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How the Great Inflation of the 1970s Happened

It's the 1970s, and the stock market is a mess. It has lost nearly 50% over a 20-month period, and for close to a decade few people want anything to do with stocks. Economic growth is weak, which results in rising unemployment that eventually reaches double-digits. 

The easy-money policies of the American central bank—designed to generate full employment by the early 1970s—also resulted in high inflation.  The central bank (once under different leadership) would later reverse its policies, raising interest rates to some 20%—a number once considered usurious. For interest-sensitive industries, such as housing and cars, rising interest rates cause a calamity. With interest rates skyrocketing, many people are priced out of new cars and homes.

Key Takeaways

  • Periods of rapid inflation occur when the prices of goods and services in an economy suddenly rise, eroding the purchasing power of savings.
  • The 1970s saw some of the highest rates of inflation in the United States in recent history, with interest rates rising in turn to nearly 20%.
  • Central bank policy, the abandonment of the gold window, Keynesian economic policy, and market psychology all contributed to this decade of high inflation.

Interest Rate Casualties

This is the gruesome story of the great inflation of the 1970s, which began in late 1972 and didn't end until the early 1980s. In his book, "Stocks for the Long Run: A Guide for Long-Term Growth" (1994), Wharton professor Jeremy Siegel, called it "the greatest failure of American macroeconomic policy in the postwar period."

The great inflation was blamed on oil prices, currency speculators, greedy businessmen, and avaricious union leaders. However, it is clear that monetary policies, which financed massive budget deficits and were supported by political leaders, were the cause. This mess was proof of what Milton Friedman said in his book, Money Mischief: Episodes in Monetary History: Inflation is always "a monetary phenomenon." The great inflation and the recession that followed wrecked many businesses and hurt countless individuals.  Interestingly, John Connally, the Nixon-installed Treasury Secretary who did not have formal economics training, later declared personal bankruptcy.

Yet these unusually bad economic times were preceded by a period in which the economy boomed, or appeared to boom. Many Americans were awed by the temporarily low unemployment and strong growth numbers of 1972.  Therefore, they overwhelmingly re-elected their Republican president, Richard Nixon, and their democratic Congress, in 1972; Nixon, the Congress, and the Federal Reserve eventually ended up failing them.

How and Why

Upon his inauguration in 1969, Nixon inherited a recession from Lyndon Johnson, who had simultaneously spent generously on the Great Society and the Vietnam War. Congress, despite some protests, went along with Nixon and continued to fund the war and increased social welfare spending. In 1972, for example, both Congress and Nixon agreed to a big expansion of Social Security—just in time for the elections.

Nixon came to office as a supposed fiscal conservative. Still, one of his advisors would later classify Nixonomics as "conservative men with liberal ideas." Nixon ran budget deficits, supported an income policy, and eventually announced that he was a Keynesian.   

John Maynard Keynes was an influential British economist of the 1930s and 1940s. He had advocated revolutionary measures: Governments should use countercyclical policies in hard times, running deficits in recessions and depressions. Before Keynes, governments in bad times had generally balanced budgets and waited for badly allocated business investments to liquidate, allowing market forces to bring about a recovery.

Nixon's other economic about-face was imposing wage and price controls in 1971. Again, they seemed to work during the following election year. Later on, however, they would fuel the fires of double-digit inflation. Once they were removed, individuals and businesses tried to make up for lost ground.

Nixon's deficits were also making dollar-holders abroad nervous. There was a run on the dollar, which many foreigners and Americans thought was overvalued. Soon they were proved right. In 1971, Nixon broke the last link to gold, turning the American dollar into a fiat currency. The dollar was devalued, and millions of foreigners holding dollars, including oil barons in the Middle East with tens of millions of petrodollars, saw the value of dollars slashed. 

Winning Elections

Still, President Nixon's primary concern was not dollar holders or deficits or even inflation. He feared another recession. He and others that were running for re-election wanted the economy to boom. The way to do that, Nixon reasoned, was to pressure the Fed for low-interest rates.

Nixon fired Fed Chair William McChesney Martin and installed presidential counselor Arthur Burns as Martin's successor in early 1970. Although the Fed is supposed to be solely dedicated to money creation policies that promote growth without excessive inflation, Burns was quickly taught the political facts of life. Nixon wanted cheap money: low-interest rates that would promote growth in the short-term and make the economy seem strong as voters were casting ballots.

Because I Say So!

In public and private Nixon turned the pressure on Burns. William Greider, in his book, Secrets of the Temple: How the Federal Reserve Runs The Country, reports Nixon as saying: "We'll take inflation if necessary, but we can't take unemployment." The nation eventually had an abundance of both. Burns, and the Fed's Open Market Committee which decided on money creation policies, soon provided cheap money.

The key money creation number, M1, which is total checking deposits, demand deposits, and traveler's checks, went from $228 billion to $249 billion between December 1971 and December 1972, according to Federal Reserve Board numbers. As a matter of comparison, in Martin's last year, the numbers went from $198 billion to $206 billion. The amount of M2 numbers, measuring retail savings and small deposits, rose even more by the end of 1972, from $710 billion to $802 billion.

It worked in the short term. Nixon carried 49 out of 50 states in the election. Democrats easily held Congress. Inflation was in the low single digits, but there was a price to pay in higher inflation after all the election year champagne was figuratively guzzled.

In the winters of 1972 and 1973, Burns began to worry about inflation. In 1973, inflation more than doubled to 8.8%. Later in the decade, it would go to 12%. By 1980, inflation was at 14%.  Was the United States about to become a Weimar Republic? Some actually thought that the great inflation was a good thing.

The Bottom Line

It would take another Fed chair and a brutal policy of tight money—including the acceptance of a recession—before inflation would return to low single digits. But, in the meantime, the U.S. would endure jobless numbers that exceeded 10%. Millions of Americans were angry by the late 1970s and early 1980s.

Yet few remember Burns, who in his memoirs, Reflections of an Economic Policy Maker (1969-1978), blames others for the great inflation without mentioning the disastrous monetary expansion. Nixon doesn't even mention this central bank episode in his memoirs. Many people who remember this terrible era blame it all on the Arab countries and oil pricing. Still, the Wall Street Journal, in reviewing this period in January 1986 said, "OPEC got all the credit for what the U.S. had mainly done to itself."

Article Sources

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