost taxpayers about $160 billion—the difference between what depositors (protected by federal deposit insurance) were owed and what the failed S&Ls’ assets were worth.

Pg. 37: From the Great Depression until the 1980s, much of the financial system was highly compartmentalized. Lending was dominated by banks and S&Ls, which provided most home mortgages and consumer and business loans. (Only blue-chip companies could raise capital by selling bonds; other firms borrowed from banks.) But inflation destroyed some of this system the S&Ls) and damaged much of the rest (commercial banks—they suffered losses on bad loans to farmers, energy companies, real estate developers and developing countries). New ways had to be found to provide credit. What emerged was “securitization.” Because banks and the few surviving S&Ls had limited funds, they—and others—increasingly originated loans but then bundled them into bondlike securities that were sold to pension funds, insurance companies, mutual funds, college endowments and other big investors. Thus were home mortgages, auto loans, credit-card debt and other types of loans increasingly financed. Now lenders and borrowers were widely separated and the lenders did not have to care if the borrower could or would repay the loan as long as they could bundle and sell it quickly enough.

Pg. 76: It was Milton Friedman who popularized the argument that inflation “is always and everywhere a monetary phenomenon in the sense that it can be produced only by a more rapid increase in the quantity of money than in (economic) output.” Friedman’s dictum merely restates the classical quantity theory of money, so his dictum is nothing new. In the 1950s, money-supply growth of 23% mainly accommodated the needs of an expanding economy. By contrast, growth was 44% in the 1960s and 78% in the 1970s. Inflation worsened accordingly. The Fed had stepped hard on the monetary brake in 1966, 1969 and 1974. Unfortunately, the initial effects were a slower economy and higher unemployment—cardinal sins in the new political climate. So each time the Fed had relented too quickly before inflation was broken, bowing to criticism from Congress and the administration. The Employment Act of 1946 required maximum employment. Defeating inflation required a new political environment.

Pg. 84: In many ways, the history of money is an unending tension between creating trust and pursuing other goals—paying armies; mediating between debtors and creditors; promoting economic growth and regulating business cycles—that may erode trust.

Pg. 101: Through its history, the Fed had made many small errors but only two major blunders. The first was permitting the Great Depression; the second was fostering the Great Inflation. Both ultimately stemmed from mistaken ideas that informed the intellectual and political climate and, thereby, the Fed’s policies.

Recommedations for the future beginning pg. 227:
1. Control inflation between 0% and 2%. Employment levels have to be allowed to
fall where they may.
2. Stem the welfare state’s mounting costs:
a. Gradually raise eligibility ages or Social Security and Medicare to age seventy
b. Trim Social Security benefits for the affluent
c. Affluent pay higher co-pays, etc for Medicare
3. Globalization is not going away, we must find ways to deal with it.
4. We need to be candid about global warming. With present technologies—which can
change—not much can be done. India and China will more than cancel out anything
the West can do.