A Martian Assesses The Great 1970s Inflation

At the Federal Reserve conference in Jackson Hole this week, all attention was on inflation. Chair Jerome Powell seemed to have moved the markets when his tight-money comments coincided with a 1000-point drop in the Dow industrials.

Inflation of some 8.5 percent is now the highest the United States has seen in 40 years—since the last burst of the Great Inflation of the 1970s and 1980s. That was when inflation was regularly 8.5 percent, when not well into the double digits, including in 1974 and in three consecutive years, 1979-81.

Today we hear that central bankers have learned the lesson of the 1970s—of how central banking has determined how not to repeat the mistakes of the Great Inflation era and solve the problem in short order today. The difficulty with this view is its premise: the Federal Reserve was responsible, in some good part, for the inflation that got big on or about 1973. The notion that the Federal Reserve controls the price level is passing strange.

The first problem, rather insurmountable, is that it assumes that the Federal Reserve determines the supply of money. Fischer Black rather definitively disproved this argument in the heat of the moment in the early 1970s (showing that the economy, not some 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 greater problem concerns intellectual curiosity. The great Robert L. Bartley, editor of the Wall Street Journal editorial page back in that time, liked to cut through confusion by assuming a Man from Mars. What would a Martian, a complete outsider uninfected with the conventional wisdom, say about what changed monetarily in the 1970s?

Surely the answer would be that the world switched its monetary regime. Prior to 1971-73 (when the switch happened), the world had been on fixed exchange rates, with the dollar redeemable in gold to the various global monetary authorities at a set historical price, $35 per ounce.

After the 1971-73 switchover, all the major currencies floated, and gold lost its official role. Inflation, which had begun while these developments proceeded apace, took off to unprecedented peacetime heights. The exchange rate markets, a backwater under fixity, soaked in tremendous sums of global capital, growing by 10-12 percent per annum for the duration in total currency turnover. The dollar tanked, as did the pound, as islands of stability and strength including the Deutsch mark and Japanese yen were identified in the process.

The suppliers of goods and services looked at the currency questions and said hold it. Suppliers would not part with real stuff for money now undefined against foreign alternatives let alone gold. The sellers of wares demanded more cash, now that the value of money was indeterminate. On came consumer price inflation.

No oil shock, no Federal Reserve mismanagement, no wage-price spiral, no neglect to increase taxes to cool off the economy—none of these warhorse arguments about the causes of the Great Inflation. You make an epic switch in the monetary regime—specifically away from classical arrangements—and the markets will choose to hold money only at a discount, at least until the new order proves its worth.

That happened in the 1980s, when tax-rate cuts affecting above all the income of the investor class increased the rate of return of dollar-denominated assets. Boom—money poured out of the currency hedges into real investments, and inflation up and fled. The shift was some $10 trillion in current dollars—no misprint—into dollar-value-vulnerable financial assets.

The Federal Reserve, with the help of its cheerleaders in punditry, took credit for the unceremonious permanent abatement of inflation, which began not two years into Ronald Reagan’s presidency. As I wrote recently in my book on this era, The Emergence of Arthur Laffer: The Foundations of Supply-Side Economics in Chicago and Washington, 1966-1976, “if Fischer Black was right at all, Paul Volcker was irrelevant to history.”

Why the recrudescence today? In the 2010s, when Janet Yellen was treasury secretary, she effectively targeted a stable price of gold, and then Donald Trump as candidate and president flattered the gold standard publicly. Cryptocurrency was on the rise. There was a general sense that some kind of ersatz classical monetary reform that could retire floating fiat currencies was underway.

Then came not just the pandemic blowout government spending, but a new administration atavistic in its hostility to the arrangements like those of the pre-1971 world and crypto to boot. Moreover, the fundamental asset in fiat banking, U.S. treasury debt, began to far outstrip in new issuance the demand of that banking system. There had been reason to hope, under late Obama and Trump, that officials would permit the markets to explore avenues of monetary reform. Not so under Joe Biden. And on came inflation—rather like in the 1970s.

N.B.: My new book, written with Arthur B. Laffer and Jeanne Sinquefield, Taxes Have Consequences: An Income Tax History of the United States, will be released in September.