What Causes Inflation? Lessons from the 1970s, Vol. 3

The definition of inflation in your first economics course is simple: "Too much money chasing too few goods." You might restate it as "an increasing amount of money chasing a fixed amount of goods," but the point is that when the quantity of money in an economy is increasing faster than its output, the result is inflation. As my previous two posts have shown, that's what happened in the 1970s, big time. And it's what some economists fear may be happening again today, as the money supply balloons from the various fiscal stimulus and bank bailout programs.

In addition to the "too much money" definition, there is another explanation called "cost-push inflation," where businesses have to charge more for their goods because of some general increase in costs. Many people who lived through the 1970s associate high inflation with sharply higher oil prices, due to an embargo on Arab oil in 1973.

But the oil theory is a myth, observes economics writer Robert Samuelson in his excellent book The Great Inflation and Its Aftermath.

It's ... true that oil aggravated inflation, but the real reason for oil's outsized role in the inflation story is that it scarred the American psyche.... From September 1973 to January 1974, the office price of Saudi Arabian oil went from $2.59 to $11.65 a barrel.

Comparing the total CPI to the index with energy costs excluded, it's clear that oil made inflation worse, but most certainly wasn't its sole cause:

According to Samuelson, the inflation of the 1970s resulted when the U.S. government tried too hard to eliminate the business cycle.

The U.S. economy was strong immediately after WWII, and the three recessions of the 1950s were mild, at least compared to the Depression. Government economists came to believe that they could keep the economy at perpetual full employment by stimulating when things got slow, and raising taxes and interest rates when the economy overheated -- as manifested in higher inflation.

But in 1966, 1969, and 1974, when the Federal Reserve appropriately tightened monetary policy and the economy stalled, politicians and the public were not happy, and the Fed caved in too early on the inflation fight. Compared to a 23 percent increase in the money supply that funded the prosperous 1950s, the Fed allowed money to expand 44 percent in the 1960s and 78 percent in the 1970s. Samuelson writes:

The real villains, claimed [Fed chairman Arthur] Burns, were "philosophic and political currents" that created inflationary pressures. Defeating inflation required a new "political environment."

Should we fear soaring inflation from today's stimulus package? Consider again the historical record, courtesy of Grant's Interest Rate Observer. The Roosevelt administration spent about eight percent of GDP to fight the Great Depression; to counteract the subsequent 10 postwar recessions, combined fiscal and monetary measures have averaged 2.9 percent of GDP. The stimuli adjacent to the Great Inflation of the 1970s were on the generous side, coming in at 2.7 percent to deal with the mild 1969-1970 recession, and 4.0 percent for the deep 1973-1975 slump.

The actions announced so far for the current recession, Grant's calculates, amount to 18.0 percent in monetary measures, and 11.9 percent in fiscal stimulus, for a total of about 30 percent of GDP. On top of that there are backstops, guarantees and investment programs that could make up another 60 percent of GDP.

Grant's adds:

This recession of ours is not so severe by GDP shrinkage alone. It is, however, off the charts in financial dislocation as well as federal intervention. And we expect that, some day, it will prove to be a record-setter in the unintended consequences of the government policies it called forth.

Skipping down to the bottom line, we renew our doubts as to the staying power of paper currencies and to the creditworthiness of the governments that print them.