The Great Inflation

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In his book, The Great Inflation And Its Aftermath, Robert J. Samuelson paints in the broadest strokes (and I mean the very broadest strokes) the economic history of the United States from 1960 until the onset of the Great Recession circa 2007.

Samuelson’s number one achievement with the book (hopefully) is to have chiseled the phrase “The Great Inflation” into the phrase-book of history.

Samuelson does not delve very deeply into the industrial and financial practices of the period he covers, but he does clearly state his disagreement with the normal telling of the economic story of the late 20th century.

In the normal version of events, according to Samuelson, the high inflation of the 1970s is attributed to two fundamental causes:  1) the costs of the Vietnam War, plus  2) the surge in oil prices.  He does not stress as number 3) the costs of the Great Society programs began in the 1960s, but we could include that in the standard story as well.

Samuelson calls this version of the 1970s American economy a “myth.”  Instead of war and oil driving inflation, he squarely puts the blame on the policies of the Federal Reserve, policies that resulted in an overly expanded money supply.  According to Samuelson, the root cause of rising prices throughout the Seventies was simply, to borrow the oft-used expression:  too much money chasing too few goods.   

Whatever the cause of the high inflation, Samuelson blames it for the simultaneous rise in interest rates during the period.  According to classical economic theory, high inflation induces banks to raise interest rates in order to compensate for the likelihood that the dollars paid back to them will not be worth as much as the dollars they lent out.

Samuelson also blames high inflation for the stagnating stock market of the 1970s.  He points out that the value of the Dow Jones Industrial Average (one of the major measures of general stock market trends) was “no higher in 1982 than in 1965.”  He explains that stock prices were pressured downward so that their yields (such as dividend payments) would stay competitive with the yields offered by the rising interest rates offered in the bond market.  As the standard ECON 101 argument goes:  when investors see the interest-return on bonds go up, they will shift away from stock purchases and into bond purchases.

Personally, I’ve never had an over-abundance of faith in this scenario.  I feel like investors understand the impact inflation has on the “real” rate of return on their investments.  Therefore, they will take inflation into account when choosing their investment vehicles.  For instance:  investors may see bonds suddenly offering 12% interest payments to purchasers; however, if investors believe inflation will be rising at 10%, then they will factor that in and realize that their “real” rate of return will only be 2%.  Maybe stocks don’t look so bad after all.

Furthermore, if bond interest rates ever start looking too good, investors will flood the market, thus putting downward pressure on the rates (the bond-issuers don’t have to try so hard to entice investors when everybody’s wanting a piece of the action).  Additionally, in a time during which the value of money is falling (inflation), the price of stocks will feel some of the same pressure to rise-just-to-stay-in-place as would milk, or shoes, or other priced items in the economy.

Therefore, I think it is misleading to directly blame rising interest rates for a stagnating stock market.  Deeper factors are in play, factors affecting the confidence investors feel in the upcoming economic performance of stock-selling companies.

Addressing the psychological angle of inflation, Samuelson believes that “high inflation is an enormous disruptive force” in people’s lives, whereas stable prices “provide a sense of security” and “help define a reliable social and political order.”  He compares stable prices to other important features of modern civilization, such as “safe streets, clean drinking water, and dependable electricity.”

Samuelson goes so far as to describe the high inflation of the 1970s as “a deeply disturbing and disillusioning experience that eroded Americans’ confidence in their future and their leaders.”

The “Great Inflation” abated in the early 1980s –due largely to a tighter-money stance taken by a Federal Reserve led by new chairman Paul Volcker.  Samuelson credits this return to price stabilization with the general prosperity which flowed for the next quarter-century.

Once the Great Inflation was over, not only did Americans go on a long-delayed “shopping spree,” but the invigorated American economy, according to Samuelson, led to a global re-emergence of Capitalism and the rise of globalization.  Samuelson suggests that capitalism would not have emerged as the 21st century’s dominate method for the production and distribution of goods and services if the crippling inflation and interest rates of the Seventies had continued riding its back. (This of course leads one to wonder –if the Great Inflation had continued– would the Soviet Union still have crumbled? would communism still have fizzled as a global force?)

[Gosh, there’s also the whole train of thought here about American adventurism in Iraq:  if we had not suffered the oil price “shocks” of the 1970s and the severe economic downturn we (rightly or wrongly) ascribe to them, would we have been so frightened of Iraq’s invasion of Kuwait in 1990?  And if our strength had not returned as it had by the 1990s, could we have put together that fateful international coalition that supported our successful attempt to drive him out?  The permutations of an alternate reality including a never-ending Great Inflation could fill a book at least…]

Samuelson believes that the history books are wrong when they do not emphasize the impact of the Great Inflation and the post-Great-Inflation re-stabilization of prices.  He considers the whole four-decade episode of an importance ranking with major social movements or large scale wars.

Samuelson tries to cobble-on to his story of the Great Inflation the subsequent tale of the Great Recession that began circa 2007.  This is the least successful part of his book.  It undercuts the narrative Samuelson wishes to construct about the Great Inflation.  In his narrative, prices are generally stable in the aftermath of the Great Inflation, thus leading to a healthy, revitalized capitalism that, more or less, takes over the world.

However, the story of the Great Recession runs along a different track.  It is a story not about disinflationary prices, but sky-rocketing prices.  In this story, the prices of homes and stocks rise and rise and rise, as if in a hot air balloon destined for the moon, a balloon over-heated by greed and speculative fury until at last it bursts, and we all fall down.

During what Samuelson describes as the “speculative excesses” of the early 2000s, Americans spent a greater portion of their current incomes and saved less.  When current income proved insufficient for Americans’ ravenous appetite for more-more-MORE, a borrowing and mortgaging frenzy began, and our trade deficits with certain other nations began to rise.

I think the book Samuelson wanted to write was one giving an economic-historical account of the last forty years or so of the 1900s.  During that period, generally inflationary prices and high interest rates dominated the first two decades, and low inflation and low interest rates dominated the last two.  But instead of sticking to this narrative, Samuelson felt the need to extend his story through the beginning of the Great Recession in 2007, and I think this extension muddles the more unified, complete, and elegant story at the heart of his endeavor.

Nevertheless, I agree with him that the “Great Inflation” deserves a prominent place in any history book to be written about the twentieth century.

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