I’ve been befuddled about this for a while. The widespread belief is that government deficit spending caused the inflation of the sixties, seventies, and early eighties.
But:
• Government debt as a percent of GDP was steadily declining until 1981.
and
• Government debt/GDP started to soar in the early eighties (for the first time since WWII), even as the inflation rate plummeted.
How to explain that? Thanks once again to Jazzbumpa, I found an answer in Alan Meltzer’s “Origins of the Great Inflation” (PDF). Meltzer offers a much more complex and nuanced view than I can impart here, but the crux very much answers the conundrum above.
In the sixties:
1. Treasuries were not auctioned.
2. The Fed was not really independent, and
3. The Fed governors by their own admission didn’t understand or much care about monetary theory. (Hence their instructions to the Manager of the System Open Market Account — who actually implements the policy — were vague to the point of uselessness, i.e. “maintain the tone and feel of the market.” !!)
The Treasury set the price of new issues, and the Fed had to issue reserves to banks to support that price, holding interest rates constant. (If that didn’t suffice, the Fed just bought the unsold issues.)
As those new issues became more frequent (and larger) with greater deficit spending (an absolute increase, not as a percent of GDP), the Fed had less and less days when it could raise interest rates (withdraw reserves) to control inflation. They were slaves to the fiscal deficit.
That all changed when:
1. The Treasury started auctioning its issues, and
2. The Fed got independent — adjusting reserves/interest rates based not on a need to support Treasury sales (because treasuries were auctioned), but on a (reasonably) coherent and effective theory of monetary policy.
Here is what for me is Meltzer’s key paragraph on what started and ended The Great Inflation, referring to William McChesney Martin Jr., Chairman of the Board of Governors 1951-70 (bold mine; italic his):
Some of his successors showed that inflation could be reduced even in a period with large deficits. In the 1980s, the federal government ran large, persistent deficits. The Federal Reserve had an independent policy, did not assist in deficit finance, and did not coordinate policy. The important operating changes were the end of the Federal Reserve’s even-keel policy of holding interest rates constant when the Treasury sold notes or bonds and the end of policy coordination as practiced in the 1960s. By the 1980s, the Treasury auctioned its securities and let the market price them instead of having the Treasury set a price that the Federal Reserve felt bound to support.
I’m not befuddled anymore. This makes perfect sense to me.
And — if declining debt/GDP throughout the 60s and 70s wasn’t enough — it also drives a spike through the standard belief that government deficits caused The Great Inflation. As is so often the case — especially with Tea-Party-esque beliefs — that belief is both childishly simplistic and profoundly wrong.
To quote Milton Friedman, “Inflation is always and everywhere a monetary [not a fiscal] phenomenon.”
Comments
10 responses to “What Caused The Great Inflation, ’65-’83?”
David Beckworth pointed me to Meltzer’s paper, which I’ve only started to read.
http://macromarketmusings.blogspot.com/2011/01/picture-is-worth-thousand-words.html
You have extracted real meat from Meltzer. Interstingly, David emphasizes unanchored expactations during that time, and Melter – a visiting scholar at the American Enterprise Institute (!?!) – begins with a gratuitous swipe at Keyensinism, continues with a little Valentine to St. Ronnie of Budgetbusteria, and blames the inflation on poor policy choices. I’m therefore skeptical of his objectivity.
What you have gleaned seems pretty mechanical, though Fed and Treasury actions do reflect policy.
Volker gets popular credit for slaying the inflation dragon. Do you think that is warranted?
Cheers!
JzB
Also, Meltzer says this, which I relate to expectations:
The Gallup organization repeatedly asked
respondents to state what they regarded as the
most important problem facing the country. Data
from the beginning of 1970, when annual CPI
inflation reached 6 percent, show that only 14
percent named inflation or “the high cost of
living†as one of the most important problems.
The percentage rose and fell with reported
inflation in the 1970s. It did not remain persistently
above 50 percent and as high as 70 percent
until 1980-81.
Unless I’m misunderstanding, significant public expectations of high inflation didn’t kick in until close to the end game. (Pure Elliott, by the way.)
Cheers!
JzB
Don’t forget about the use of a gold standard under Bretton Woods which underpinned all of this.
it also drives a spike through the standard belief that government deficits caused The Great Inflation.
It technically did, but only because of the monetary framework and circumstances that existed at the time.
@jazzbumpa Yes, I think Volcker gets full credit. He shut the tap, caused a recession, and got inflation under control. Then in late ’83 he started opening the tap (with expectations of more), and the economy — including the unemployment rate — turned around *within months.* (Krugman has pointed this out over and over.)
Also he actually understood and cared about monetary theory, which according to Meltzer his predecessors didn’t.
A stunning display of the power and leverage of well-executed monetary policy, especially when rates are high (inflation/real interest/nominal interest — I haven’t figured out which one or which combination really matters in giving oomph to monetary policy.)
Fiscal policy truly is the weak sister when it comes to moving the economy, at least in the near term. But: 1. when rates are at/near zero and capacity is seriously underutilized, it’s all you’ve got — monetary policy is pushing on a string at that point, and 2. the real advantage of fiscal policy in that situation is it can give monetary policy its moxie back. Spend a lot, hopefully inflation and interest rates will go up, and the Fed can start doing what it’s supposed to do.
Yes, Meltzer takes glancing swipes at Keynesianism, etc., but they’re not terribly full-throated. Like he can’t resist, but doesn’t really have his heart (or analytical mind) in it.
Yes the ultimate cause of the inflation was arguably deficit spending, but the proximate cause was the Fed’s mis-management of that. Interesting situation — where if you remove the proximate cause (bad monetary policy/management), the ultimate cause (fiscal policy) has no effect. That’s what happened in the ’80s.
But: 1. when rates are at/near zero and capacity is seriously underutilized, it’s all you’ve got — monetary policy is pushing on a string at that point, and 2. the real advantage of fiscal policy in that situation is it can give monetary policy its moxie back. Spend a lot, hopefully inflation and interest rates will go up, and the Fed can start doing what it’s supposed to do
I couldn’t agree more. The problem is do you honestly think these knuckle heads that are about to take over the budget are going to pursue a spending/deficit, inflationary policy? Quite the opposite, I’m afraid. Be very afraid…
Like nanute, I’m afraid, and actually quite pessimistic.
Steve:
Yes the ultimate cause of the inflation was arguably deficit spending, .
I can’t buy it as the ultimate cause, when in both before and after periods, there is absolutely no relationship or even correlation between deficits and inflation. I’ll link this post again.
http://jazzbumpa.blogspot.com/2011/01/of-deficits-and-inflation-part-3.html
This really just casts the uniqueness of the 1950 (or more narrowly ’65)-80 period in bold relief.
Cheers!
JzB
Jazzbumpa: >I can’t buy it as the ultimate cause
Actually on reconsideration you’re right. Lousy monetary policy was the cause — its failure to deal with the economy effectively, fed deficits being one of many pieces.
@Asymptosis
I think you may have proximate and ultimate causes reversed.
Personally, I question deficit spending’s effectiveness a) this late in the game and b) after a major credit bubble. A lot of demand arguably should not have existed in the first place.
If you look at the following table of historical oil prices
http://inflationdata.com/inflation/inflation_rate/historical_oil_prices_table.asp
you will see that after years of stability between ’72 and ’76 oil prices more than tripled. This was Nixon’s last term, finished out by Ford. You might remember Nixon’s wage and price controls and Ford’s WIN buttons aimed at the inflation caused by this oil spike which was, in turn, caused by turmoil in the middle east.
During Carter’s term oil more than doubled, again due to the middle east. Carter was (unfairly, I think) blamed for the inflation spike caused by this jump in oil. The two inflation spikes during this time period (’72-’80) correspond precisely (with appropriate delays) to the oil price jumps. Carter’s response was to tell people to wear sweaters and turn down the heat which has been ridiculed ever since. More importantly and seemingly now forgotten he got CAFE standards for auto efficiency and requirements for appliance efficiency (those little yellow tags in new refrigerators, microwaves, washers and dryers and such) introduced. Also attention was given to building efficiency improvements. These programs had the effect of actually reducing foreign oil imports into the US for a number of years with corresponding reductions in oil prices and in inflation thus performing a nearly impossible feat: making Reagan look like a genius.
This was how it happened. I’m an old fart and saw it all first hand. Deficit schmeficit. In that time frame it was all about oil.
A good 2012 to all.
Dick