To better understand the U.S. economy right now, read history rather than economics or Wall Street punditry. But don’t just focus on market crashes or recessions. Instead, examine the most important Post-World War II trauma, the “great inflation.”
The 1929 crash and ensuing Great Depression have been examined to death, by John Kenneth Galbraith, Anna Schwartz and Milton Friedman (in their 1963 Monetary History of the United States); Ben Bernanke (before he became chairman of the Federal Reserve); and others. The current consensus is that while the causes of the Depression were complex, bad monetary policy was a key factor.
Few historians have focused on the inflation that started in the mid-1960s. By 1984, the average price level was 3.4 times what it had been in 1965. During the Civil War, federal issuance of paper money had caused prices to spike. But we had never before experienced a long-term, apparently inexorable rise in prices during peacetime.
Moreover, as inflation worsened, output stagnated and unemployment rose. This contradicted the prevailing Keynesian view that inflation and recession were opposite ends of a pendulum. You could suffer one or the other, but not both simultaneously.
Allan Meltzer, the Carnegie-Mellon economist who became the dean of monetarism at Friedman’s death, is adding to our understanding with a detailed history of the Federal Reserve.
Meltzer’s account of the great inflation is sobering. There is plenty of blame to spread around.
Politicians in both parties, but especially presidents Johnson and Nixon, wanted the impossible. Johnson wanted to maintain high levels of Cold War spending, to sharply increase spending on poverty-reduction programs and to fight the Vietnam War, all without higher taxes or interest rates.
Nixon sought to use Keynesian policies for overtly political purposes, pumping up the economy with new spending before elections while reminding Fed Chair Arthur Burns that inflation never cost anyone an election. Nixon’s cynicism was particularly marked in 1972, since he had imposed wage and price controls that held down measured inflation while deficit spending stoked the economy.
The Federal Reserve had unclear priorities and a muddled understanding of the causes of inflation. Economists in academia and government gave conflicting advice, but most were infatuated with a simple Keynesian model that urged government micromanagement of the economy with budget deficits and changes in the money supply. Most hung onto their beliefs even as inflation and unemployment both grew in the 1970s.
It is easy to look back now and wonder why all the actors were so blind. It is sobering to think of how our children eventually may judge us when they look back on 2008.
Meltzer’s concise summary, “Origins of the Great Inflation,” from the St. Louis Fed’s Review of March-April 2005, is available online at research.stlouisfed.org/publications/review/05/03/part2/Meltzer.pdf.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.