A Martian assesses the Great Inflation of the 1970s

At the Federal Reserve conference in Jackson Hole this week, all the attention was on inflation. Chairman Jerome Powell appeared to have moved the markets when his comments on silver coincided with a 1,000 point decline by Dow Jones Industrialists.

Inflation of around 8.5% is now the highest the United States has seen in 40 years since the last Great Inflation spurt of the 1970s and 1980s. inflation was regularly 8.5%, while it did not reach the double digits, including in 1974 and for three consecutive years, 1979-81.

Today we learn that central bankers have learned the lesson of the 1970s, how the central bank determined how not to repeat the mistakes of the Great Inflation era and fix the problem quickly today. The difficulty with this view lies in its premise: the Federal Reserve was responsible, in large part, for the inflation that worsened around 1973 or around 1973. The idea that the Federal Reserve controls the level of prices is rather strange.

The first, rather insurmountable, problem is that it assumes that the Federal Reserve determines the money supply. Fischer Black rather definitely refuted this argument in the heat of the moment in the early 1970s (showing that the economy, not a central bank, creates money), but the signs are everywhere. The Eurodollar market alone is enough to destroy any ability of the Federal Reserve to control monetary quantities or interest rates or anything like that in the United States.

The biggest problem concerns intellectual curiosity. The great Robert L. Bartley, editor of the the wall street journal editorial page at the time, liked to break up the confusion by assuming a Man from Mars. What would a Martian, a complete stranger uninfected by conventional wisdom, say about what changed monetarily in the 1970s?

The answer would surely be that the world has changed its monetary regime. Prior to 1971-73 (when the change occurred), the world had fixed exchange rates, with the dollar exchangeable for gold at the various global monetary authorities at a set historical price, $35 an ounce.

After the switchover from 1971 to 1973, all major currencies floated and gold lost its official role. Inflation, which had begun as these developments progressed rapidly, reached unprecedented heights in peacetime. Exchange rate markets, a backwater under fixity, have absorbed huge sums of global capital, rising 10-12% per year for the duration of the total currency rotation. The dollar fell, as did the pound, as islands of stability and strength, including the German mark and the Japanese yen, were identified in the process.

Suppliers of goods and services looked at monetary matters and said to hold it. Vendors wouldn’t part with real stuff for now indefinite cash for foreign alternatives let alone gold. Commodity sellers demanded more money, now that the value of money was indeterminate. Then came consumer price inflation.

No oil shock, no Federal Reserve mismanagement, no wage-price spiral, no neglect to raise taxes to calm the economy – none of those workhorse arguments about the causes of the Great Inflation. You make an epic shift in the monetary regime – particularly away from the classic arrangements – and the markets will choose to hold money only at a discount, at least until the new order proves its worth.

This happened in the 1980s, when tax rate cuts affecting mostly the incomes of the investor class increased the rate of return on dollar-denominated assets. Boom – money poured from currency hedges into real investments, and inflation rose and ran away. The shift has been around $10 trillion in current dollars – without misprint – into dollar value vulnerable financial assets.

The Federal Reserve, with the help of its punditry cheerleaders, took credit for the unceremonious permanent reduction in inflation, which began less than two years after Ronald Reagan’s presidency. As I wrote recently in my book at that time, The emergence of Arthur Laffer: the foundations of supply-side economics in Chicago and Washington, 1966-1976“if Fischer Black was right, Paul Volcker had nothing to do with the story.”

Why the resurgence today? In the 2010s, when Janet Yellen was Treasury Secretary, she was effectively aiming for a stable gold price, and then Donald Trump, as candidate and president, publicly flattered the gold standard. Cryptocurrency was on the rise. There was a general feeling that some kind of classic ersatz monetary reform that could retire floating fiat currencies was underway.

Then came not only the explosion of government pandemic spending, but a new administration atavistic in its hostility to arrangements like those of the pre-1971 world and crypto to boot. Moreover, the fiduciary bank’s fundamental asset, US Treasury debt, began to far exceed that banking system’s demand for new issues. There had been reason to hope under the fires of Obama and Trump that officials would allow markets to explore avenues of monetary reform. This is not the case under Joe Biden. And inflation came, much like in the 1970s.

NB: My new bookwritten with Arthur B. Laffer and Jeanne Sinquefield, Taxes Have Consequences: A History of Income Tax in the United Stateswill be released in September.

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