Financial history doesn’t repeat itself, but it tends to rhyme.
In 2008, the kinds of excessive risk-taking and speculation on Wall Street that had sparked the Great Depression in 1929 contributed to another massive global downturn.
Now some economists are voicing concern that 2021 could see a rerun of another economic calamity: the Great Inflation of the 1970s.
For those of us not alive then and who have never lived through a period of debilitating inflation, the fears voiced by baby boomer economists like Larry Summers and Olivier Blanchard that massive price increases could be coming might ring hollow. But their worry, which many economists share, reflects a real history. The Great Inflation, which began in the late 1960s and finally ebbed in the early ’80s, was a genuine calamity that worsened living standards for years.
Understanding the warning that figures like Summers and Blanchard are issuing is important. But equally important is understanding the key differences between what happened in the 1970s and what’s happening today.
Summers, Blanchard, and many mainstream economists have internalized a story about the 1970s Great Inflation, and inflationary phenomena more generally, that informs their outlook.
The story goes like this: President Lyndon B. Johnson spent a lot of money on the war in Vietnam. Wartime spending flooded the economy with money; prices crept up. LBJ’s profligacy — and the Federal Reserve’s willingness to tolerate it — led the whole economy to lose faith in the idea that prices would remain stable. Once everyone expected inflation, it became a self-fulfilling prophecy: because workers expected prices to increase, they demanded higher wages; because businesses expected wages to rise, they raised their prices; and so on, in an ever-escalating “wage-price spiral.”
By the end of the 1970s, the inflation rate was nearing double digits, or even higher, depending on the measure.
The experience came to an end thanks to a new, radical approach by the Federal Reserve. Now, a quick primer on how the Fed affects the economy: Broadly speaking, the Fed is in charge of how much money is circulating in the economy at any given time. If there’s too much money, then you can get inflation; too little might mean low inflation — but that might also mean businesses and households have trouble borrowing money, grinding the economy to a halt.
In 1979, grinding the economy to a halt was the path the Fed chose to take to tame inflation. Paul Volcker, installed as Fed chair by Jimmy Carter that year, raised interest rates, effectively shutting off the money spigot at the Fed, and signaling to markets that more rate hikes would follow until the problem was fixed.
What resulted was a gradual decline in inflation — but also two deep recessions in the early ’80s that drove the unemployment rate to its highest level since the Great Depression. The process worked, Reagan adviser Michael Mussa later said, because the Fed proved it was willing “to spill blood, lots of blood, other people’s blood” to get inflation under control.
That story now looms over the economy today. The high-spending Biden administration and its very cooperative partner in economic policy, Federal Reserve Chair Jerome Powell, feel to inflation-worriers like the story of ’70s inflation repeating itself.
Less than two months into office, Biden signed a $1.9 trillion stimulus bill, much of which went toward $1,400 checks to most Americans. Powell is accommodating this policy by continuing to keep rates near zero and buy up Treasury bonds, effectively financing the stimulus with printed money; moreover, he urged Congress to pursue stimulus during the debate over Biden’s bill, and dismissed concerns this could cause inflation.
With inflation reaching 3.4 percent in May, its highest level in 30 years, worries about a ’70s flashback appear to have some grounding. But there’s good reason to think that this worry of a replay is overblown. New economic research suggests that the story mainstream economics has been telling about the Great Inflation of the ’70s might not be entirely accurate.
The new story looks at other policies and conditions, previously understated in narratives of the period, that could have contributed to the calamity of the ’70s. This story emphasizes specific challenges, like an oil shortage and turmoil in world food markets, that drove the 1970s inflation and that are just not relevant today.
In other words, this time really might be different. And understanding that might help steer policymakers toward novel solutions and away from unnecessarily spilling “other people’s blood.”
The standard story of the Great Inflation of the 1960s and ’70s
Using the Fed’s preferred measure of inflation, we can see that prices began to rise, year over year, more rapidly starting around the mid-1960s.
They fluctuated a bit after a brief recession in 1970, but then surged to great heights, first in 1974-’75 and then at the end of the 1970s. After Volcker’s appointment in 1979, inflation peaked and then plummeted rapidly. It has never exceeded 4 percent on an annual basis again.
The popular story of the Great Inflation holds that it was the result of a chain of policy decisions starting with the budget policies of President Lyndon B. Johnson, particularly the war in Vietnam.
Whereas Johnson paid for some of his domestic priorities, like Medicare, with new taxes, he and Congress were reluctant to raise taxes to pay for the war. That meant that the war — more specifically, money spent on the war — was firing up the economy at a time when it was already growing fast, without taxes doing anything to cool the economy back down. The government was just pumping a lot more money into a private economy that didn’t have much spare capacity, meaning the money could only translate into price increases.
But the conventional story only posits Vietnam as the proximate cause. The truest cause has something to do with a trade-off economists dub the “Phillips curve” (named after economist A.W. Phillips).
In its purest form, the Phillips curve is merely a plot of the unemployment rate against the inflation rate, and it is usually downward sloping: The higher inflation is, the lower unemployment is. Here is an example of a Phillips curve graph from the Federal Reserve Bank of St. Louis:
Essentially, as Brad DeLong argued in his excellent history of the Great Inflation, policymakers in the 1960s thought they could just move leftward on the Phillips curve, to a point with higher inflation and lower unemployment, without much pain.
But they were wrong. Pushing unemployment too low, the story goes, risks not just higher inflation (as the Phillips curve suggests) but accelerating inflation: inflation that grows higher and higher without stopping.
This happens because of expectations: Once it becomes clear the Federal Reserve doesn’t really care about inflation and won’t do much to contain it, businesses and consumers start to expect inflation and plan for it. Workers might demand more money because they know $1,000 today will be worth a lot more than $1,000 a year or even a month from now. Businesses will raise prices for the same reasons.
These dynamics themselves create inflation, in the form of higher wages and prices, which in turn reinforces people’s predictions of inflation in the future, leading to a toxic spiral.
As economists Richard Clarida (now the vice chair of the Fed), Jordi Galí, and Mark Gertler wrote in 2000, under Fed policy of the time, inflation was considered at risk of spiraling out of control “because individuals (correctly) anticipate that the Federal Reserve will accommodate a rise in expected inflation.”
The next turn in this story came with Volcker’s appointment. Volcker raised interest rates dramatically, mostly to signal that the Fed was, in fact, committed to crushing inflation. It would do whatever it took to crack down, up to and including raising interest rates so high that two recessions occurred, in 1980 and 1981-’82.
The policy followed by Volcker and his successor Alan Greenspan, according to Clarida, Galí, and Gertler, killed off the possibility of self-fulfilling cycles spurring inflation. The Volcker policy made it clear that “the Federal Reserve adjusts interest rates sufficiently to stabilize any changes in expected inflation.”
The (assumed) trade-off between unemployment and inflation
These days, economists reject the idea, held by Johnson and his advisers, that you could just increase inflation with little worry about setting off a spiral, and get lower unemployment as a result.
At the center of their thinking is a concept that came to dominate Fed philosophy in recent decades: the NAIRU. That’s the non-accelerating inflation rate of unemployment — or the jobless rate below which economists claim you’ll get the inflation of the 1960s and 1970s all over again.
How does this work? The Congressional Budget Office currently estimates the NAIRU at 4.5 percent for the third quarter of 2021. Under NAIRU-driven policy, the Fed shouldn’t let unemployment, currently at 5.9 percent, go below 4.5 percent, lest it tempt the inflation gods. And the way to do that is to jack up interest rates, like Volcker did.
One reason for concern among the inflation-worriers is that we no longer have a Fed with a NAIRU-driven policy — the Fed under Powell has removed references to NAIRU from its statement of strategy.
The worriers like Blanchard and Summers also are concerned that Biden might be doing what Johnson did, but with economic stimulus and other domestic spending instead of the Vietnam War; that he’s juicing the economy so much that unemployment will swiftly fall below the NAIRU and create an inflationary spiral that can only be ended through a painful economic contraction down the road.
There are two important caveats to the conventional story. One is that you can buy its basic premise — and still think that the actual NAIRU, at least right now, is very, very low, lower than the CBO estimate of 4.5 percent, lower even than the 3 percent rate that supposedly caused problems in the 1970s. That is, the economy can continue to expand at a rapid pace for a long time and push unemployment down to historic lows, all without triggering inflation problems.
Jón Steinsson, a professor at UC Berkeley who, with his co-author Emi Nakamura, has helped make macroeconomics much more empirically grounded, basically thinks that’s the case. He told me that he’s still firmly convinced that inflation expectations matter, and that the Federal Reserve’s credibility matters. But his research leads him to believe that NAIRU could be very low, and that we should be aiming for very low unemployment rates without having to worry about inflationary pressures.
“Whether you look at the 1980s expansion, the 1990s expansion, or the 2010s expansion,” Steinsson told me in a phone call, “the unemployment rate, if you just plot it, it just keeps falling. It keeps falling and falling and falling and it never levels out. Maybe at some point it would, but one view of that is that we’ve just never gotten to the point where we have true full employment.” Indeed, for two years before Covid-19, the US enjoyed unemployment at or below 4 percent without any inflationary problems.
Another caveat to the conventional story is that some economists have suggested the increase in aggregate demand during the 1960s and 1970s that led to the Great Inflation was not due to Vietnam, but at least partially to an obscure rule called Regulation Q that capped interest rates on checking and savings accounts.
In 1965, Q’s cap (then 4 percent) fell below the Federal Reserve’s interest rate for the first time. That meant anyone with money in a checking or savings account was making less than the actual market interest rate — they were losing money.
Economists Itamar Drechsler, Alexi Savov, and Philipp Schnabl argue in a recent paper that this led to a massive outflow of deposits from the banking system. That both increased aggregate demand, by spurring people to spend rather than save their money, and contracted the economy, because fewer deposits meant banks had less money to loan out to businesses. Regulation Q was effectively repealed in 1978 and 1979, with the introduction of Money Market Certificates and Small Saver Certificates, which offered market-rate interest with no caps — and the Great Inflation started to wane soon thereafter.
There are reasons to doubt this story a bit (for one thing, the Great Inflation also occurred in a bunch of other countries that didn’t have Regulation Q), but it matches the timing of the rise and fall in inflation eerily well, and suggests that a repeat of that exact situation is unlikely — Joe Biden is not proposing bringing back Regulation Q.
What if inflation is not about the price of everything, but the prices of a few specific things?
But there’s another major weakness in the conventional story of the 1970s inflation — it doesn’t take some incredibly significant world events around that time very seriously. And if you take those into account, contemporary fears about a return to ’70s-style inflation start to wane.
The 1973 oil embargo, in which Saudi Arabia and allied Arab nations blocked oil exports to the US and some of its allies in retaliation for supporting Israel in the Yom Kippur War, is little more than a side note in the inflation expectations story. Some, like former Fed Chair Ben Bernanke in his earlier academic work with Gertler and Mark Watson, go so far as to argue the embargo mostly mattered because of the Fed’s response to it, which was to sharply raise interest rates (though not as much as Volcker would later on).
But that claim seems unrealistically dismissive of the effects of a brute fact: The price of gas nearly quadrupled between October 1973 and January 1974.
While the oil shock was the most famous supply shock of the period, it was hardly the only one. Commodities of all kinds, from oil to minerals to agriculture products like grain, saw prices boom in the 1970s. And in many cases, these booms were clearly related to supply-side issues, not an inflation in prices caused by consumers with too much to spend. The price of grain, for instance, spiked in part because of a massive drought in the Soviet Union in 1972, which greatly reduced its food output, led it to purchase the US’s entire wheat reserves, and pushed up food prices worldwide.
Skanda Amarnath, executive director of the macroeconomic policy organization Employ America, explains that the baby boom in the US and Europe and the resulting higher population increased demand for these kinds of commodities and goods over the 1960s and ’70s, and supply struggled to catch up in the absence of more investment in capacity expansion.
“The response to these demographic-induced shortages was a breakneck pace of investment in everything from housing to oil wells,” Amarnath told me. “Oil, in particular, takes years of exploration and development to translate initial investment into expanded production capacity.” Eventually that investment would bear fruit and help end shortages — but while those shortages raged, the result could be inflation.
Another supply-side factor was the introduction and withdrawal of President Richard Nixon’s wage and price controls. In 1971, Nixon ended the convertibility of the dollar to gold, which removed a key part of the system that had been stabilizing exchange rates between the US and the rest of the world since World War II. To try to minimize the aftershocks, Nixon imposed mandatory limits on wages and prices from 1971 to 1974. The limits constrained prices a little, temporarily — until they were repealed, which contributed to the 1974 upward spiral of inflation.
Economist Alan Blinder has been arguing for a supply-centered explanation like this since at least 1979, and he and colleague Jeremy Rudd summarized the “supply-side” view well in a 2013 paper.
The Great Inflation, they note, was really two inflations: one between 1972 and 1974, which “can be attributed to three major supply shocks—rising food prices, rising energy prices, and the end of the Nixon wage-price controls program”; and another spike from 1978 to 1980, which reflected food supply limitations, energy prices, and rising mortgage rates. Mortgage interest payments were, until 1983, included in the most-used inflation measure, meaning that when the Fed responded to inflation by raising interest rates — and that policy change in turn caused mortgage rates to rise — this change all on its own increased measured inflation.
A supply-side story for 1970s inflation has markedly different policy implications than the “Volcker shock” of high interest rates meant to shrink the economy. In the counterfactual, instead of shrinking demand and spending so as to meet the lower supply of the period, the government could have actively tried to increase the supply of those scarce goods, as economists like then-American Economic Association president and future Nobelist Lawrence Klein argued in 1978. That could have taken the form of attempts to boost crop yields, or encourage US domestic oil production.
We’ll never know if that would have worked, but it’s a compelling and — in my view — persuasive alternative to the story we’ve been told for decades.
What this revised story of the Great Inflation means for policy in 2021
In the context of 2021, this alternate story implies that Federal Reserve Chair Jerome Powell should not be considering slowing down the economy as a blunt tool to keep prices down. Instead, the federal government should be intervening in specific areas to keep specific types of prices that are rising rapidly from further accelerating.
As my colleagues Emily Stewart and Rani Molla have noted, the biggest price increases affecting “core” non-gas or food inflation in recent months have come from new and used cars and air travel. The Biden Council of Economic Advisers estimates that at least 60 percent of inflation in June was due to car prices alone, and a big chunk of the rest came from services like air travel increasing in price as everyone rushes back to travel post-pandemic.
A huge part of the rise in car prices is a semiconductor shortage — implying that a better way to tackle inflation than the Fed raising interest rates might be an effort to improve supply of semiconductors, including boosting production in the US. Biden’s recent efforts to get Taiwan to boost production for US car companies is exactly the kind of intervention implied by this analysis.
The Fed itself seems to be thinking this way; Powell recently testified to Congress that “supply constraints have been restraining activity in some industries, most notably in the motor vehicle industry, where the worldwide shortage of semiconductors has sharply curtailed production so far this year.” Lael Brainard, an influential member of the Fed’s Board of Governors, has said the same.
“If you do think that this supply side story is convincing, then that does really change the way you want to think about this,” Steinsson told me. “Somebody’s going to build a new semiconductor factory at some point … that gives you a rationale for not using the blunt tool of raising interest rates for the whole economy.”
Yes, inflation is rising, there is a great deal of uncertainty, and the specter of the ’70s looms large. But given how much economic pain was visited on millions in the fight against inflation decades ago, it’s encouraging that today’s policymakers seem more willing to consider the path their predecessors did not take.