The F story about the Great Inflation


On his Mainly Macro blog, Simon Wren-Lewis had posted The F story about the Great Inflation. He starts the post by describing the false story.

Here F could stand for folk. The story that is often told by economists to their students goes as follows. After Phillips discovered his curve, which relates inflation to unemployment, Samuelson and Solow in 1960 suggested this implied a trade-off that policymakers could use. They could permanently have a bit less unemployment at the cost of a bit more inflation. Policymakers took up that option, but then could not understand why inflation didn’t just go up a bit, but kept on going up and up. Along came Milton Friedman to the rescue, who in a 1968 presidential address argued that inflation also depended on inflation expectations, which meant the long run Phillips curve was vertical and there was no permanent inflation unemployment trade-off. Policymakers then saw the light, and the steady rise in inflation seen in the 1960s and 1970s came to an end.

As great as the article is, the back and forth commentary may be even better. The comment that I found most compelling was the one by Blissex. I found the initial connection of the inflation to the huge government “global security” oriented spending in the USA a little overwrought. However, on second reading, and thinking about the Vietnam War and what Lyndon Johnson did about guns and butter, I see the connection better.

«If it wasn’t a belief in a long run inflation unemployment trade-off, what was it that allowed inflation to gradually rise during those two decades? Forder has a lot to say on this, but the following is my own take. I think two things were critical: the idea that demand management was primarily designed to achieve full employment, and that full employment had primacy over the objective of price stability.»

And here we have another version of the usual neoliberal story of the completely imaginary “wage-price” spiral of the 70s and 80s, according to which nasty greedy workers pushed up their wages and this caused endogenous price inflation.

The story that is instead apparent from the numbers of the 1960s, 1970s, 1980s is that the great inflation was the product of huge government “global security” oriented spending in the USA, and other factors that caused the USA to switch from a net exporter to a net importer, and the international dollar shortage of the 1940s and 1950s to become slowly a dollar glut, which resulted not many years later in the decision to devalue the dollar by a huge amount, the *symptom* of which was the end of the gold standard.

The huge devaluation of the dollar was in effect a “cram-down”. The oil producers refused to be crammed down and increased massively the price of their product after the dollar devaluation, and the Fed Board decided to “accomodate” the huge exogenous price shock, to avoid undermining the USA government’s global security policy, and this created a massive eurodollar recycling problem.

All this transmitted the cram-down shock wave through the value chain, and unionized workers reacted to sharply rising prices driven by oil and commodity inflation by demanding higher wages, which was temporarily successful. At that point because of the exogenous price shock caused by the falling dollar and oil and commodity producers and unionized workers resisting the cram-down it was creditors and businesses who were forced to take the cram-down as massive losses on existing bond valuation because of increasing nominal interest rates and much reduced profits.

Eventually creditors and businesses fought back and thanks to Volcker and Reagan managed to push the costs of the cram-down onto unionized and non-unionized workers, and debtors, and the cram-down continues today: in the USA median hourly wages have been flat or declining since 1973, and the interest rates have been falling for decades, generating enormous capital gains for creditors.

Most other anglo-american economies just followed the leader, in various particular ways, and most of the world economy was deeply affected.

It was a gigantic price-push shock caused by USA government dollar policy, not
by greedy unions causing wage-push price increases.

The greatness of this article and the ensuing discussion was the raising of the many different events that occurred in the history of the times that had an impact on economies, inflation, wages, and employment. It starts to become so much clearer that trying to focus on one specific cause as opposed to all the others is a fool’s errand. You really have to take everything into consideration at once. Each factor had more or less impact varying with time over the period. If you try to ignore one factor during one period of time, you find that factor to not be ignorable at a different point in time. To think you have a model that works for all time, but does not account for all factors, then you are kidding yourself and others.

This fits quite nicely with my December 14, 2011 post Stop Arguing About Economic Theory And Politics. It also fits with my April 23, 2015 post Constructing Models of the Economy. The discussion of today’s post adds some concrete examples to the abstract discussions in the previous posts.

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